Capital Allocation in Large Banks - A Renewed Look at Practice

Abstract

Capital allocation frameworks play an important role in large financial institutions for risk management and performance measurement. These frameworks are predominately developed by practitioners and undergo continuous change. Instead of using economic capital, banks rely for the allocation of equity capital to their business units increasingly on regulatory capital measures like risk-weighted assets. In my paper, I assess the methods used in nowadays practice from a theoretical viewpoint. I demonstrate based on simulated asset and equity returns that some of the commonly used methods provide unreliable results. For example, if RAROC is used in combination with a single firm-wide cost of equity rate, the capital charge is systematically overestimated for businesses that are lowly correlated with the overall market, or for businesses with a left-skewed return distribution. Further, if the cost of equity of listed standalone peers is used as a reference to determine business unit specifc hurdle rates, it is essential to consider differences in leverage, as in the absence of a leverage adjustment the capital charge is underestimated.

Keywords: capital allocation, Risk-adjusted Performance, RAROC, Economic Profit

JEL Classification: G32