Regulatory Capital for Market and Credit Risk Interaction: Is Current Regulation Always Conservative?

In the work of the Basel Committee there has been a tradition of distinguishing market from credit risk and to treat both categories independently in the calculation of risk capital. In practice positions in a portfolio depend simultaneously on both market and credit risk factors. In this case, an approximation of the portfolio value function splitting value changes into a pure market risk plus pure credit risk component can lead to underestimation of risk. It can therefore not be argued that the current regulatory approach would always be conservative from a risk assessment perspective. We discuss this fact in the context of foreign currency loans and argue that under the traditional regulatory approach the true risk of a portfolio of foreign currency loans would be significantly underestimated.