Allocation of Risk Capital on an Internal Market

European Journal of Operational Research 234 (1/2014), 186-196.

48 Pages Posted: 4 Mar 2008 Last revised: 8 Jan 2014

Date Written: April 12, 2012

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.

Keywords: capital allocation, economic capital, risk capital, risk contributions, internal market, asymmetric information, empire building

JEL Classification: D44, G31

Suggested Citation

Baule, Rainer, Allocation of Risk Capital on an Internal Market (April 12, 2012). European Journal of Operational Research 234 (1/2014), 186-196.. Available at SSRN: https://ssrn.com/abstract=1102195 or http://dx.doi.org/10.2139/ssrn.1102195

Rainer Baule (Contact Author)

University of Hagen ( email )

Universitaetsstrasse 41
Hagen, 58097
Germany

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