(see equation 26.3.) This is based on research by Rosenberg and Schuermann that is
referenced in the text.
The total economic capital for the whole bank is less than the sum of the individual
economic capital amounts. Section 26.6 discusses how the total economic capital for the
bank should be allocated to business units. The problem here is analogous to the problem of
allocating VaR that is considered in Chapter 12. Arguably the theoretically best allocation
scheme is to allocate an amount
xi
∂E
∂xi
to business unit iwhere xiis a measure of the size of business unit iand Eis the total
economic capital. Euler’s theorem shows that the sums of the allocated economic capital
amounts equals the total economic capital, E. Example 26.4 illustrates this.
The final section of the chapter is on RAROC, risk-adjusted return on capital. Once
economic capital has been allocated to business units RAROC can be calculated. It is
important to distinguish between the use of RAROC to measure past performance and
the use of RAROC to decide whether particular business units should be expanded or
contracted.
Any of Problems 26.10 to 26.13 can be used as assignment questions.
Chapter 27: Enterprise Risk Management
This chapter is new to the fourth edition. It explains the nature of enterprise risk
management, the importance of defining risk appetite, and issues concerning risk culture.
The chapter also covers the role of cognitive biases in risk management. The chapter
argues that risk culture is to a large extent about the trade offs a company makes between
the short-term and longer-term consequences of a decision. The chapter discusses caselets
involving Goldman Sachs, Santander, and Bankers Trust.
Problem 27.9 (based on the Santander caselet) and 27.10 (concerned with how the
beta of an investment should reflect risk appetite) can be used as assignment questions.
Chapter 28: Risk Management Mistakes to Avoid
This chapter describes some well-publicized losses of the last 20 years and discusses
the lessons that can be learned from them.
Chapter 28 is a great chapter for the final class of a course. Students love talking
about disasters such as SocGen and LTCM. I often use the chapter to review key points
covered during the course.
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