Economic Capital Evaluation Using two Approaches of Structural Models: Taking Fluctuating Asset Correlations into Account Versus Classical Merton Model

The financial crisis has become one of the most important challenges for financial institutions. To overcome this challenge, financial institutions must have an accurate estimate of the risks involved and maintain adequate capital to protect the bank. In recent years, in the international community, economic capital, as the appropriate capital to cover unexpected loss, has become a more accurate criterion for estimating the required capital to deal with risks. In this paper, we estimate economic capital of a selected bank portfolio which includes publicly traded companies using Monte Carlo simulation with two approaches of structural models. The first approach is to use the random matrix method in order to take fluctuating asset correlations into account and the second one is the classical Merton method which does not take into account the fluctuations of correlations. The results show that the bank ‘s risk will be significantly underestimated if the classical Merton approach is used.

Economic Capital Evaluation Using two Approaches of Structural Models: Taking Fluctuating Asset Correlations into Account Versus Classical Merton Model Keywords:

Merton model , Loss Distribution , Fluctuations of Covariance Matrix , economic capital , Monte-Carlo Simulations