Skip to content

FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank allocates group EC to business units using stand-alone EC, and the sum of stand-alone figures is 1,000 million versus diversified group EC of 800 million. The head of a small, highly volatile trading desk argues that stand-alone allocation overstates the capital his desk consumes relative to its contribution to group risk. Which statement is most accurate?

Contribution-based (marginal or Euler-type) allocation reflects the desk's correlation with the rest of the bank and distributes the 200 million diversification benefit so allocations sum to group EC. Stand-alone EC ignores diversification, so it can overstate a diversifying desk's capital use and distort its performance measures.

  1. AStand-alone allocation fully reflects diversification, so the complaint is invalid
  2. BIncremental or marginal (contribution-based) allocation would reflect the desk's correlation with the rest of the bank, and allocations sum to group EC only if the diversification benefit is distributed, for example via a Euler-type methodCorrect
  3. CAllocation method has no impact on business-line performance measures
  4. DUsing stand-alone EC always understates risk for every business unit

Explanation

Stand-alone EC ignores diversification, so a desk with low correlation to other activities is allocated more than its contribution. Marginal or Euler-based allocation reflects correlations and distributes the 200 million diversification benefit so that allocations sum to group EC; the choice affects performance measures and incentives.

Did you get it right without looking?

One question tells you little. A timed set on Range of Practices and Issues in Economic Capital Frameworks shows your real accuracy, how long you take and where you lose marks.

Practise Range of Practices and Issues in Economic Capital FrameworksFree diagnostic mock

More Range of Practices and Issues in Economic Capital Frameworks questions