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Capital Allocation and Risk Performance Measurement In a Financial Institution
Author(s) -
Turnbull Stuart M.
Publication year - 2000
Publication title -
financial markets, institutions and instruments
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.386
H-Index - 23
eISSN - 1468-0416
pISSN - 0963-8008
DOI - 10.1111/1468-0416.00039
Subject(s) - risk adjusted return on capital , economic capital , cost of capital , capital adequacy ratio , capital requirement , return on capital employed , capital (architecture) , economics , portfolio , return on capital , physical capital , financial capital , finance , capital budgeting , business , actuarial science , microeconomics , capital formation , human capital , profit (economics) , archaeology , incentive , history , economic growth , project appraisal
This paper provides an analytical and practical framework, consistent with maximizing the wealth of existing shareholders, to address the following questions: What are the costs associated with economic capital? What is the tradeoff between the probability of default and the costs of economic capital? How do we take into account the time profile of economic capital when assessing the performance of a business? What is the appropriate measure of profitability, keeping the probability of default constant? It is shown that the capital budgeting decision depends not only on the covariance of the return of a project with the market portfolio, but also on the covariance with the bank's existing assets. This dependency arises from the simple fact that the economic capital is not additive.