Managing Bank Capital: Capital Allocation and Performance Measurement, 2nd Edition

9

Asset Volatility as a Capital Allocation Tool

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.¹

The risk manager's job is not just about capital allocation—it is mostly concerned with ensuring that adequate risk policies are established and adhered to, limits observed etc. But in the context of capital management, the question posed by the risk manager is: How much capital do we really think we need, in the absence of any supervisory regulations?

The techniques used by the risk manager to measure the amount of risk carried by the organisation will be highly quantitative in nature, relying on detailed statistical models and the latest advances in financial mathematics. It is a very specialised area that has emerged over the past decade as a profession in its own right. Although the non-specialist does not need to understand the exact techniques and formulae used, a broad understanding of this area is imperative for anyone interested in capital management, not least because the numbers produced by the risk manager's models are often used to allocate capital. It is important to understand what these numbers mean, and to ...