Risk‐Based Capital Allocation Using a Coherent Measure of Risk

This article outlines a procedure for quantifying risk‐adjusted capital reserves that may be used for both performance evaluation and capital allocation. The author identifies and quantifies the sources of risk capital that must be addressed, to cover current investment and withstand market shocks, for any business line that exhibits earnings volatility. The author classifies risk capital into two types: market‐risk capital and earnings volatility‐related capital . Market risk capital may be divided into two categories; risks due to “normal” or “diffusion” type price movements and catastrophic moves or “stress” events. In contrast, earnings volatility‐related capital is directly related to the firm's equity‐at‐risk , in the event that market shocks lead to sustained earnings volatility. The author suggests that these risk‐adjusted capital measures may be used as a benchmark, in conjunction with net earnings, to evaluate performance, or to allocate equity capital across different operations within a firm.