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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank allocates economic capital to its business units using each unit's stand-alone capital, computed as if the unit were an independent firm. The sum of the stand-alone capital figures exceeds the bank's total economic capital. Which statement best describes this outcome?

The sum of stand-alone capital exceeds total bank capital because stand-alone figures ignore diversification across business units. The difference is the diversification benefit, which must be allocated using an incremental or marginal approach so that allocated capital reconciles to the bank's total economic capital.

  1. AIt signals a calculation error, because allocated capital must always exceed total capital
  2. BIt reflects diversification benefit across units, so a further step is needed to allocate itCorrect
  3. CIt shows that the bank is undercapitalized relative to its risk
  4. DIt arises only when unit returns are perfectly correlated

Explanation

Stand-alone capital ignores diversification across units, so the sum exceeds the bank-wide capital figure. The difference is the diversification benefit, which must be allocated by a method such as incremental or marginal capital to reconcile to the total. Perfect correlation would remove the benefit, so option D is wrong.

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