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Optimal Capital Allocation Using RAROC And EVA

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  • Stoughton, Neal
  • Zechner, Josef

Abstract

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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Bibliographic Info

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 1999
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Handle: RePEc:cpr:ceprdp:2344

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Related research

Keywords: Allocation; Banking; Budgeting; Capital; Divisions; Evaluation; Institution; RAROC;

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References

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  1. Christopher James, 1996. "RAROC Based Capital Budgeting and Performance Evaluation: A Case Study of Bank Capital Allocation," Center for Financial Institutions Working Papers 96-40, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Ralph C. Kimball, 1997. "Innovations in performance measurement in banking," New England Economic Review, Federal Reserve Bank of Boston, issue May, pages 23-38.
  3. Rogerson, William P, 1997. "Intertemporal Cost Allocation and Managerial Investment Incentives: A Theory Explaining the Use of Economic Value Added as a Performance Measure," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 770-95, August.
  4. Myerson, Roger B, 1979. "Incentive Compatibility and the Bargaining Problem," Econometrica, Econometric Society, vol. 47(1), pages 61-73, January.
  5. Guesnerie, Roger & Laffont, Jean-Jacques, 1984. "A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm," Journal of Public Economics, Elsevier, vol. 25(3), pages 329-369, December.
  6. M. Harris & C. H. Kriebel & A. Raviv, 1982. "Asymmetric Information, Incentives and Intrafirm Resource Allocation," Management Science, INFORMS, vol. 28(6), pages 604-620, June.
  7. Edward Zaik & John Walter & Gabriela Retting & Christopher James, 1996. "Raroc At Bank Of America: From Theory To Practice," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(2), pages 83-93.
  8. Darrough, Masako N & Stoughton, Neal M, 1989. "A Bargaining Approach to Profit Sharing in Joint Ventures," The Journal of Business, University of Chicago Press, vol. 62(2), pages 237-70, April.
  9. Mookherjee, Dilip & Reichelstein, Stefan, 1992. "Dominant strategy implementation of Bayesian incentive compatible allocation rules," Journal of Economic Theory, Elsevier, vol. 56(2), pages 378-399, April.
  10. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," NBER Working Papers 5403, National Bureau of Economic Research, Inc.
  11. Harris, Milton & Raviv, Artur, 1996. " The Capital Budgeting Process: Incentives and Information," Journal of Finance, American Finance Association, vol. 51(4), pages 1139-74, September.
  12. Jeremy C. Stein, 1995. "Internal Capital Markets and the Competition for Corporate Resources," NBER Working Papers 5101, National Bureau of Economic Research, Inc.
  13. Heinkel, Robert & Stoughton, Neal M, 1994. "The Dynamics of Portfolio Management Contracts," Review of Financial Studies, Society for Financial Studies, vol. 7(2), pages 351-87.
  14. Mirrlees, James A, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Wiley Blackwell, vol. 38(114), pages 175-208, April.
  15. Spence, A Michael, 1973. "Job Market Signaling," The Quarterly Journal of Economics, MIT Press, vol. 87(3), pages 355-74, August.
  16. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
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Citations

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Cited by:
  1. Christian Gourieroux & Jean-Paul Laurent & Olivier Scaillet, 2000. "Sensitivity Analysis of Values at Risk," Working Papers 2000-05, Centre de Recherche en Economie et Statistique.
  2. Naik, Narayan Y. & Yadav, Pradeep K., 2003. "Do dealer firms manage inventory on a stock-by-stock or a portfolio basis?," Journal of Financial Economics, Elsevier, vol. 69(2), pages 325-353, August.
  3. Chris D'Souza & Alexandra Lai, 2002. "The Effects of Bank Consolidation on Risk Capital Allocation and Market Liquidity," Working Papers 02-5, Bank of Canada.
  4. Ishikawa, Tatsuya & Yamai, Yasuhiro & Ieda, Akira, 2003. "On the Risk Capital Framework of Financial Institutions," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 21(3), pages 83-105, October.
  5. Mierzejewski, Fernando, 2006. "Economic capital allocation under liquidity constraints," MPRA Paper 2414, University Library of Munich, Germany.
  6. Pegaret Pichler, 2004. "Optimal Contracts for Teams of Money Managers," Econometric Society 2004 North American Winter Meetings 495, Econometric Society.
  7. Chris D'Souza, 2002. "How Do Canadian Banks That Deal in Foreign Exchange Hedge Their Exposure to Risk?," Working Papers 02-34, Bank of Canada.
  8. Kulpmann, Mathias, 2000. "Incentives in an international bank," Journal of Multinational Financial Management, Elsevier, vol. 10(3-4), pages 481-493, December.
  9. Gonzalo Cortazar & Alejandro Bernales & Diether Beuermann, 2005. "Methodology and Implementation of Value-at-Risk Measures in Emerging Fixed-Income Markets with Infrequent Trading," Finance 0512030, EconWPA.
  10. Socol Adela, 2008. "Capital Adequacy In The Romanian Banking System," Annales Universitatis Apulensis Series Oeconomica, Faculty of Sciences, "1 Decembrie 1918" University, Alba Iulia, vol. 1(10), pages 42.
  11. Victoria Geyfman, 2005. "Risk-adjusted performance measures at bank holding companies with section 20 subsidiaries," Working Papers 05-26, Federal Reserve Bank of Philadelphia.

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