Capital Allocation in Financial Firms

This paper develops a theory of capital allocation in opaque financial intermediaries. The model endogenizes risk management and capital structure decisions, and it provides a simple setting within which to address questions relating to capital budgeting, performance measurement, and employee compensation. It provides a theoretical foundation for understanding the appropriate use, and misuse, of the widely-employed RAROC methodology. The main implications of the model are as follows: • Projects should be valued by calculating the net present value of cash flows using marketdetermined discount rates, and subtracting a deadweight cost of capital that is related to the project’s marginal contribution to firm-wide risk. • Diversification across business units reduces the firm’s deadweight cost of risk capital. The diversified firm thus faces a larger investment opportunity set and can operate its units on a larger scale than comparable units operated stand-alone. • Incentive compensation serves an important risk sharing function that results in managerial compensation being less performance-sensitive in units operated within a diversified firm than in units operated stand-alone. First Draft: July 25, 1997 This Draft: February 25, 2001 Capital Allocation in Financial Firms