IDEAS home Printed from https://ideas.repec.org/a/eee/ejores/v234y2014i1p186-196.html
   My bibliography  Save this article

Allocation of risk capital on an internal market

Author

Listed:
  • Baule, Rainer

Abstract

We propose an allocation process for economic risk capital using an internal sequential auction in which investment allowances are based on marginal risk contributions. Division managers have incentive to give truthful bids because of bonus payments, which are linear in the division’s profit and linked to the auction bids. With our model, the auction process reaches an equilibrium identical to the optimal allocation if division managers have no diverging interests. When division managers do have diverging preferences in terms of empire building, headquarters faces a trade-off between incurring opportunity costs for achieving a suboptimal allocation and bonus costs paid to division managers to overcome their diverging interests. However, bonus costs are partially offset by proceeds from the auction. Depending on the model parameters, total agency costs can become negative. We show that for large values of new risk capital to be allocated, headquarters can always choose a level of bonus payments so that total costs are negative.

Suggested Citation

  • Baule, Rainer, 2014. "Allocation of risk capital on an internal market," European Journal of Operational Research, Elsevier, vol. 234(1), pages 186-196.
    • Handle: RePEc:eee:ejores:v:234:y:2014:i:1:p:186-196
    DOI: 10.1016/j.ejor.2013.09.005
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0377221713007418
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.ejor.2013.09.005?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Edward Zaik & John Walter & Gabriela Retting & Christopher James, 1996. "Raroc At Bank Of America: From Theory To Practice," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(2), pages 83-93, June.
    2. Stein, Jeremy C, 1997. "Internal Capital Markets and the Competition for Corporate Resources," Journal of Finance, American Finance Association, vol. 52(1), pages 111-133, March.
    3. Niclas Andrén & Håkan Jankensgård & Lars Oxelheim, 2005. "Exposure‐Based Cash‐Flow‐at‐Risk: An Alternative to VaR for Industrial Companies," Journal of Applied Corporate Finance, Morgan Stanley, vol. 17(3), pages 76-86, June.
    4. Saita, Francesco, 2007. "Value at Risk and Bank Capital Management," Elsevier Monographs, Elsevier, edition 1, number 9780123694669.
    5. Stulz, ReneM., 1990. "Managerial discretion and optimal financing policies," Journal of Financial Economics, Elsevier, vol. 26(1), pages 3-27, July.
    6. Krishna, Vijay, 2009. "Auction Theory," Elsevier Monographs, Elsevier, edition 2, number 9780123745071.
    7. Homburg, Carsten & Scherpereel, Peter, 2008. "How should the cost of joint risk capital be allocated for performance measurement?," European Journal of Operational Research, Elsevier, vol. 187(1), pages 208-227, May.
    8. Harris, Milton & Raviv, Artur, 1998. "Capital budgeting and delegation," Journal of Financial Economics, Elsevier, vol. 50(3), pages 259-289, December.
    9. Sanjiv Ranjan Das & Rangarajan K. Sundaram, 1997. "Auction Theory: A Summary with Applications to Treasury Markets," NBER Working Papers 5873, National Bureau of Economic Research, Inc.
    10. Dirk Tasche, 2005. "Measuring sectoral diversification in an asymptotic multi-factor framework," Papers physics/0505142, arXiv.org, revised Jul 2006.
    11. Michael Kalkbrener, 2005. "An Axiomatic Approach To Capital Allocation," Mathematical Finance, Wiley Blackwell, vol. 15(3), pages 425-437, July.
    12. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32, September.
    13. Li, David D & Li, Shan, 1996. "A Theory of Corporate Scope and Financial Structure," Journal of Finance, American Finance Association, vol. 51(2), pages 691-709, June.
    14. David S. Scharfstein & Jeremy C. Stein, 2000. "The Dark Side of Internal Capital Markets: Divisional Rent‐Seeking and Inefficient Investment," Journal of Finance, American Finance Association, vol. 55(6), pages 2537-2564, December.
    15. Stoughton, Neal M. & Zechner, Josef, 2007. "Optimal capital allocation using RAROC(TM) and EVA(R)," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 312-342, July.
    16. M. Harris & C. H. Kriebel & A. Raviv, 1982. "Asymmetric Information, Incentives and Intrafirm Resource Allocation," Management Science, INFORMS, vol. 28(6), pages 604-620, June.
    17. Dennis G. Uyemura & Charles C. Kantor & Justin M. Pettit, 1996. "Eva® For Banks: Value Creation, Risk Management, And Profitability Measurement," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(2), pages 94-109, June.
