Economic Capital Modelling and Basel II Compliance in the Banking Industry

Abstract

Risk is an inevitable part of every financial institution, above all banks and insurance companies. Risks are implicitly accepted when such institutions provide their financial services to customers and explicitly when they take risk positions that offer profitable, above-average returns. There is no unique view on risk and usually it is considered in certain sub-classes such as market risk, credit risk and operational risk, also interest rate risk and liquidity risk. Market risk is associated with trading activities; it is defined as the potential loss arising from adverse price changes of a bank’s positions in financial markets and encompasses interest rate, foreign exchange, equity and creditspread risk. Credit risk is defined as potential losses arising from a customer’s default or loss of credit rating. Such risks usually include loan default risk, counterparty risk, issuer risk and country risk. Finally, operational risk is due to losses resulting from inadequate or failed internal processes, human errors, technological breakdowns, or from external events.