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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 a separate firm. The sum of stand-alone capital figures is greater than the bank's total diversified economic capital. Which statement best describes the implication for attribution?

Stand-alone capital measures each unit in isolation and ignores diversification, so the units' capital sums to more than the bank's diversified capital. The gap, the diversification benefit, must be allocated or reconciled using another method, such as marginal or incremental attribution.

  1. AStand-alone allocation fully reflects diversification benefits, so no adjustment is needed
  2. BStand-alone allocation ignores diversification, so the sum exceeds total capital and an allocation of the diversification benefit is required for reconciliationCorrect
  3. CStand-alone allocation understates each unit's risk because it ignores correlations with other units
  4. DStand-alone allocation guarantees that the sum of unit capital equals total capital

Explanation

Stand-alone capital ignores imperfect correlation between units, so the sum of units exceeds diversified firm capital. The difference is the diversification benefit, which must be allocated or reconciled by another method such as incremental or marginal allocation. Options claiming it reflects diversification are wrong.

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