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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, then sums these amounts. The total exceeds the bank's enterprise-wide economic capital. Which statement best explains why?

The sum exceeds group capital because stand-alone capital ignores diversification. Business units are imperfectly correlated, so combined risk is less than the sum of individual risks. The gap is the diversification benefit, which attribution methods must then allocate back to the units.

  1. AStand-alone capital ignores diversification benefits across business units, so the sum of the parts exceeds the wholeCorrect
  2. BStand-alone capital understates risk because it assumes perfect correlation between units
  3. CEnterprise-wide capital is always measured at a lower confidence level than unit capital
  4. DStand-alone capital includes only expected losses, which are double counted at the group level

Explanation

Stand-alone capital measures each unit as if it were independent of the rest of the bank. Because correlations between units are below one, the group's aggregate risk is lower than the sum of unit risks. The difference is the diversification benefit, which must be allocated somehow.

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