Effective capital allocation methods can reduce banks' risk and increase profits, the Office of the Comptroller of the Currency said Tuesday.
From a survey of 10 large national banks, the agency concluded that institutions developing internal models to allocate capital among their business lines gain a better sense of each area's risk and profitability.
"Capital allocation is a very thoughtful, conscious way of quantifying risk in different business lines, and that allows banks to measure profitability in these different areas on a risk-adjusted basis," Michael L. Brosnan, acting senior deputy comptroller for capital markets, said in an interview.
The survey listed seven characteristics of effective capital allocation systems. For example, a bank should not focus solely on credit risks but should use a broader allocation process.
"Allocating for risks across all business and product lines facilitates comparative analysis, allowing managers to make more informed decisions," the survey said.
In addition, banks should not rely only on mathematical models when deciding how much capital to set aside for specific businesses. The judgment of management should come into play as well, the study said.
"There is a limit to how much you can blindly depend on numbers that pop out of a mathematical model," said Robert W. Strand, senior economist at the American Bankers Association.
Mr. Strand applauded the OCC paper as "an excellent step forward in the discussion of how to change the way banks hold capital."
Indeed, bank capital allocation models will be especially important as regulators mull how to revamp risk-based capital requirements, said Scott Calhoun, deputy comptroller for risk evaluation.
Regulators are considering a variety of approaches to make capital rules more sensitive to the differences in banks' risk profiles. For example, the Federal Reserve Board is experimenting with a so-called precommitment approach, which would require a bank to classify its loans based on the likelihood of default. The bank would then decide how much capital to devote to each category and pay fines if it underestimates its needs.
"Strong capital allocation methods are a prerequisite for a precommitment approach that can be prudently managed and not be dependent upon a regulatory framework," Mr. Calhoun said.
