[Economic Capital in Banking: Using Risk Aggregation and Capital Allocation Models]

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ACKNOWLEDGEMENT

I would take this opportunity to thank my research supervisor, family and friends for their support and guidance without which this research would not have been possible.

DECLARATION

I, [type your full first names and surname here], declare that the contents of this dissertation/thesis represent my own unaided work, and that the dissertation/thesis has not previously been submitted for academic examination towards any qualification. Furthermore, it represents my own opinions and not necessarily those of the University.

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ABSTRACT

Banks compute total risk to determine the total capital required to meet losses arising from different risk types. Banks often measure different risks separately and then add the risk to determine economic capital. But this approach misses complex interactions between the risk types. Up to now no state-of-the-art integrating approach that is able to fulfill this task has emerged. Two sophisticated methods of risk integration are copula approach and variance/covariance approach. To understand the impact on the total risk of different approaches, copula and variance/covariance approaches are applied to integrate market, credit and operational risk. The overall risk variation and the diversification benefit from different methods are explored and compared. This comparison supports the notion that different approaches drastically affect the overall risk and the diversification benefit level. The copula approach has a natural way to describe the dependence, but this is not absolutely right as the normal copula can't describe tail dependence.

Key words: Risk correlation; Risk integration; Copula; Variance/Covariance Approach

TABLE OF CONTENTS

ACKNOWLEDGEMENT2

DECLARATION3

ABSTRACT4

CHAPTER 1: INTRODUCTION7

CHAPTER 2: LITERATURE REVIEW16

2.1 Economic Capital16

2.1.1 Calculation16

2.1.2 Economic capital vs. regulatory capital18

2.2 Calculation of economic capital as a gauge of the maturity of risk management19

2.2.1 Calculation of economic capital21

2.3 Role and Importance of Economic Capital Banks21

2.4 Evaluation and Stages Model22

2.4 Integration of market, credit and operational risk22

2.5 Risk Management Techniques23

2.6 Risk management, equity and bank management on securitization operations24

2.6.1 Ensure an efficient allocation of capital25

2.6.2 Expiration of the securitization transaction27

2.6.3 Credit Portfolio Management28

2.7 Credit portfolio models and general framework30

2.8 Multi-factor Normal copula model32

2.9 Capital allocation and risk contributions36

2.9.1 Definitions37

2.10 Risk measures and coherent capital allocation39

2.11 Problem in implementing economic capital42

2.12 The New Currency Risk Management43

2.12 Comprehensive Risk Assessment48

2.13 Summary and further research50

CHAPTER 3: METHODOLOGY54

2.1 The variance/covariance approach54

2.2 The copula approach56

2.2.1 Marginal risk distributions: market, credit and operational58

2.2.2 Correlation between credit, market and operational risk62

2.2.3 Choosing an appropriate copula function63

2.2.4 Total loss rate distribution Calculation64

2.2.5 VaR of total risk Calculation65

2.3 Diversification Coefficient65

CHAPTER 4: EMPERICAL RESULTS AND DISCUSSION66

3.1 Data description66

3.2 Estimation of Parameters of risk distributions67

3.3 Empirical results68

3.3.1 Results of the variance-covariance approach68

3.3.2 Results of the copula approach69

3.4 Diversification coefficient73

CHAPTER 5: CONCLUSION75

REFEERENCES76

CHAPTER 1: INTRODUCTION

Banks are exposed to different types of risks, such as market, credit, operational and business risks and they measure and manage different types of risks separately, to manage their overall risk. But in order to support top management decisions concerning capital management and capital allocation, an integrated picture of risks is necessary. Therefore, risk integration, incorporating multiple types or sources of risks across different business units, is particularly important ...