The previous two sections discuss how difficult it can be for firms to correctly reflect tail events in aggregation methods and to validate risk aggregation methods. This section, tackles the diversification benefits which for many firms are an important by-product of their risk aggregation process. Firms increasingly urge financial regulators and supervisors to recognise these computed benefits in regulatory capital determinations. However, this
ditions. Other interviewed firms indicated that the level of risk reduction through diversification can be as high as 60 percent relative to regulatory calculations or to simple summations across the different efits varied widely even
diversification stem from materially different sources. Systematic risk is determined by the
on risk drivers and the idiosyncratic factors).
section raises a large number of caveats related to the computed diversification benefits that are derived from traditional aggregation methods and raises questions that senior management and supervisors should ask about any estimated diversification benefit. In particular, questions should be directed at issues such as: are the diversification benefits backed by real economic rationale or mainly the result of modelling features and aggregation methods; how do the level of benefits change under varying business models; and will the benefits remain under severe events and stressful economic and financial market conditions. The computed benefits typically reflect the calculation that the risk of unexpected losses at higher levels of aggregation may differ from a simple summation of standalone risks, given imperfect dependencies or relationships between exposures at any given point in time.9 Differences in firms’ methodologies seemed to drive some of the estimates, as the levels of diversification benefits computed differed markedly across the firms interviewed. Some firms reported that they do not even compute group-wide diversification benefits as they do not believe these benefits will be realised under more stressful con
risk types. Moreover, the magnitude of measured diversification ben
across firms that were superficially similar, suggesting that differences in computed diversification may importantly stem from differences in conceptual approaches to diversification and measurement methodologies. Whether these computed diversification benefits actually can and will be realised depends on the real economic underpinnings and determinants of the potential diversification benefits across a firm.
Real economic determinants of potential diversification effects
The term "diversification" is often used quite generically; for instance, very often no distinction is made between diversification across idiosyncratic factors and common or systematic drivers of risk. However, making a distinction between the two types of diversification is actually necessary to understand the firm’s risks, as these two types of common underlying drivers or sources of risk, and potentially can be reduced by diversifying exposures across those risk drivers; in contrast, idiosyncratic risk is the risk that remains – that is, not due to common underlying risk drivers – and can be reduced (to a certain extent) by increasing the number of names or counterparties in the firm’s portfolio. In this respect, diversification can be referred to as the potential risk reduction from spreading the firm’s exposures across different common risk drivers and idiosyncratic risk factors (assuming a different behaviour between the comm
The extent of risk diversification also depends on the prevailing market conditions, the state of the economy and other elements of the 'external' environment. The more two positions or
9
Opposite exposures to the same risk factor may also reduce risk, but are not encompassed in this description of diversification benefits.
risk exposures differ in terms of their pattern of variation over time, the more likely their combination will generate diversification benefits. However, the pattern of variation often is not constant, but instead changes along with developments in the external environment, and
r augment or reduce the effect on risk that would otherwise be observed. Many firms either neglect or explicitly choose not to reflect the dynamic elements
ite firms’ attempts to mitigate some of the risks. Firms also often recognise risk reductions from diversification effects between risk activities or risk categories that are not managed through an integrated effective realisation of these
ggregation of risk within financial institutions. However, when grouping risks into different categories, a crucial
ation techniques, recognising a larger number of risk factors within the portfolio risk measure results in greater "diversification the impact of a risk driver on risk exposures may significantly vary thereby potentially reducing the levels of diversification.
Traditional portfolio theory and risk aggregation approaches commonly rely on the assumption that these patterns are constant over time. They typically also disregard crucial factors that have a significant influence on the actual realised portfolio risks. Many "qualitative" factors – such as knowledge of local habits, economies, markets, and products – also affect whether any "diversification" is realised.
The extent of any risk reduction attributable to diversification effects may also importantly be affected by management’s behaviour. Actions taken by the management of a firm as market conditions evolve, or actions taken by other market participants in reaction to changing conditions, may eithe
of their management actions in the risk aggregation process, even though these actions taken by firms in response to market developments and changes can materially influence the interactions between risks. This has important implications, since it is quite possible that some of the dependencies may be reinforced by firm actions, desp
approach, leading one to question whether there can be diversification effects.
Additionally, there may be structural or legal impediments to realisation of diversification benefits; examples of such impediments are restrictions on the transfer of capital and liquidity. In that case, even though the underlying economics might suggest potential for diversification, no diversification benefits could be realised in practice.
The impact of methodology on measured diversification
Computed diversification benefits are influenced by many factors of the aggregation process, which greatly complicates the understanding of (and discussion of) diversification benefits. For example, compartmentalising of risk exposures into different risk groups or risk types is a common approach to the management, measurement, and a
assumption made is that risks can be cleanly separated. In reality, risk exposures in these different buckets or compartments typically have some common underlying or potentially interacting risk drivers that evoke an interaction between risk exposures in different buckets. Therefore, conventional methods that compartmentalise risks into different buckets and aggregate through common distribution assumptions may lead to significant underestimation of risks or overestimation of diversification benefits. In addition, this compartmentalisation of risks may also hinder appropriate management of the risks, as the bucketing may lead management to ignore certain important risks or risk interactions.
The level of granularity within the risk aggregation approach is a crucial factor affecting the management and measurement of diversification benefits. With regard to risk measurement, the level of granularity of the aggregation method influences computed diversification benefits. Under traditional portfolio measurement and aggreg
benefits" computed. The same effect comes into play for traditional approaches that compartmentalise the risks according to the different risk types, business units, product
types, legal entities or geography. Typically, the more the aggregation approach differentiates portfolios or activities according to these categories, the greater the diversification benefit. A greater focus by the financial institution on risk management at the level of compartmentalised entities or sub-portfolios may lead to a stronger emphasis on diversification within the financial institution but might also hinder the recognition (and hence management) of concentrated exposures at the group level.
Methodological choices within the entire aggregation process are rife with decisions based at least somewhat, and often to a large extent, on the judgment of experts. For instance, expert judgment often is used to compensate for the now widely recognised non-linear
y be used to ation benefits
gregation results
A survey of supervisory authorities from a number of jurisdictions indicated that most banking
As part of ongoing supervisory activities, supervisors generally review and assess aggregation methods used by firms to evaluate capital adequacy and as part of the firms’
s process typically includes a e Internal Capital Adequacy
dependencies that are not captured by linear approaches. Expert judgment ma incorporate or reflect real economic determinants of portfolio risks or diversific
in risk aggregation methods. Clearly any such expert-based changes (to correlation values, other dependency measures, or the entire aggregation approach) may materially affect the computed diversification benefits and make the estimated diversification benefits sensitive to the methodological choices as opposed to the economics of the underlying activities.