Does adding up of economic capital for market- and credit risk amount to conservative risk assessment?

There is a tradition in the banking industry of dividing risk into market risk and credit risk. Both categories are treated independently in the calculation of risk capital. But many financial positions depend simultaneously on both market risk and credit risk factors. In this case, an approximation of the portfolio value function separating value changes into a pure market risk plus pure credit risk component can result not only in an overestimation, but also in an underestimation of risk. We discuss this compounding effect in the context of foreign currency loans and argue that a separate calculation of economic capital for market risk and for credit risk may significantly underestimate true risk. (C) 2009 Elsevier B.V. All rights reserved.