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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 measures credit risk using a one-year horizon at a 99.9% confidence level, while its market risk capital is computed from a 10-day VaR at 99%. An analyst wants to aggregate these figures into a single economic capital number. Which step is most appropriate before aggregation?

Market risk capital should be rescaled to the same one-year horizon and confidence level as credit risk before aggregation. Risk measures built on different horizons and confidence levels are not comparable, so adding them or choosing the larger one gives a meaningless economic capital figure.

  1. AConvert the market risk measure to the same horizon and confidence level as the credit risk measureCorrect
  2. BConvert the credit risk measure to a 10-day horizon at 99% confidence
  3. CAdd the figures as they are, because VaR is additive across risk types
  4. DUse the larger of the two figures as total capital

Explanation

Aggregation requires a common horizon and confidence level, usually the one tied to the target solvency standard, such as one year at 99.9%. Adding unadjusted figures mixes incompatible measures. Taking the maximum ignores diversification and the contribution of each risk.

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