Holistic Principle for Risk Aggregation and Capital Allocation
35 Pages Posted: 23 Mar 2020 Last revised: 26 Mar 2020
Date Written: February 25, 2020
Risk aggregation and capital allocation are of paramount importance in business, as they play critical roles in pricing, risk management, project financing, performance management, regulatory supervision, etc. The state-of-the-art practice often includes two steps: (i) determine standalone capital requirements for individual business lines and aggregate them at a corporate level; and (ii) allocate the total capital back to individual lines of business or at more granular levels. There are three pitfalls with such a practice, namely, lack of consistency, negligence of cost of capital, and disentanglement of allocated capitals from standalone capitals.
In this paper, we introduce a holistic approach that aims to strike a balance between competing interests for various stakeholders and conflicting priorities in a corporate hierarchy. In spite of the unconventional strategy, the new approach leads to the allocation of diversification benefits, which is common in many risk capital frameworks including regulatory capital and economic capital. The resulting "all-in-one" capital setting and allocation principle provides a remedy to many problems with the existing two-step practice in the financial industry.
Keywords: Risk Management, Risk Aggregation, Capital Allocation, Pareto Optimality, Diversification Benefit
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