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

A bank's risk team compares two ways of allocating diversified capital to units: (1) pro-rata scaling of stand-alone capital, and (2) incremental (marginal) capital, measured as group capital with the unit minus group capital without it. Which is a known limitation of the incremental approach when applied to every unit?

Incremental capital measured unit by unit usually does not add up to total group capital, leaving an unallocated residual. It does reflect correlation with the rest of the bank, but the sum of the increments falls short of the whole, so an additional allocation rule is needed.

  1. AIt ignores the unit's correlation with the rest of the bank
  2. BThe incremental amounts generally do not sum to total group capital, leaving an unallocated residualCorrect
  3. CIt always allocates more capital than stand-alone capital
  4. DIt requires that all units have identical volatility

Explanation

Incremental capital captures each unit's correlation with the rest of the firm, but because of diversification and non-linearity, the sum of the individual increments is usually below total group capital. A residual must be allocated by another rule. Option 0 is wrong because correlation is precisely what it captures.

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