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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank computes economic capital for credit, market and operational risk separately and then adds the three figures to obtain total capital, without recognising any diversification. Which statement best describes the effect of this simple summation approach, relative to an approach that aggregates using correlations below one?

Adding stand-alone capital figures is conservative because it implicitly assumes perfect dependence between risk types. With correlations below one, the aggregate would be lower, so simple summation overstates capital relative to a correlation-based approach.

  1. AIt is conservative, because it implicitly assumes perfect dependence across risk types in the tailCorrect
  2. BIt is aggressive, because it ignores that losses across risk types can occur together
  3. CIt is neutral, because diversification benefits across risk types are always zero
  4. DIt understates capital, because standard deviations are not additive

Explanation

Simple summation of stand-alone capital is equivalent to assuming perfect correlation (and comonotonic tails) between risk types. Any actual correlation below one would produce a lower total, so summation is conservative. The aggressive option reverses the direction of the bias.

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