LO 5.5: Com pare the results o f research on “top-down” and “ bottom -up” risk

LO 5.5: Com pare the results o f research on top-down and bottom -up risk aggregation methods.
A banks assets can be viewed as a series of subportfolios consisting of market, credit, and operational risk. Flowever, these risk categories are intertwined and at times difficult to separate. For example, foreign currency loans will contain both foreign exchange risk and credit risk. Thus, interactions among various risk factors should be considered.
The top-down approach to risk aggregation assumes that a banks portfolio can be cleanly subdivided according to market, credit, and operational risk measures. In contrast, a bottom-up approach attempts to account for interactions among various risk factors.
In order to assess which approach is more appropriate, academic studies calculate the ratio of unified capital to compartmentalized capital (i.e., the ratio of integrated risks to separate risks). Top-down studies calculate this ratio to be less than one, which suggest that risk diversification is present and ignored by the separate approach. Bottom-up studies also often calculate this ratio to be less than one, however, this research has not been conclusive, and has recently found evidence of risk compounding, which produces a ratio greater than one. Thus, bottom-up studies suggest that risk diversification should be questioned.
It is conservative to evaluate market risk and credit risk independently. However, most academic studies confirm that market risk and credit risk should be looked at jointly. If a bank ignores risk interdependencies, a banks capital requirement will be measured improperly due to the presence of risk diversification. Therefore, separate measurement of
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Topic 5 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
market risk and credit risk most likely provides an upper bound on the integrated capital level.
Note that if a bank is unable to completely separate risks, the compartmentalized approach will not be conservative enough. Thus, the lack of complete separation could lead to an underestimation of risk. In this case, bank managers and regulators should conclude that the banks overall capital level should be higher than the sum of the capital calculations derived from risks individually.
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