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

A bank allocates capital to its loan book using marginal contributions to portfolio unexpected loss. Loan X has standalone UL of 10 million and correlation with the rest of the portfolio is low. Loan Y has standalone UL of 10 million and correlation with the rest is high. Which statement is correct about a contribution-based (risk-contribution) allocation?

Loan Y receives more capital. Under risk-contribution allocation, capital depends on standalone risk and correlation with the rest of the portfolio. Y's high correlation offers less diversification, so it adds more to portfolio unexpected loss than X despite equal standalone UL.

  1. AX and Y receive equal capital because their standalone ULs are equal
  2. BX receives more capital because low correlation increases portfolio risk
  3. CY receives more capital because its higher correlation with the portfolio gives a larger contribution to portfolio ULCorrect
  4. DNeither receives capital because contributions sum to expected loss

Explanation

Risk contribution depends on both standalone risk and correlation with the portfolio; higher correlation means less diversification and a bigger contribution. Equal standalone UL gives equal capital only under standalone allocation, which ignores diversification.

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