    18. Matsusaka, John G. & Nanda, Vikram, 2002. "Internal Capital Markets and Corporate Refocusing," Journal of Financial Intermediation, Elsevier, vol. 11(2), pages 176-211, April.
    19. Bernardo, Antonio E. & Cai, Hongbin & Luo, Jiang, 2001. "Capital budgeting and compensation with asymmetric information and moral hazard," Journal of Financial Economics, Elsevier, vol. 61(3), pages 311-344, September.
    20. Milgrom,Paul, 2004. "Putting Auction Theory to Work," Cambridge Books, Cambridge University Press, number 9780521536721, September.
    21. Jeremy C. Stein & Stephen E. Usher & Daniel LaGattuta & Jeff Youngen, 2001. "A Comparables Approach To Measuring Cashflow‐At‐Risk For Non‐Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 13(4), pages 100-109, January.
    22. Robert Wilson, 1979. "Auctions of Shares," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 93(4), pages 675-689.
    23. Robert H. Gertner & David S. Scharfstein & Jeremy C. Stein, 1994. "Internal versus External Capital Markets," NBER Working Papers 4776, National Bureau of Economic Research, Inc.
    24. Adolfo de Motta, 2003. "Managerial Incentives and Internal Capital Markets," Journal of Finance, American Finance Association, vol. 58(3), pages 1193-1220, June.
    25. Robert H. Gertner & David S. Scharfstein & Jeremy C. Stein, 1994. "Internal versus External Capital Markets," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 1211-1230.
    26. Roman Inderst & Christian Laux, 2005. "Incentives in Internal Capital Markets: Capital Constraints, Competition, and Investment Opportunities," RAND Journal of Economics, The RAND Corporation, vol. 36(1), pages 215-228, Spring.
    27. Isabelle Huault & V. Perret & S. Charreire-Petit, 2007. "Management," Post-Print halshs-00337676, HAL.
    28. Stanley Baiman & Paul Fischer & Madhav V. Rajan & Richard Saouma, 2007. "Resource Allocation Auctions within Firms," Journal of Accounting Research, Wiley Blackwell, vol. 45(5), pages 915-946, December.
    29. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
    30. William Vickrey, 1961. "Counterspeculation, Auctions, And Competitive Sealed Tenders," Journal of Finance, American Finance Association, vol. 16(1), pages 8-37, March.
    31. Philippe Artzner & Freddy Delbaen & Jean‐Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228, July.
    32. André F. Perold, 2005. "Capital Allocation in Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 17(3), pages 110-118, June.
    33. Antonio E. Bernardo, 2004. "Capital Budgeting in Multidivision Firms: Information, Agency, and Incentives," The Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 739-767.
    34. Dirk Tasche, 2007. "Capital Allocation to Business Units and Sub-Portfolios: the Euler Principle," Papers 0708.2542, arXiv.org, revised Jun 2008.
    35. Stoughton, Neal & Zechner, Josef, 1999. "Optimal Capital Allocation Using RAROC And EVA," CEPR Discussion Papers 2344, C.E.P.R. Discussion Papers.
    36. Michael C. Jensen, 2003. "Paying People to Lie: the Truth about the Budgeting Process," European Financial Management, European Financial Management Association, vol. 9(3), pages 379-406, September.
    37. Harris, Milton & Raviv, Artur, 1996. "The Capital Budgeting Process: Incentives and Information," Journal of Finance, American Finance Association, vol. 51(4), pages 1139-1174, September.
    38. Back, Kerry & Zender, Jaime F, 1993. "Auctions of Divisible Goods: On the Rationale for the Treasury Experiment," The Review of Financial Studies, Society for Financial Studies, vol. 6(4), pages 733-764.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Cuong, Ly Kim, 2021. "Are financial holding companies' subsidiaries riskier than bank holding companies’ affiliates?," International Review of Economics & Finance, Elsevier, vol. 76(C), pages 1025-1033.
    2. Ly, Kim Cuong & Liu, Hong & Opong, Kwaku, 2017. "Who acquires whom among stand-alone commercial banks and bank holding company affiliates?," International Review of Financial Analysis, Elsevier, vol. 54(C), pages 144-158.
    3. Anachit Bagntasarian & Emmanuel Mamatzakis, 2019. "Testing for the underlying dynamics of bank capital buffer and performance nexus," Review of Quantitative Finance and Accounting, Springer, vol. 52(2), pages 347-380, February.
    4. Bernd Engelmann & Ha Pham, 2020. "A Raroc Valuation Scheme for Loans and Its Application in Loan Origination," Risks, MDPI, vol. 8(2), pages 1-20, June.
    5. Mamatzakis, Emmanuel & Bagntasarian, Anna, 2019. "The nexus between underlying dynamics of bank capital buffer and performance," MPRA Paper 92961, University Library of Munich, Germany.
