Validation of economic capital models: State of the practice, supervisory expectations and results from a bank study

Abstract

A challenge in economic capital modelling within financial institutions is developing a coherent approach to model validation. This has been motivated by rapid financial innovation, developments in supervisory standards (Pillar 2 of the Basel II framework) and the recent financial turmoil. Various practices are surveyed in validating economic capital models, both quantitative and qualitative approaches, and supervisory expectations and concerns regarding this process are discussed. The paper then illustrates several of these approaches (benchmarking, sensitivity analysis and testing for predictive accuracy) utilising data from major banking institutions’ loss experience (from supervisory call reports), and estimates and compares alternative established frameworks for risk aggregation (including alternative copula models). Results suggest 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 well as more stable than the other models, in a nonparametric bootstrap experiment.