Chapter 9 - Risk-Adjusted Performance Targets, Capital Allocation, and the Budgeting Process

Abstract

This chapter focuses on risk-adjusted performance targets; and the capital allocation process and its links with the planning and budgeting process. Risk-adjusted performance measures the way in which VaR-based RAP measures enter into the budgeting process and it can sometimes influence top managers' perceptions about which businesses should be allowed to grow, thereby indirectly affecting capital allocation. Defining risk-adjusted profitability targets requires estimating the cost of equity capital for the bank and then translating it into a target return on capital at risk. Linking capital allocation and the budgeting and planning process can pave the way for a continuous incremental improvement of the capital allocation. Careful planning process is also important to check capital needs in terms of both regulatory capital and economic capital, to define priorities for growth at the group level, to identify proper risk-adjusted targets for the different divisions and legal entities, and to understand which capital management plans may be needed at the group level. The planning process should be designed and periodically checked so as to avoid making capital allocation a purely mechanical exercise.