Validation of Economic Capital Models: State of the Practice, Supervisory Expectations and Results from a Bank Study

Abstract

A challenge in economic capital modeling within financial institutions is developing a coherent approach to model validation. This has been motivated by rapid financial innovation, developments in supervisory standards (Pillar II of the Basel II framework) and the recent financial turmoil. We survey various practices in validating economic capital models, both quantitative and qualitative approaches, and discuss supervisory expectations and concerns regarding this process. We then illustrate several of these approaches (benchmarking, sensitivity analysis and testing for predictive accuracy) utilizing data from major banking institutions' loss experience (from supervisory call reports), estimate and compare alternative established frameworks for risk aggregation (including alternative copula models). Results suggests that practitioners may want to consider implementing a simple non-parametric methodology (empirical copula simulation - ECS) in order to quantify integrated risk, in that it is found to be more conservative, as wells as more stable than the other models, in a non-parametric bootstrap experiment.

Keywords: Risk Aggregation, Enterprise Risk Management, Economic Capital, Credit Risk, Operational Risk, Market Risk, Copula

JEL Classification: G10, G20, C10