Bank capital allocation and performance management under multiple capital constraints

To measure performance of individual businesses and maximise shareholder value for the firm as a whole, banks need to decide how much capital to allocate to each business and what cost of capital to charge. Capital is typically allocated to reflect differences in risks and/or regulatory capital requirements. The cost of capital has typically been set more judgmentally and often is not differentiated across business lines. This paper outlines why the authors believe the focus needs to shift to the determination of the appropriate cost of capital. If the cost of capital accounts for differences in risk across business lines, the amount of allocated capital can be chosen more freely and naturally as a function of all competing regulatory and internal capital requirements. This paper describes how differentiation in the cost of capital can be achieved in a practical manner, and how a lack of differentiation leads to flawed pricing incentives and wrong conclusions about the contribution to shareholder value of individual business lines.