Bounds on total economic capital: the DNB case study
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Most banks use the top-down approach to aggregate their risk types when computing total economic capital. Following this approach, marginal distributions for each risk type are first independently estimated and then merged into a joint model using a copula function. Due to lack of reliable data, banks tend to manually select the copula as well as its parameters. In this paper we assess the model risk related to the choice of a specific copula function. The aim is to compute upper and lower bounds on the total economic capital for the aggregate loss distribution of DNB, the largest Norwegian bank, and the key tool for computing these bounds is the Rearrangement Algorithm introduced in Embrechts et al. (J. Bank. Financ. 37(8):2750–2764 2013). The application of this algorithm to a real situation poses a series of numerical challenges and raises a number of warnings which we illustrate and discuss.
KeywordsModel risk Risk aggregation Total economic capital Value-at-Risk Diversification benefit rearrangement algorithm.
Mathematics Subject Classifications (2010):60E05 91B30
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