Chapter 6 - Risk Capital Aggregation

Abstract

Risk aggregation and the size of diversification benefits that might result from being exposed to different risks in different businesses are relevant both from a regulatory and from the individual bank's point of view, even if one focuses mainly on the bank's perspective. After measuring market, credit, operational, and business risk, a bank still has to derive an aggregated capital measure in order both to support capital management decisions and to better understand the size of diversification benefits arising from its business mix. The starting point is to harmonize the different risk measures for each risk in terms of time horizon, confidence level, and their underlying notion of capital. There are different aggregation methodologies that can be used and that should be selected taking into consideration its conceptual soundness, its computational complexity, and the actual possibility of consistently estimating the parameters that the aggregation methodology requires. While adopting the usual portfolio VaR formula applied by the variance–covariance approach in a context of multivariate normally distributed returns is the easiest and perhaps currently most common solution, alternative and more refined solutions should be considered, such as copulas, the multifactor approach, and the mixed multifactor approach. The chapter also presents the experience of the Fortis Group, large diversified group active in both the banking and the insurance business, in developing an aggregated VaR measure.