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FRM Part II · FRM Exam Part II · Integrated Risk Management

A bank's capital committee finds that business lines have been rewarded on stand-alone economic capital, which ignores correlations. A trading desk whose losses are negatively correlated with the rest of the bank appears expensive on this basis. Which change to the allocation approach would best align incentives with the bank's integrated view of risk?

The bank should move to a marginal (Euler-style) contribution allocation, which measures each unit's effect on total portfolio risk and so credits a desk whose losses are negatively correlated with the rest of the bank. Equal, revenue-based or regulatory-only allocations do not reflect that diversification.

  1. ASwitch to a marginal or Euler-based contribution allocation that reflects each unit's effect on total portfolio riskCorrect
  2. BAllocate capital equally across all business lines to avoid disputes over correlations
  3. CAllocate capital in proportion to each unit's revenue
  4. DUse only regulatory capital for performance measurement

Explanation

Marginal or Euler contribution methods capture how each unit changes total bank risk, so a unit that hedges the rest of the bank receives a lower charge. Equal or revenue-based splits are unrelated to risk. Regulatory capital ignores the bank's own correlation structure.

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