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CEBS Position Paper on the Recognition of Diversification Benefits under Pillar 2 Summary

Core Content

This CEBS position paper, published on 2 September 2010, provides an analysis of the recognition of diversification benefits within the context of Pillar 2 of the Basel II capital framework. It is based on a fact-oriented study conducted by CEBS in the first half of 2010, focusing on current supervisory practices and the limitations of economic capital models used to estimate diversification benefits. The paper highlights the cautious stance of CEBS member authorities regarding the inclusion of diversification benefits in the Supervisory Review and Evaluation Process (SREP).

Main Views

Diversification Benefits Overview

• Diversification is expected to reduce idiosyncratic risk but not systemic risk.
• The Basel II framework already includes diversification benefits in Pillar 1, particularly through the IRB and AMA approaches.
• Diversification benefits can be categorized into intra-risk, inter-risk, and intra-group types.

Cautious Stance on Recognition

• Intra-risk diversification (e.g., within credit risk) is still controversial, with uncertainty about its measurement and validity, especially under stress conditions.
• Inter-risk diversification is less developed, with limited methodologies and subjective benchmarks.
• Supervisors are cautious about relying on institutions' methodologies, due to the difficulty in capturing real-world loss distributions.

Supervisory Approaches

• Supervisory authorities can be divided into three categories:

  1. Pillar 1 plus logic: SREP capital is based on Pillar 1 metrics with add-ons.
  2. Qualitative approach: SREP does not lead to a capital estimate but focuses on management quality.
  3. Risk-weighted assessment: SREP includes an overall risk profile and capital needs, and diversification benefits are considered in the process.

• Diversification benefits are not always prioritized in SREP discussions, and supervisory review of economic capital models is limited.

Key Information

Institutions' Approaches to Modelling Diversification

• Most institutions use VaR as the primary risk metric, though one integrates stress tests.

• The confidence level and time horizon vary between institutions and risk types.

• Aggregation methods include:

  • Simple summation: All correlations are assumed to be 1.
  • Variance-covariance matrices: Linear and fixed correlations.
  • Copulas: More flexible, but complex to implement.

• The variance-covariance method may overestimate diversification benefits due to its linear assumption and lack of tail dependency.

Quantitative Analysis

• Internal capital estimates for 10 institutions are significantly lower than regulatory Pillar 1 capital charges.
• Credit risk internal capital estimates are 36% lower than regulatory capital.
• Pillar 2 capital (including interest rate risk, real estate, pension, etc.) is 53bn EUR for 10 institutions.
• Stress testing and other buffers add 27.2bn EUR to the capital estimate.
• Inter-risk diversification reduces the total internal capital estimate by 32bn EUR to 215.7bn EUR.
• The total internal capital (ICAAP) is 244.2bn EUR, and the own funds amount to 323bn EUR, creating a capital cushion of 107.3bn EUR.

Governance and Model Outputs

• Results of risk aggregation are used in capital allocation and management decisions, but limited use is made of economic capital models in group-level capital allocation.
• Supervisors emphasize the need for independent validation and extensive analysis before accepting diversification benefits.
• "Black-box" models are generally not accepted by supervisors, especially host supervisors.

Conclusion

CEBS emphasizes the importance of prudence and rigorous validation in the recognition of diversification benefits under Pillar 2. While diversification can contribute to capital efficiency, the current models and supervisory approaches are not yet mature enough to fully support their inclusion. Institutions are encouraged to improve their risk measurement and capital aggregation frameworks to better reflect real-world conditions and systemic risk considerations.