Value at Risk and Bank Capital Management

CHAPTER

♦

6

Risk Capital Aggregation

So far we have discussed how different risk types, such as market, credit, operational,

and business risks, can be measured. Yet in order to support top-management decisions

concerning capital management and capital allocation, an integrated picture of risks is

needed. The challenge of risk aggregation, i.e., the development of quantitative risk mea-

sures, such as an aggregated estimate of economic capital, incorporating multiple types

or sources of risk (see Joint Forum 2003) across different business units, is therefore

particularly important.

Risk aggregation and the size of diversifi cation benefi ts that might result from being

exposed to different risks in different businesses are relevant both from a regulatory and

from the individual bank’s point of view, even if we focus mainly on the bank’s perspec-

tive. The debate about the extent of diversifi cation benefi ts that can be achieved by running

different activities in the fi nancial sector has been a topic of discussion in the past during

the debate concerning whether restrictions on U.S. bank activity should be abolished by

adopting a universal banking approach as in European countries (see Saunders and Walter

1993). In this context, a number of empirical studies were conducted in order to under-

stand whether “nonbank” activities could reduce overall risk for bank holding companies

(for a survey, see Brewer, Fortier, and Pavel 1988). At present, the regulatory debate is

related to whether and how diversifi cation benefi ts among businesses or risks can and

should be taken into account in setting minimum capital requirements (see Kuritzkes,

Schuermann, and Weiner 2001, 2002; Joint Forum 2003).

However, apart from minimum regulatory capital requirements, understanding how

risk could be aggregated and, consequently, the size of diversifi cation benefi ts is extremely

important from the point of view of bank decision making in an economic capital perspec-

tive. Risk aggregation is important for capital management, since it can enable the risk

manager to give top managers a measure of the overall capital needed to run the bank

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