Risk Budgeting for Banks

Leslie Rahl and Nicholas Le Pan

While risk budgeting was originally developed as a tool for institutional investors, it can also be adapted as a useful tool for banks, but the evolution of risk budgeting for banks is probably where we were for pension funds when the first edition of this book was published in 2000. This chapter explores the issues in applying risk-budgeting concepts to banks.

While pension plans embraced risk budgeting earlier than banks and in many ways are more sophisticated in their use of it to drive risk-adjusted compensation than banks, banks generally have more sophisticated risk metrics and tools than are available to a pension plan.

The risk-budgeting process is actually two parallel processes: first, the numerically driven process (driven mainly by historic or projected financial results); and, second, a qualitative-driven process or “expert judgement”. Both are needed; one without the other does not work.

CONCEPTUAL ISSUES IN APPLYING RISK BUDGETING TO BANKS

For pension funds or investment portfolios, risk budgeting is based on several key concepts. The principle is that asset-allocation decisions can benefit from measurement of active risk from a specific aspect of the portfolio