Internal Capital Allocation Research Articles

Internal and External Capital Markets

This study tests the proposition that firms that make efficient use of their internal capital markets can lower the cost of transacting in the external capital market. Using a large panel data set of diversified firms from 1980-1998, I show that diversified firms with an efficient internal capital allocation display a higher propensity to use external capital relative to comparable single segment firms. This result is robust to including other controls, such as measures of information asymmetry, capital needs, relative valuation and firm size. Further, a higher use of external capital by diversified firms relative to single segment firms is associated with a higher excess value, but only for efficient internal capital market users. I also demonstrate the robustness of these findings by employing a sample of firms that experience an increase in expected investment outlays. My findings support predictions from theoretical models, such as Stein (1997), and are consistent with the interpretation that diversified firms with an efficient internal capital market benefit from lower-cost access to external capital by alleviating information asymmetry problems between managers and investors.

The Dark Side of Internal Capital Markets: Divisional Rent‐Seeking and Inefficient Investment

We develop a two‐tiered agency model that shows how rent‐seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent‐seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of “socialism” in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.

Credit risk modeling and internal capital allocation processes: implications for a models-based regulatory bank capital standard

This paper surveys the current state-of-the-art in credit risk modeling at large U.S. banks. Within this context, the paper examines the near-term feasibility of an internal models approach to setting formal regulatory capital requirements for banks, as a replacement for the 1988 Basle Accord. Such an overhaul of the international capital standards would require, in our view, specific attention to several deficiencies in current modeling practices, including questions relating to model specification, parameter estimation, and model validation procedures. The paper also discusses possible uses of internal risk models for setting regulatory capital requirements against selected credit instruments and/or improving examination guidance dealing with the capital adequacy of large, complex banking organizations.

Risk-Based Capital in General Insurance

ABSTRACTThis paper looks at the problems of assessing, for solvency purposes, the capital requirements of a non-life insurer in the context of the United Kingdom. It considers how these capital requirements might vary according to the different risks to which an insurer is subject and how this Risk-Based Capital (RBC) might be measured in practice, using as a case study the RBC formula recently introduced in the United States of America. The paper also discusses the application of RBC concepts to the problem of internal capital allocation, to assist in measuring an insurer's rate of return to shareholders by business unit, as well as the more obvious regulatory application. The advantages and disadvantages of a formula-based approach to capital requirements for solvency purposes are discussed in comparison with possible alternative approaches to insurance supervision.

Internal versus External Capital Markets

This paper presents a framework for analyzing the costs and benefits of internal versus external capital allocation. We focus pritnarily on comparing an internal capital market with bank lending. While both represent centralized forms of financing, in the former case the financing is owner-provided, while in the latter ceise it is not. We argue that the ownership aspect of internal capital allocation has three important consequences: (1) it leads to more monitoring than bank lending; (2) it reduces managers' entrepreneurial incentives; and (3) it makes it easier to efficiently redeploy the assets of projects that are performing poorly under existing management.