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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.

Suggested Citation

  • Stoughton, Neal & Zechner, Josef, 1999. "Optimal Capital Allocation Using RAROC And EVA," CEPR Discussion Papers 2344, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:2344
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    3. Gourieroux, C. & Laurent, J. P. & Scaillet, O., 2000. "Sensitivity analysis of Values at Risk," Journal of Empirical Finance, Elsevier, vol. 7(3-4), pages 225-245, November.
    4. 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 1-42.
    5. Homburg, Carsten & Scherpereel, Peter, 2008. "How should the cost of joint risk capital be allocated for performance measurement?," European Journal of Operational Research, Elsevier, vol. 187(1), pages 208-227, May.
    6. Carsten Homburg & Marliese Uhrig-Homburg, 2004. "Zentrales und dezentrales Risikocontrolling in Industrieunternehmen," Schmalenbach Journal of Business Research, Springer, vol. 56(4), pages 311-332, June.
    7. Chris D'Souza, 2002. "How Do Canadian Banks That Deal in Foreign Exchange Hedge Their Exposure to Risk?," Staff 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. Chris D'Souza & Alexandra Lai, 2006. "The Effects Of Bank Consolidation On Risk Capital Allocation And Market Liquidity," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 29(2), pages 271-291, June.
    10. Victoria Geyfman, 2005. "Risk-adjusted performance measures at bank holding companies with section 20 subsidiaries," Working Papers 05-26, Federal Reserve Bank of Philadelphia.
    11. Izhar, Hylmun, 2012. "Measuring Operational Risk Exposures in Islamic Banking: A Proposed Measurement Approach," Islamic Economic Studies, The Islamic Research and Training Institute (IRTI), vol. 20, pages 45-86.
    12. Boot, Arnoud W. A. & Schmeits, Anjolein, 2000. "Market Discipline and Incentive Problems in Conglomerate Firms with Applications to Banking," Journal of Financial Intermediation, Elsevier, vol. 9(3), pages 240-273, July.
    13. 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.
    14. 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, University Library of Munich, Germany.
    15. Mierzejewski, Fernando, 2006. "Economic capital allocation under liquidity constraints," MPRA Paper 2414, University Library of Munich, Germany.
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    17. 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.

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    More about this item

    Keywords

    Allocation; Banking; Budgeting; Capital; Divisions; Evaluation; Institution; RAROC;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • 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
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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