Risk Management and Value Creation in ... - Arabictrader.com

170 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
we will not address), we are trying to provide a detailed and consistent
approach that:
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First, estimates economic capital “bottom-up,” that is, we:
– Determine economic capital for each of the three types of risk
separately, transaction by transaction, at a consistent time horizon
(H) and confidence level, and then aggregate the capital
requirements within that risk type. 169 Note that, therefore—unlike
what is often done for limiting and management purposes—
only the marginal risk contribution of a single transaction to the
(total) portfolio risk (of that risk type) counts.
– Then aggregate economic capital across the three types of risk in
a second step by using the correlations between these three categories,
because this seems to be the only realistic way to accomplish
aggregation up to the bank level.
Second, uses a newly suggested “top-down” approach to provide a
meaningful check for the bottom-up results.
Ways to Determine Economic Capital for Various
Risk Types in Banks (Bottom-Up)
In this section, we will discuss how economic capital can be calculated from
the bottom up for the various types of risk introduced previously. We
will start with credit risk, followed by market risk, and then operational
risk. We will close this section by discussing potential ways of aggregating
economic capital across these three types of risk and concerns with using
such a bottom-up approach.
Credit Risk In this section we will first define what credit risk is. We will
then discuss the steps to derive economic capital for credit risk and the
problems related to this approach.
Definition of Credit Risk Credit risk is the risk that arises from any nonpayment
or rescheduling of any promised payments (i.e., default-related events)
or from (unexpected) credit migrations (i.e., events that are related to changes
in the credit quality of a borrower) of a loan 170 and that gives rise to an
economic loss to the bank. 171 This includes events resulting from changes in
169 This, of course, assumes that our total risk measure can be broken down to the
single transaction level.
170 This includes all credit exposures of the bank, such as bonds, customer credits,
credit cards, derivatives, and so on.
171 See Ong (1999), p. 56. Rolfes (1999), p. 332, also distinguishes between default
risk and migration risk.