Bank Capital Allocation under Multiple Constraints
32 Pages Posted: 10 Nov 2017
Date Written: October 2017
Abstract
Banks allocate capital across business units while facing multiple constraints that may bind contemporaneously or only in future states. When risks rise or risk management strengthens, a bank reallocates capital to the more efficient unit. This unit would have generated higher constraint- and risk-adjusted returns while satisfying a tightened constraint at the old capital allocation. Calibrated to US data, our model reveals that, when credit or market risk increases, market-making attracts capital and lending shrinks. Leverage constraints affect banks only when measured risks are low. At low credit risk, tighter leverage constraints may reduce market-making but support lending.
Keywords: internal capital market, Value-at-Risk, leverage ratio, risk-adjusted return on capital
JEL Classification: G21, G28, G3
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