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Optimal Capital Allocation Using RAROC And EVA Author info | Abstract | Publisher info | Download info | Related research | Statistics Stoughton, Neal
Zechner, Josef
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This paper analyzes financial institutions' capital allocation decisions when their required equity capital depends on the risk of their projects chosen. We discuss the relevance of strict position limits against discretionary trading through the use of an optimal compensation function. We show that (under full information) the first-best investment decision can be delegated through an economic value added (EVA) compensation contract and solve for the optimal capital allocation rules. We demonstrate how the concept of incremental Value at Risk must be used to deal with the multidivisional firm. The results are extended to deal with asymmetric information on the part of the trading division(s). The analysis defines precisely the notion of risk-adjusted return on capital (RAROC) and how it can be used as a performance measure.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
2344.
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Date of creation: Dec 1999Date of revision:
Handle: RePEc:cpr:ceprdp:2344Contact details of provider: Postal: Centre for Economic Policy Research, 53--56 Great Sutton Street, London EC1V 0DG Phone: 44 - 20 - 7183 8801 Fax: 44 - 20 - 7183 8820
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Keywords: Allocation ; Banking ; Budgeting ; Capital ; Divisions ; Evaluation ; Institution ; RAROC ; Find related papers by JEL classification: G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
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