Abstract
This paper described a theory of capital allocation for decentralized businesses, taking into account the costs associated with risk capital. We derive an adjusted present value expression for making investment decisions, that incorporates the time varying profile of risk capital. We discuss the implications for business performance measurement.
Highlights
The credit worthiness of a bank is a major concern to its management, trading partners, creditors and bank regulators
Erel et al (2015) (EMR) take a top-down approach to asset and risk capital allocation subject to constraints on the default put to liability ratio and the total amount of risk capital
We show how the credit risk limit assigned to individual businesses by senior management can be set such that the portfolio effect is zero
Summary
The credit worthiness of a bank is a major concern to its management, trading partners, creditors and bank regulators. Senior management must decide on the optimal size of a buffer to hold and the allocation to individual businesses within the bank.1 Erel et al (2015) (EMR) take a top-down approach to asset and risk capital allocation subject to constraints on the default put to liability ratio and the total amount of risk capital. They consider the bank as a whole and as a multi business.
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