A new approach to optimal capital allocation for RORAC maximization in banks

•We develop a new multi-period internal capital allocation model for banks.•The paper provides first empirical evidence of RORAC maximization under both regulatory and economic capital constraints.•The model incorporates risks arising from divisional level debt and information asymmetry.•We show tha...

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Bibliographic Details
Published inJournal of banking & finance Vol. 106; pp. 153 - 165
Main Authors Kang, Woo-Young, Poshakwale, Sunil
Format Journal Article
LanguageEnglish
Published Elsevier B.V 01.09.2019
Subjects
Banks
Economic capital
Euler principle
Optimal capital allocation
Regulatory risk
Economic capital
C11
Euler principle
E22
G31
G21
Banks
Regulatory risk
Optimal capital allocation
D81
G28
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Summary:•We develop a new multi-period internal capital allocation model for banks.•The paper provides first empirical evidence of RORAC maximization under both regulatory and economic capital constraints.•The model incorporates risks arising from divisional level debt and information asymmetry.•We show that banks can improve their RORAC by using our internal capital allocation model. We introduce a new model for optimal internal capital allocation, which would allow banks to maximize their Return on Risk-Adjusted Capital (RORAC) under regulatory and capital constraints. We extend the single period model of Buch et al. (2011) to a multi-period model and improve its forecasting accuracy by including the debt effect and Bayesian learning innovations. The empirical application shows that our model significantly improves the RORAC of a sample of banks listed in the S&P 500 index.
ISSN:0378-4266
1872-6372
DOI:10.1016/j.jbankfin.2019.06.006