In this paper, we consider the risk capital framework adopted by financial institutions. Specifically, we review the recent literature on this issue, and clarify the economic assumptions behind this framework. Based on these observations, we then develop a simple model for analyzing the economic implications of this framework.
The main implications are as follows. First, risk capital allocations are theoretically unnecessary without deadweight costs for raising capital, which are not usually assumed in the business practices of financial institutions. Second, the risk-adjusted rate of return is redundant as it provides no additional information beyond the net present value. Third, risk capital allocation is intrinsically difficult because it is hard to incorporate the correlations among asset returns.
Keywords: Risk capital; Risk management; Capital structure; Capital budgeting; Risk-adjusted rate of return; Capital allocation; Deadweight cost
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.