Working Paper: CEPR ID: DP2344
Authors: Neal M. Stoughton; Josef Zechner
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.
Keywords: RAROC; EVA; Capital Allocation; Budgeting; Banking; Institution Divisions
JEL Codes: G21; G28; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| EVA compensation contract (M52) | optimal capital allocation (G31) |
| incremental value at risk (IVAR) (C26) | optimal capital allocation (G31) |
| capital allocation (G31) | shareholder value maximization (G34) |
| asymmetric information (D82) | sensitivity to risk-taking in capital allocation (G41) |
| volatility increase (E32) | capital allocation increase (G31) |
| RAROC implementation (G32) | enhancement of shareholder value (G34) |