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Regulatory capital for trading book positions includes two components that cover different risks but apply to the same portfolio, one for market risk and one for credit risk. Similar approaches are common in banks' internal models for economic capital. Although it is known that joint market and credit risk of certain investments can be larger than the sum of risks, the problematic cases identified so far have been relatively exotic. I show that very common investments – corporate bond holdings or CDS portfolios – are also affected. There are realistic conditions under which credit risk (represented by ratings and default) and spread risk (represented by rating specific spread indices) combine to a total value-at-risk (VaR) 50 percent larger than the sum of spread and credit VaR; this effect is even stronger for the expected shortfall. If migration risk is segregated from default risk and incorporated into spread risk, as recently put forward by the Basel Committee, total risk is no longer underestimated. Furthermore, I improve a theoretic result of Breuer et al. (2010) that defines a sufficient condition under which risk separation is harmless.

We look at the effect of capital rules on a banking system that is connected throughcorrelated credit exposures and interbank lending. The rules, which combine individualbank characteristics and interconnectivity measures of interbank lending, are to minimizea measure of system-wide losses. Using the detailed German Credit Register forestimation, we find capital rules based on eigenvectors to dominate any other centralitymeasure, followed by closeness. Compared to the baseline case, capital reallocation basedon the Adjacency Eigenvector saves about 15% in system losses as measured by expectedb