Capital Allocation

Isil Erel, Stewart C. Myers and James A. Read, Jr.
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Isil Erel: Ohio State University
Stewart C. Myers: MIT
James A. Read, Jr.: Brattle Group, Inc, Cambridge, MA

Working Paper Series from Ohio State University, Charles A. Dice Center for Research in Financial Economics

Abstract: Banks and other financial institutions should allocate capital in proportion to the marginal default value of each line of business, which is the derivative of the value of the bank's default put with respect to a change in the scale of the business. Marginal default values give a unique allocation that adds up exactly. Cross subsidies are avoided if capital allocations are set so that capital-adjusted marginal default values are the same for all lines. We include a series of examples showing how our procedures work and why the allocations are different from allocations based on VaR and the allocations implicit in risk-weighted bank capital requirements. We explain how capital allocations should be "priced" and charged to each line of business.

Date: 2009-05
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