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Internal Capital Budgeting and Allocation in Financial Firms

In: Encyclopedia of Finance

Author

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  • Woo-Young Kang

    (Brunel University London)

Abstract

Internal capital budgeting for financial firms differs from that for nonfinancial firms. Financial firms are highly leveraged, risk-sensitive, and possess limited equity capital to cover their illiquid risks compared to nonfinancial firms. Thus, some issues regarding internal capital budgeting – such as type of firm, financial shock, and capital budgeting methodologies – are somewhat different in case of financial and nonfinancial firms, while almost all their other characteristics including agency problem, optimal timing for capital budgeting, relative dependence on the external capital market, firm boundary, and market type remain near identical. Internal capital budgeting for financial firms aims to maximize their risk-adjusted performance measured by risk-adjusted return on capital (RAROC), return on risk-adjusted capital (RORAC), risk-adjusted return on risk-adjusted capital (RARORAC) and so on, leading to the maximization of shareholder value. On the other hand, internal capital budgeting for nonfinancial firms is largely affected by the traditional standard discounted cash flow (DCF) method. Financial firms are required to reflect regulatory capital requirements in their internal capital budgeting process, and using RORAC or RARORAC performance measures, which emphasize the risk component of capital, can be quite helpful for this.

Suggested Citation

  • Woo-Young Kang, 2022. "Internal Capital Budgeting and Allocation in Financial Firms," Springer Books, in: Cheng-Few Lee & Alice C. Lee (ed.), Encyclopedia of Finance, edition 0, chapter 90, pages 2117-2137, Springer.
    • Handle: RePEc:spr:sprchp:978-3-030-91231-4_92
    DOI: 10.1007/978-3-030-91231-4_92
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    More about this item

    Keywords

    Internal Capital Market; External Capital Market; Financial Firms; Nonfinancial Firms; Capital Budgeting; Economic Capital; Financial Regulation;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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