The Case for Fully Integrated Models of Economic Capital

28 Pages Posted: 17 Dec 2008 Last revised: 10 Feb 2009

See all articles by Alexander J. McNeil

Alexander J. McNeil

Heriot-Watt University

Axel Kirchner

University of Edinburgh

Gavin Lee Kretzschmar

University of Edinburgh - Accounting and Finance

Date Written: December 17, 2008

Abstract

Economic capital models are potentially powerful tools for enterprise risk management (ERM), and for the supervisory review process (Pillar 2) of the Basel II and Solvency II regulatory capital frameworks. We argue that, to fulfill this potential, economic capital models need to be fully integrated and to go beyond the more modular approaches that dominate Pillar 1 methodology. In a modular approach capital is determined at business-unit or risk category level (e.g. market, credit and liquidity risk separately) and aggregated ex post by simple summation or correlation-adjusted summation; in a fully integrated approach aggregation occurs implicitly by relating all risks to a common set of fundamental risk drivers.

We explain how calibrated economic scenario generation lies at the heart of a fully integrated approach to modelling the risks on the asset side of a firm's balance sheet and discuss how stochastic scenario generation gives the ideal framework for exploring the diversification benefits that different units or asset classes bring to an enterprise. We explain how this approach allows us to understand the sources of tail risk and gives us a platform for integrated stress testing, sensitivity analysis, and the allocation of capital to business units for risk-adjusted performance comparisons.

Keywords: risk management, economic capital, enterprise risk management, Basel II, Solvency II, stochastic models, stress testing

Suggested Citation

McNeil, Alexander J. and Kirchner, Axel and Kretzschmar, Gavin Lee, The Case for Fully Integrated Models of Economic Capital (December 17, 2008). Available at SSRN: https://ssrn.com/abstract=1317251 or http://dx.doi.org/10.2139/ssrn.1317251

Alexander J. McNeil

Heriot-Watt University ( email )

Axel Kirchner

University of Edinburgh ( email )

Old College
South Bridge
Edinburgh, Scotland EH8 9JY
United Kingdom

Gavin Lee Kretzschmar (Contact Author)

University of Edinburgh - Accounting and Finance ( email )

William Robertson Building
Edinburgh EH8 9JY
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
744
Abstract Views
2,566
rank
33,976
PlumX Metrics