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Category: Risk Management in Banking

Capital allocation figures are ex post absolute risk contributions, or simpler alternative metrics, such as standalone loss volatilities of facilities. In this example, the capital allocation criterion is the standalone loss volatility (equivalent in this case to using risk contributions). The loss volatility of each facility is Lgd x VEdf(l — Edf). It is an output of the portfolio report, for each facility. The standalone loss volatility of a facility is intrinsic to that facility and does not depend on any portfolio effect.

Allocating capital to each facility follows the rule of the pro rata of the standalone facilities. For each facility, the ratio of the individual standalone loss volatility to the sum over the entire portfolio serves for allocating the economic capital in excess of expected loss. The capital allocation of each facility is equal to this percentage times the total portfolio capital. Note that, due to uniform correlation, the ratio of capital allocation K to portfolio capital Kp, Kj/Kp, is identical to the ratio LV;/LVp for all facilities. This ratio appears in the first appendix to this chapter, along with the main inputs.

The facility data, both inputs and outputs, are given in the appendices. Together with the AIS and excess spread, the capital allocation serves to calculate the RaRoC and SVA of each individual facility as well. Once the allocation is available, all facilities have a risk-return profile. Subsequent chapters provide detailed reports on individual facility risk-return profiles.

Portfolio Reporting

This chapter provides views on the portfolio structure, slicing the portfolio along various dimensions of interest. These include risk, performance and business dimensions as well. The overall view does not suffice because managers need to drill down in the portfolio to find the sources of excess risks or insufficient returns and decide where they should focus corrective actions.

The Information Technology (IT) architecture needs to accommodate all demands. This necessitates a data warehouse combined with adequate reporting and front-end tools to manipulate simultaneously all risks and business dimensions.

Slicing the portfolio along risk dimensions shows how different risk components, exposure size, default probability or recovery, contribute to risk. Views differ across risk dimensions because each single one does not provide a complete picture. For example, exposure is not risk. It is only a risk component. This raises the issue of how to synthesize risk, paving the way for limits in terms of expected loss or capital, which combine all dimensions.

Performance reports address the mispricing or gaps between target income and actual income or, alternatively, the average portfolio risk-adjusted return. Mispricing reports visualize these gaps and help focus on corrective actions (ex post view) or future decisions (ex ante view). Plain Risk-adjusted Return on Capital (RaRoC) and Shareholders Value Added (SVA) reports show which transactions and subportfolios contribute more or less to the overall portfolio performance.

Finally, reporting risk and return along business dimensions allows managers to move back and forth from financial views to business views.

The first section deals with the information architecture required to monitor risk. The second section provides sample reports on risk and risk-adjusted performance measures.

The last section provides business views of the portfolio segments and sample combinations with risk and return dimensions.

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