After a brief review of the current theory and practice of risk capital by financial firms, the authors define the concept of risk capital and identify the costs and benefits of using more or less of it. Next, they present their procedure for allocating risk capital to assets and lines of business on the basis of marginal default values, and in a way designed to prevent risk shifting and internal arbitrage. Then, they show how allocations of risk capital are likely to be affected by, and in turn influence, a financial firm’s decisions about both the scale and composition of its portfolio of businesses. Finally, the authors present a number of applications and consider their implications for maximizing the value of financial firms.
In so doing, the authors also show how their method produces very different allocations of risk capital than those based on two measures that have long been widely used by financial firms: value at risk (VaR) and risk-adjusted return on capital (RAROC). Moreover, the adjusted present value (APV) rule for evaluating investment opportunities is shown to be workable for nonfinancial as well as financial firms.