A General Approach to Integrated Risk Management with Skewed, Fat-tailed Risks
by Joshua V. Rosenberg of the Federal Reserve Bank of New York, and
February 4, 2005
Abstract: Integrated risk management in a financial institution requires an approach for aggregating risk types (market, credit, and operational) whose distributional shapes vary considerably. In this paper, we construct the joint risk distribution for a typical large, internationally active bank using the method of copulas. This technique allows us to incorporate realistic marginal distributions, both conditional and unconditional, that capture some of the essential empirical features of these risks such as skewness and fat-tails while allowing for a rich dependence structure. We explore the impact of business mix and inter-risk correlations on total risk, whether measured by value-at-risk or expected shortfall. We find that given a risk type, total risk is more sensitive to differences in business mix or risk weights than to differences in inter-risk correlations. There is a complex relationship between volatility and fat-tails in determining the total risk: depending on the setting, they either offset or reinforce each other. The choice of copula (normal versus Student-t), which determines the level of tail dependence, has a more modest effect on risk. We then compare the copula-based method with several conventional approaches to computing risk.
Keywords: Market risk, credit risk, operational risk, risk diversification, copula.
Published in: Journal of Financial Economics, Vol. 79, No. 3, (March 2006), pp. 569-614.