Thus far we have developed risk management aspects into risk management at the individual (standalone) risk level, such as market risk, credit risk, and liquidity. While the individual silo risk management allows easy risk identification, measurement, and mitigation, recent global financial crises have proven the need for firmwide risk measurement, control, and decision making. Firmwide risk measurement requires ability to aggregate risk, identify risk concentrations and potential contagions among different risk sources, and accurately report and respond to the risk issues at the firmwide level.
Firmwide risk levels can be obtained in different ways. We will label two approaches according to Basel Committee (2010b):
- Top-down approach
- Bottom-up approach
The top-down approach to firmwide risk will be the focus in this chapter on firmwide risk aggregation while the next chapter on firmwide scenario analysis and stress testing will focus on the bottom-up approach to firmwide risk.
In the top-down approach we apply a correlated aggregation model to the results from the standalone risk analysis, for example, obtaining a firmwide risk measure like . In the bottom-up approach we analyze standalone risk types based on the same scenarios from joint, correlated, market, and economic scenarios on financial risk factors. We then aggregate the results per ...