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

A bank's economic capital framework aggregates risk types by simply adding the stand-alone capital for credit, market and operational risk. Relative to an approach that uses a correlation matrix, what is the most likely effect of simple summation?

Simple summation of stand-alone capital implicitly assumes perfect correlation between risk types, so it gives no diversification benefit and typically overstates total capital, making it conservative compared with a correlation-matrix approach.

  1. AIt understates total capital because it ignores negative correlations
  2. BIt gives a conservative estimate because it implicitly assumes perfect dependenceCorrect
  3. CIt produces the same result whenever risk distributions are non-normal
  4. DIt gives the exact capital when risk types share a common macro factor

Explanation

Simple summation is equivalent to assuming perfect correlation between risk types, so no diversification benefit is recognized. This yields a higher, conservative total. Option A is wrong because summation does not reduce capital for negative correlation. It is not exact even with a common factor unless correlation is one.

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