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15 - Validation of Risk Aggregation in Economic Capital Models

Published online by Cambridge University Press:  02 March 2023

By
Ibrahim Ergen ,
Hulusi Inanoglu  and
David Lynch
Edited by
David Lynch ,
Iftekhar Hasan  and
Akhtar Siddique
David Lynch
Affiliation:
Federal Reserve Board of Governors
Iftekhar Hasan
Affiliation:
Fordham University Graduate Schools of Business
Akhtar Siddique
Affiliation:
Office of the Comptroller of the Currency
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Summary

This chapter implements a coherent statistical framework for validation of economic capital models via copula methods using a unique dataset to aggregate credit, market, operational, and interest rate risks. This framework includes benchmarking with alternative copula models and backtesting with alternative penalty functions, in addition to stability and stress tests of economic capital estimates. The analysis is expanded to include the latest supervisory guidance on model validation (i.e. SR11-7) and Basel Accord changes (i.e., Basel III). Second, proprietary confidential loss data is used from major US banks for market risk and operational risk. Lastly, both analytic and visual goodness-of-fit tests for copula models are included. For the data used in this study, the T copula with 4 degree of freedom provides a good statistical fit, superior backtesting performance, reasonable model stability and sufficient sensitivity to stress. In addition, the results provide some support for regulators’ hesitation to recognize diversification benefits by demonstrating a wide range of diversification benefits across risk types under different dependence models.

Keywords

Economic capital
Type
Chapter
Information
Validation of Risk Management Models for Financial Institutions
Theory and Practice
 , pp. 379 - 421
Publisher: Cambridge University Press
Print publication year: 2023

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