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

A bank's risk team computes stand-alone economic capital of 60 for market risk, 100 for credit risk and 40 for operational risk, and simply adds them to obtain total economic capital of 200. Compared with an approach that models dependence between the risk types, which statement best describes the simple-sum result?

Simple summation of stand-alone capital assumes perfect positive correlation between risk types, so it gives no credit for diversification. It is conservative compared with models that allow correlations below one, which would produce a lower total capital figure.

  1. AIt implicitly assumes perfect positive correlation between the risk types and ignores diversification benefitsCorrect
  2. BIt implicitly assumes zero correlation and therefore understates total capital
  3. CIt implicitly assumes negative correlation between the risk types and overstates diversification
  4. DIt is the only method that is consistent with a common confidence level across risks

Explanation

Adding stand-alone capital figures is equivalent to assuming perfect dependence (correlation of one) among the risks, so no diversification benefit is recognised. It is generally conservative relative to models with correlations below one. Zero correlation would produce a smaller total than the simple sum.

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