Business — Banking — Management — Marketing & Sales

Capital allocation aims at allocating both credit and market risk to the business units and the transactions that originate them. They provide the top-down and bottom-up links between the post-diversification risk of the bank and individual transactions. The relationship is far from obvious because the risks do not add up arithmetically, so that the total risk is less than the sum of individual risks. Capital allocation defines meaningful keys for tracing back the overall risk to its sources.

Capital allocations are risk contributions of facilities to the overall portfolio risk. They apply to both credit risk and market risk using the same techniques. The risk contributions should comply with simple constraints to be usable. They should add up arithmetically to obtain the total risk, in order to reconcile allocated risks with overall risk. For pricing purposes, they should also be such that pricing based on risk contributions keeps the portfolio return in line with the overall target. The analytics show that the risk contributions complying with these two objectives differ. To allocate existing risks, absolute risk contributions apply. For pricing purposes, marginal risk contributions apply. This chapter highlights these differences and explains their sources.

The capital allocation system allows us to break down and aggregate risk contributions according to any criteria as long as individual transaction risk contributions are available. These properties allow us to deal with most issues related to allocating risks. For example, portfolios by business unit and portfolios by counterparty do not coincide. They might overlap or not. The implication is that the measures of credit risk and of business unit risk do not refer to the same portfolios in general. The capital allocation system solves the issue. It provides the risk contributions for individual facilities for both market risk and credit risk. If several business units deal with the same customer, it is possible to aggregate the risk contributions of all facilities with this customer into subsets relative to each business unit. When the same customer generates both credit risk and market risk with market transactions, it is possible to allocate both credit and market risk to the corresponding business units.