Internal Capital Budgeting and Allocation in Financial Firms

Woo-Young Kang ()
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Woo-Young Kang: Brunel University London

Chapter 90 in Encyclopedia of Finance, 2022, pp 2117-2137 from Springer

Abstract: Abstract Internal capital budgeting for financial firms differs from that for nonfinancial firms. Financial firms are highly leveraged, risk-sensitive, and possess limited equity capital to cover their illiquid risks compared to nonfinancial firms. Thus, some issues regarding internal capital budgeting – such as type of firm, financial shock, and capital budgeting methodologies – are somewhat different in case of financial and nonfinancial firms, while almost all their other characteristics including agency problem, optimal timing for capital budgeting, relative dependence on the external capital market, firm boundary, and market type remain near identical. Internal capital budgeting for financial firms aims to maximize their risk-adjusted performance measured by risk-adjusted return on capital (RAROC), return on risk-adjusted capital (RORAC), risk-adjusted return on risk-adjusted capital (RARORAC) and so on, leading to the maximization of shareholder value. On the other hand, internal capital budgeting for nonfinancial firms is largely affected by the traditional standard discounted cash flow (DCF) method. Financial firms are required to reflect regulatory capital requirements in their internal capital budgeting process, and using RORAC or RARORAC performance measures, which emphasize the risk component of capital, can be quite helpful for this.

Keywords: Internal Capital Market; External Capital Market; Financial Firms; Nonfinancial Firms; Capital Budgeting; Economic Capital; Financial Regulation (search for similar items in EconPapers)
JEL-codes: D82 E22 G20 G21 G23 G28 G31 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1007/978-3-030-91231-4_92

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