A Theory of Risk Capital

Dice Center Working Paper No. 2009-10

Fisher College of Business Working Paper No. 2009-03-010

54 Pages Posted: 29 May 2009 Last revised: 5 May 2014

See all articles by Isil Erel

Isil Erel

Ohio State University (OSU) - Department of Finance

Stewart C. Myers

Massachusetts Institute of Technology (MIT); National Bureau of Economic Research (NBER)

James Read

The Brattle Group

Date Written: April 21, 2014

Abstract

We present a theory of risk capital and of how tax and other costs of risk capital should be allocated in a financial firm. Risk capital is equity investment that backs obligations to creditors and other liability holders and maintains the firm’s credit quality. Credit quality is measured by the ratio of the value of the firm’s option to default to the default-free value of its liabilities. Marginal default values provide a full and unique allocation of risk capital. Efficient capital allocations maintain credit quality and preclude risk shifting. Our theory leads to an adjusted present value (APV) criterion for making investment and contracting decisions. We set out implications for risk management and corporate finance.

Keywords: Capital, Capital requirements, Financial Institutions, Regulation

JEL Classification: G21, G28

Suggested Citation

Erel, Isil and Myers, Stewart C. and Read, James, A Theory of Risk Capital (April 21, 2014). Dice Center Working Paper No. 2009-10; Fisher College of Business Working Paper No. 2009-03-010. Available at SSRN: https://ssrn.com/abstract=1411190 or http://dx.doi.org/10.2139/ssrn.1411190

Isil Erel (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

Stewart C. Myers

Massachusetts Institute of Technology (MIT) ( email )

Sloan School of Management
Cambridge, MA 02142
United States
617-253-6696 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

James Read

The Brattle Group ( email )

1 Beacon Street
Suite 2600
Boston, MA 02108
United States

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