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Economic versus Regulatory Capital for Financial Conglomerates

Jacob Bikker () and Iman Lelyveld

Research Series Supervision (discontinued) from Netherlands Central Bank, Directorate Supervision

Abstract: The new Basel Capital Accord will result in more risk sensitive regulatory capital for banks. Likewise, financial conglomerates' internal models will become more important in group-wide supervision. Such models are relatively well developed for market and credit risk but for others, such as operational risk, many issues remain to be resolved. An even greater challenge is the development of models that aggregate risks across risk areas and business units, in particular across bank and insurance activities. Such internal economic capital models should deliver the total amount of capital needed to cover risks, as perceived by a financial conglomerate. An important determinant of total risk, and hence capital, are the diversification effect that the combination of different activities, such as banking and insurance, might offer. Two empirical analyses investigate cross-sector correlations and diversification effects in order to find the optimal level of capital for Financial Conglomerates. The results suggest substantial diversification effects but they may be offset by contagion risk.

Date: 2002-04
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