Allocation of Risk Capital in Financial Institutions

Financial Management (Financial Management Association), Autumn, 1999 by Francesco Saita

* achieving a total division of risks can be difficult if not impossible;

* synergies may exist in the management of multiple risks; and

* even if it is possible to disaggregate risks, it may be extremely difficult to disaggregate the corresponding returns, making it impossible to measure risk-adjusted performance for individual units.

First, even when a particular risk can be isolated so that it can be hedged on a single-transaction basis, synergies may exist in managing multiple risks simultaneously (e.g., credit and interest rate risk in a junk bond portfolio). Second, it may be difficult or impossible to isolate different types of risk completely. For instance, an option trader is exposed both to directional risk (the risk of changes in the price of the underlying asset, as measured by the option's delta and gamma) and to volatility (vega) risk. Volatility risk is a unique attribute of option instruments and may therefore be considered the core risk of an option position. However, even if a bank could persuade an option trader to transfer his directional risk to the trader of the underlying asset, only the delta component of directional risk could be hedged with the underlying asset, while gamma risk would still have to be borne by the option trader. In other words, gamma risk is no less an attribute of an option position than vega risk, so that a complete separation of directional and volatility risks is impossible.

Last but not least, separating risks must not distort the calculation of organizational unit returns. Otherwise, a cleaner picture from a risk control viewpoint would make it impossible to measure risk-adjusted performance correctly. Therefore, every time a multi-risk position is transformed into a single-risk position through an internal deal, a transfer price must be defined. This task is not easy. For instance, in the case of credit products with market risk exposure (e.g., a five-year fixed-rate commercial loan), market risk can be internally hedged in a relatively simple way through funds transfer pricing. This permits the bank to compare the credit risk being assumed with the credit spread over financing costs. On the other hand, for market-risk-sensitive positions, defining the correct transfer price for credit risk is much more complex. The practice in all organizations is to divide counterparty credit risk assessment from market risk decisions; the former is a task for credit officers, while the latter are undertaken by traders operating within defined credit lines. Yet, counterparty risk and market risk are not independent. In fact, market risk is associated with an unfavorable shift of the market, whereas counterparty risk increases when the market moves favorably to the trader. Moreover, traders can obtain a remarkable amount of information about counterparties' behavior that could be useful to credit officers. Hence, counterparty and market risk measurement should be as integrated as possible.

In conclusion, defining the characteristics of risk-taking centers requires finding the right balance between competing criteria. The basic objective is therefore to achieve as much risk specialization as possible, provided that: