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FRM Part I · FRM Exam Part I · Enterprise Risk Management and Future Trends

A bank calculates economic capital for credit, market and operational risk separately and then simply adds the three figures to obtain total economic capital. Compared with an approach that models the joint distribution of the risks with correlations below one, the simple summation most likely:

Adding stand-alone capital figures assumes perfect correlation across risk types. Because actual correlations are below one, diversification is ignored and total economic capital is overstated relative to a joint-distribution approach that recognizes diversification benefits.

  1. AUnderstates total capital because it ignores tail dependence
  2. BOverstates total capital because it ignores diversification benefitsCorrect
  3. CGives the same answer because capital is additive by definition
  4. DUnderstates total capital because it ignores differing time horizons

Explanation

Simple summation implicitly assumes perfect correlation between the risk types. When correlations are below one, diversification reduces total risk, so the sum exceeds the aggregate figure. The tail-dependence option is a real caveat of correlation-based methods but is not what summation does; summation is conservative.

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