Evaluating Capital Allocation Below Portfolio Level

Sammanfattning: This thesis explores the ability for retail banks to allocate economic capital below portfolio level. First, a discussion about capital requirements and risk measures to provide a sound basis for determining the economic capital of the bank. In general, economic capital is allocated to the banks portfolios but not on a more granular level, through a capital allocation method. This study discuss three dierent approaches for allocation of economic capital below portfolio level; game theory, nance and optimization. Both the game theory and nance approach reach the same conclusion, that the best allocation principle is the gradient of the risk measure. The optimization method allocates economic capital through minimization of a concept called risk residual, which conclude that the optimal allocation is derived from the marginal distribution of a customer. Capital allocation below portfolio level give the management a good overview of risks from dierent customers. In order to determine the performance of the portfolios in the bank a Risk-Adjusted-Return-On-Capital is used, with economic capital as input. The thesis include some comments about how the choice of capital allocation methods aect the performance measurement. The thesis concludes with an evaluation of the methods by simulations of a ctional bank conducted in the software R. Key Words: Risk Appetite, Economic Capital, Risk measure, Capital Allocation Methods, Allocation Below Portfolio level, Game theory, Optimization, Marginal Contribution