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FRM Part II · FRM Exam Part II · Integrated Risk Management

A bank's risk team aggregates stand-alone economic capital for credit, market and operational risk by simply adding the three figures together. Compared with an aggregation that recognises imperfect correlation among the risk types, what is the effect of simple addition?

Simple addition of stand-alone economic capital overstates total capital. It implicitly assumes perfect correlation between risk types, so no diversification benefit is recognised. Any correlation below one lowers the diversified total below the simple sum.

  1. AIt understates total economic capital because it ignores tail dependence
  2. BIt overstates total economic capital because it assumes perfect correlation and no diversification benefitCorrect
  3. CIt produces the same total because economic capital is additive by construction
  4. DIt overstates capital only if operational risk is excluded

Explanation

Adding stand-alone capital figures is equivalent to assuming a correlation of one across risk types. Any correlation below one produces a diversification benefit, so the simple sum is higher than the diversified total. The tail-dependence claim describes a different concern and does not make simple addition understate capital in this comparison.

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