ALLOCATION OF ECONOMIC CAPITAL IN BANKING – A SIMULATION BASED APPROACH October 2006

An institute’s economic capital allocation taking efficiency aspects into account requires the coexistence of a certain centralisation and delegation. On the one hand information pooling concerning portfolio optimization kind considerations is afforded. On the other hand exclusively possessed knowledge by decentralized entities has to be used through delegation of decision rights. Information asymmetries cause a lack of reliable performance expectations which represent an important input factor concerning an optimization like allocation of economic capital. The model describes a bank dealing in Dow Jones Industrial Average stocks over a certain time period. The model bank applies an economic capital allocation with benchmark character equating to a pure optimization problem. Information asymmetries are overcome to a certain degree through Bayesian inference. The model is meant to be used for numerical comparative analyses providing an informative basis concerning the impact of different economic capital allocation’s efficiency increasing efforts.