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    BoE Examines Optimal Methods of Internal Capital Allocation by Banks

    June 22, 2018

    BoE published an article that discusses the range of methods that banks use to allocate equity capital to their business lines, drawing on reviews conducted by PRA. The article complements a previous Quarterly Bulletin article that describes Fund Transfer Pricing (FTP) practices of banks. It also examines the potential implications of capital allocation methods for banks and prudential regulation.

    The article discusses the capital allocation practices observed in a sample of banks reviewed by PRA. In general, risk‑weighted assets (RWAs) are the primary basis of the allocation process. Some banks go further, employing more complex methodologies with a blend of different regulatory capital metrics. An example of this is the inclusion of the leverage ratio requirement—a non-risk-adjusted metric—in the allocation process. Where relevant, banks also take into account the capital buffer for global systemically important banks (G‑SIBs) and the impact of severe stress scenarios on their equity capital. 

    PRA reviews show that there are significant variations in the allocation practices used by banks. It is important for banks to understand the limitations of their practices and the implications of different approaches for their business decisions, strategy, and incentives within their organizations. Banks should carefully consider the most appropriate approach for their circumstances and continue to keep this under review. From a regulatory perspective, different approaches used by banks may have implications for the effectiveness and impact of micro- and macro-prudential policies. For example, some banks allocate capital to business lines proportionate to the individual contributions of those lines to the group’s overall stress losses. This could generate stronger incentives for business lines to take actions to mitigate losses in future periods of stress. The findings in this article suggest that further research by the academic community may be beneficial—both to guide banks as they further refine their practices and understand the associated incentive effects as well as to help policymakers understand their significance in aggregate terms.

     

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    Keywords: Europe, UK, Banking, Regulatory Capital, RWA, Internal Capital Allocation, BoE

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