Why is economic capital across market, credit and operational risks simply added up to arrive at an estimate of aggregate economic capital in practice?

Why is economic capital across market, credit and operational risks simply added up to arrive at an estimate of aggregate economic capital in practice?
A . Market, credit and operational risks are perfectly correlated which justifies adding up their associated economic capital.
B . In practice, it is very difficult to estimate the correlations between the risk categories and as a result a conservative estimate is obtained by adding up the risks.
C . Regulators require banks to add up economic capital across market, credit and operational risks.
D . Since market, credit and operational risks are significantly different measures of risk, there is no
diversification benefit to computing economic capital to banks across types of risks.

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Answer: B

Explanation:

In practice, financial institutions often sum the economic capital required for market, credit, and operational risks to arrive at an aggregate economic capital estimate. This is done because:

Difficulty in Estimating Correlations: Estimating the correlations between different types of risks is complex and data-intensive. These correlations can change over time and under different market conditions, making it challenging to arrive at accurate estimates.

Conservatism: To avoid underestimating the total risk, a conservative approach is often taken by adding up the individual risk capitals. This ensures that the institution holds sufficient capital to cover potential losses from all types of risks, even if they were to occur simultaneously.

Regulatory Guidance: Although regulations encourage a more integrated approach, the lack of precise data often leads banks to use simpler, more conservative methods in practice.

Thus, option B correctly reflects the practical approach taken due to the difficulty in estimating correlations between different risk categories.

References: How Finance Works, discussions on risk aggregation and challenges in estimating correlations between risk types??.