A Theory of Risk Capital
Dice Center Working Paper No. 2009-10
54 Pages Posted: 29 May 2009 Last revised: 5 May 2014
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: Suggested Citation
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)
