Banks allocate capital to their business lines to assess those lines’ relative performance, which informs their strategic decisions. Capital allocation, together with Fund Transfer Pricing (FTP), are two important internal processes used by banks to support business optimization decisions. This article discusses the range of methods that banks use to allocate equity capital to their business lines, drawing on reviews conducted by the Prudential Regulation Authority (PRA). It complements a previous Quarterly Bulletin article which describes banks’ FTP practices. We also discuss in this article potential implications of capital allocation methods for banks and prudential regulation.
In general, risk‑weighted assets (RWAs) — a bank’s assets and off balance sheet exposures, weighted according to their risk as measured under the regulatory framework — 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.
The 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 consider carefully the most appropriate approach for their circumstances (eg their business model) 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 macroprudential 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.