    6. Ho, Kelvin & Wong, Eric & Tan, Edward, 2022. "Complexity of global banks and the implications for bank risk: Evidence from foreign banks in Hong Kong," Journal of Banking & Finance, Elsevier, vol. 134(C).
    7. Ly, Kim Cuong & Liu, Frank Hong & Opong, Kwaku, 2018. "Can parents protect their children? Risk comparison analysis between affiliates of multi- and single-bank holding companies," Journal of Financial Stability, Elsevier, vol. 37(C), pages 1-10.
    8. Van Son Lai & Duc Khuong Nguyen & William Sodjahin & Issouf Soumaré, 2018. "Discretionary Idiosyncratic Risk, Firm Cash Holdings and Investment," Working Papers 2018-008, Department of Research, Ipag Business School.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Stoughton, Neal M. & Zechner, Josef, 2007. "Optimal capital allocation using RAROC(TM) and EVA(R)," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 312-342, July.
    2. Gatzer, Sebastian & Hoang, Daniel & Ruckes, Martin, 2015. "Internal Capital Markets and Diversified Firms: Theory and Practice," EconStor Preprints 169432, ZBW - Leibniz Information Centre for Economics.
    3. Hoang, Daniel & Gatzer, Sebastian & Ruckes, Martin E., 2018. "The economics of capital allocation in firms: Evidence from internal capital markets," Working Paper Series in Economics 115, Karlsruhe Institute of Technology (KIT), Department of Economics and Management.
    4. Sandro Brusco & Fausto Panunzi, 2020. "Internal financing, managerial compensation and multiple tasks," Annals of Finance, Springer, vol. 16(4), pages 501-527, December.
    5. Stein, Jeremy C., 2003. "Agency, information and corporate investment," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 2, pages 111-165, Elsevier.
    6. Stoughton, Neal & Zechner, Josef, 1999. "Optimal Capital Allocation Using RAROC And EVA," CEPR Discussion Papers 2344, C.E.P.R. Discussion Papers.
    7. Björn Häckel, 2010. "Risikoadjustierte Wertbeiträge zur ex ante Entscheidungsunterstützung: Ein axiomatischer Ansatz," Metrika: International Journal for Theoretical and Applied Statistics, Springer, vol. 21(1), pages 81-108, June.
    8. Kang, Woo-Young & Poshakwale, Sunil, 2019. "A new approach to optimal capital allocation for RORAC maximization in banks," Journal of Banking & Finance, Elsevier, vol. 106(C), pages 153-165.
    9. Choe, Chongwoo & Yin, Xiangkang, 2009. "Diversification discount, information rents, and internal capital markets," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 178-196, May.
    10. Roman Inderst & Holger M. Mueller & Felix Münnich, 2006. "Financing a Portfolio of Projects," The Review of Financial Studies, Society for Financial Studies, vol. 20(4), pages 1289-1325.
    11. Bernardo, Antonio E. & Cai, Hongbin & Luo, Jiang, 2002. "Capital Budgeting in Multi-Division Firms: Information, Agency, and Incentives," University of California at Los Angeles, Anderson Graduate School of Management qt0779b20v, Anderson Graduate School of Management, UCLA.
    12. Joël Bessis, 2009. "Risk Management in Banking," Post-Print hal-00494876, HAL.
    13. Markus Glaser & Florencio Lopez-De-Silanes & Zacharias Sautner, 2013. "Opening the Black Box: Internal Capital Markets and Managerial Power," Journal of Finance, American Finance Association, vol. 68(4), pages 1577-1631, August.
    14. Matsusaka, John G. & Nanda, Vikram, 2002. "Internal Capital Markets and Corporate Refocusing," Journal of Financial Intermediation, Elsevier, vol. 11(2), pages 176-211, April.
    15. Roper, Andrew H. & Ruckes, Martin E., 2012. "Intertemporal capital budgeting," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2543-2551.
    16. Erel, Isil & Myers, Stewart C. & Read, James A., 2015. "A theory of risk capital," Journal of Financial Economics, Elsevier, vol. 118(3), pages 620-635.
    17. Aivazian, Varouj A. & Qiu, Jiaping & Rahaman, Mohammad M., 2015. "Bank loan contracting and corporate diversification: Does organizational structure matter to lenders?," Journal of Financial Intermediation, Elsevier, vol. 24(2), pages 252-282.
    18. Andrey Malenko, 2011. "Optimal Design of Internal Capital Markets," 2011 Meeting Papers 442, Society for Economic Dynamics.
    19. Roman Inderst & Manuel Klein, 2007. "Innovation, endogenous overinvestment, and incentive pay," RAND Journal of Economics, RAND Corporation, vol. 38(4), pages 881-904, December.
    20. Shih-Chu Chou & Ramachandran Natarajan & Kenneth Zheng, 2022. "Conglomerate internal informational advantage and resource allocation efficiency," Review of Quantitative Finance and Accounting, Springer, vol. 59(2), pages 717-748, August.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:ejores:v:234:y:2014:i:1:p:186-196. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/eor .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.