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B-505: Risk Management in Banking

Chapter-52:
Marginal Risk Contributions
 Chapter Outline:

1st Section 2nd Section 3rd Section 4th Section

• Defines MRC • Demonstrates • Deals with • Contrasts the

& ARC relationship MRC & Risk underlying
• Summarizes between MRC based Pricing philosophies
the features & ARC • Addresses the of ARC Vs.
of Risk • Reveals the pricing MRC
Contributions ranking of the Paradox
two
 Marginal Risk Contributions (MRC):
• Marginal Contributions to Loss Volatility:
Marginal Risk Contributions to Capital:

The portfolio distribution is a prerequisite for

defining capital and its relation to loss volatility.

Capital derives from the loss distributions and the

loss percentiles at various confidence levels.

Marginal contributions to capital require a two-step

procedure.

The First-in obligor in the Two-obligor portfolio has a

capital identical to his MRC to capital.

The Second-in obligor equals portfolio capital minus

initial capital used by the first in obligor.
General Properties of Marginal Contributions:

MRC portfolio risk volatility are lower than the ARC and lower than the standalone
loss volatilities

Accordingly, MRC to portfolio loss volatility add up to a value lower than the
portfolio loss volatility

MRC to portfolio capital can be higher or lower than ARC to capital

In addition, they add up to portfolio capital if we calculate sequentially the MRC of

each obligor when enters the portfolio.
 Calculation of MRC to capital : Several Observations

1. The MRC to capital calculated following the two-

step procedure are additive.
2. MRC to capital can be positive or negative
depends on ..
I. The Shape of the distribution
II. The Confidence level selected
3. MRC to capital can be higher or lower then the
ARC to capital.
4. The MRC of the 1st entrant & 2nd entrant depend
on who is 1st & who is 2nd with confidence level.
MRC to Volatility Vs. ARC to Volatility:

• Decisions for adding/removing a sub-

portfolio.
MRC Relevant For • Pricing a new transaction according to its
incremental risks.

• With small portfolio no mechanical link

between the two.
Size of Portfolio: • With Large portfolio, the ARC to volatility
& to capital might proxy MRC.

• KMV portfolio Manager calculates ARC.

Model of
Portfolio Manager • Credit Metrics calculates the MRC.
Relationship between MRC & ARC:
MRC Vs. ARC for a New facility:
Firstly, MRCfp+f > MRCf
Secondly, ARCfp+f f
 Implication of relationship between
MRC & ARC:
• When the additional facility is small, chances are that
the gap between the MRC & ARC to loss volatility
gets small.
• Capital allocation & risk based performance using
ARC can’t be equivalent to using MRC.
• When we add a facility to an existing portfolio, we
have two effects.
I. If ARC of new facility is positive, increases
portfolio risk volatility & vice-versa.
Marginal Risk Contributions & Pricing:

The goal of risk-based pricing is to ensure

a minimum target return on capital

A required rate serves as a benchmark

for risk-Based Pricing

Hurdle rate helps in creation of

‘Shareholders Value Addition’ (SVA)

SVA refers to the target rate of return on

existing equity or Economic Capital
Risk Based Pricing: General Formulation

A Target Revenue= r%*m*σ p

Where, r= Required pre-tax pre-operating return
m= constant multiple
P=existing portfolio
Pricing paradox with Risk Contributions:

Usages of MRC lower than ARC for

pricing purposes sounds puzzling!

MRC based pricing is lower than ARC

based pricing.

MRC based pricing inconsistent with

overall target return on capital.

This is because capital sums up all

ARC not MRC.
 Capital Allocation View Vs. Pricing View:

The implication of both risk contributions are used for different

purposes.

Absolute risk contributions are ex post measures. They measure

risk contributions for a given set of facilities.

Therefore, absolute risk contributions serve to allocate

Capital for an existing portfolio.

Marginal risk contributions are ex ante measures and serve

for risk-based pricing.
Ex-Ante & Ex-Post View of Risk & Return:
 Capital Allocation:
As long as the capital is a multiple of the
portfolio loss volatility, allocating loss
volatility provides an allocation proportional
to capital.

It is possible to allocate capital at the pro rata

of exposures or of standalone risks measured
by standalone risk volatility.

This is the management choice of an

appropriate allocation depending on trade-
off between ease of interpretation & the
need to capture differentiated correlation
effects.
 Risk-Adjusted performance Vs. Risk
Based Pricing
• This discussion relates to the distinction between the ex ante
measure of risk required to meet a target return on capital.
• The ex post risk-based performances necessary for
comparing ex post the risk–return profile.
• Without risk-based pricing, we do not know the
required revenues.
• Without ex post risk-adjusted performances, we cannot
compare the risk–return profile of sub-portfolios.
• Both are necessary because they serve different purposes.