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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank allocates capital to a loan portfolio using the contribution of each loan to the portfolio's unexpected loss (marginal or risk contribution approach). A large loan to a borrower in a sector where the bank is already heavily concentrated is added. Compared with its stand-alone unexpected loss, the loan's risk contribution will most likely be:

The loan's risk contribution will be close to or above its stand-alone unexpected loss. Because the borrower is highly correlated with existing sector exposures, diversification benefit is small. Risk contributions depend on correlation with the portfolio, not on the loan in isolation.

  1. ALower, because all new loans reduce portfolio risk through diversification
  2. BEqual, because risk contributions always equal stand-alone risk
  3. CZero, because expected loss is already provisioned
  4. DHigher or close to stand-alone, because high correlation with existing exposures leaves little diversification benefitCorrect

Explanation

Risk contribution depends on correlation with the rest of the portfolio. In a concentrated sector, correlation is high, so the contribution is near or above the stand-alone figure. Contributions equal stand-alone only when correlation is perfect, and provisions cover expected, not unexpected, loss.

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