Internal capital budgeting and allocation in financial firms

Abstract

Internal capital budgeting for financial firms differs from that for non-financial firms. Financial firms are highly leveraged, risk sensitive and possess limited equity capital to cover their illiquid risks compared to non-financial 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 non-financial 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 non-financial 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.