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Risk Aggregation across credit, market, operational

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I have conflicting information in my notes regarding risk aggregation across credit, market, and operational risk areas that I am trying to reconcile (and determine if I have something mistaken.)

First, I have written that "For Basel II the capital requirement is a simple summation of the three risks and does not try to account for any potential diversification impact across the 3 risk categories."

Elsewhere I have written that "Diversification effect should be taken into consideration so that firm-wide VAR will be less than the sum of the 3 risk categories. A Variance-Covariance Matrix risk aggregation method can be used as a means for determining the diversification benefits."

I'm wondering if the potential answer might be that the first item may be referring to only regulatory requirements under Basel (which just takes the simple sum), while the second item is referring to economic capital which should consider diversification. Is this the answer, or is it something else?


David Harper CFA FRM

David Harper CFA FRM
Staff member
Hi Andrew - I fully agree, and IMO it's the only reconcile. B2/B3 do not allow capital reduction for imperfect correlation between the three big buckets; e.g., the FRM likes to query the notion that Basel implicitly assumes a perfect correlation between the three top-level buckets.

The economic capital rule, IMO, is more like "advice" or "best practice" since EC practices vary by firm (e.g., somebody else could argue: to be conservative, EC should follow Basel and not credit imperfect correlation), but not a rule like Basel. David
Here's a related question I have on the ERM topic... "With non-normal distributions, the use of correlations estimated using historical data from a stable period may not adequately capture how extreme returns from one type of risk are related to extreme returns of another type of risk." -- This statement is indicated to be wrong, but seems logical to me. Can anyone explain why? thanks