Equity and Development: Berlin Workshop Series 2006 Book

Banks want to optimize Economic Profit, i.e. Adjusted Net Income - Economic Capital x Required Return on Capital

Economic Capital is risk-based, and includes credit risk (around Tail), market risk (around Mean) and operational risk.

Credit risk comes from the credit default loss. It depends on default probability and default correlation. One way to estimate credit risk capital is to simulate asset value (based on their return distribution and correlation assumption) and count defaults under all scenarios. The output is portfolio's future value distribution, after accounting for default loss. Should include loss from spread widening or rating downgrade too.

Market risk is VaR based.

Three types of risk attribution: standalone, which is used to evaluate managers' performance; marginal attribution, which is often used in acquisitions or divestitures; diversified capital, which is based on each part's beta to the portfolio. The sum of standalone attribution is bigger than the total capital requirement, the sum of marginal attribution smaller, and the sum of diversified capital is exactly the total capital.