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

A bank uses a top-down approach to aggregate risk types, but a risk committee notes that correlations estimated from limited historical data for operational and credit risk are unstable. Which action is most consistent with sound practice for handling this parameter uncertainty?

The bank should apply conservative correlation assumptions and run sensitivity analysis on aggregate capital. Diversification benefits depend heavily on uncertain correlations, so low or zero values would overstate them, and excluding operational risk would understate total capital.

  1. AApply conservative correlation assumptions and test sensitivity of aggregate capital to themCorrect
  2. BSet correlations to zero between all risk types to simplify the model
  3. CUse the lowest historical correlation observed, to reflect diversification
  4. DRemove operational risk from the aggregation because its data is limited

Explanation

With unreliable correlation estimates, sound practice is to use conservative values and examine sensitivity of results, since diversification benefits are highly assumption-dependent. Zero or lowest correlations would overstate diversification, and excluding a material risk understates capital.

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