Integrated risk modelling

Xeni Kristine Dimakos · Kjersti Aas

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Financial Risk and Volatility Modeling Risk Management in Financial Firms Probability and Risk Models

Abstract

In this article, we present a new approach to modelling the total economic capital required to protect a financial institution against possible losses. The approach takes into account the correlation between risk types, and in this respect, it improves upon the conventional practice that assumes perfectly correlated risks. A statistical model is built, and Monte Carlo simulation is used to estimate the total loss distribution. The methodology has been implemented in the Norwegian financial group DnB’s system for risk management. Incorporating current expert knowledge of relationships between risks, rather than taking the most conservative stand, gives a 20% reduction in the total economic capital for a one year time horizon.

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References

1988A Capital Asset Pricing Model with Time-Varying Covariances 2001Extreme Correlation of International Equity Markets 2001Value at Risk 2001Coherent allocation of risk capital 2002An Introduction to Credit Risk Modeling 1999Correlation: Pitfalls and Alternatives 2002An Introduction to Credit Risk Modeling 2015Probability of Loss on Loan Portfolio

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2005A general approach to integrated risk management with skewed, fat-tailed risks 2013On the aggregation of credit, market and operational risks 2009Does adding up of economic capital for market- and credit risk amount to conservative risk assessment?2009Interaction of market and credit risk 2009Top-down approaches for integrated risk management: How accurate are they?2007Risk Capital Aggregation 2006What We Know, Don't Know and Can't Know About Bank Risks: A View from the Trenches

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