Regulatory capital for marketand credit risk interaction:is current regulation always conservative?

In the work of the Basel Committee there has been a tradition ofdistinguishing market from credit risk and to treat both categories independentlyin the calculation of risk capital. In practice positionsin a portfolio depend simultaneously on both market and credit riskfactors. In this case, an approximation of the portfolio value functionsplitting value changes into a pure market risk plus pure credit riskcomponent can lead to underestimation of risk. It can therefore not beargued that the current regulatory approach would always be conservativefrom a risk assessment perspective. We discuss this fact in thecontext of foreign currency loans and argue that under the traditionalregulatory approach the true risk of a portfolio of foreign currencyloans would be significantly underestimated.[...]