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

A bank's trading unit has stand-alone economic capital of 100 million, and its marginal (incremental) contribution to bank-wide economic capital is 55 million. Its pro-rata (diversified) allocation is 70 million. The unit earns risk-adjusted net income of 14 million. The bank's hurdle rate is 18%. The CRO argues that the unit should be judged on a basis consistent with its true contribution to bank risk when evaluating a decision to expand it. Which assessment is most appropriate?

Marginal capital is the suitable basis for an expansion decision. Return is 14 divided by 55, about 25.5 percent, above the 18 percent hurdle, so expansion is supported. The caveat is that marginal contributions do not sum to total economic capital, so they are unsuitable for full allocation.

1. AUsing stand-alone capital, return is 14% and the unit should be cut, though this overstates its contribution to bank risk
2. BUsing marginal capital, return is about 25.5%, exceeding the hurdle, so expansion is supported on an incremental basis, though marginal contributions do not sum to total capitalCorrect
3. CUsing pro-rata capital, return is 20%, exceeding the hurdle, which is the only valid measure for incremental decisions
4. DUsing marginal capital, return is 39%, so expansion is clearly supported