Apples and Pears: The Comparison of Risk Capital and Required Return in Financial Institutions

42 Pages Posted: 11 Feb 2007

See all articles by Alistair Milne

Alistair Milne

Loughborough University - School of Business and Economics

Mario Onorato

Algorithmics

Date Written: February 2007

Abstract

Risk capital is the contribution of an exposure to the default risk of a financial institution. We investigate its relationship with required shareholder returns, showing that the use of return on risk capital (RAROC) as a risk-adjusted performance measure is inconsistent with the standard theory of financial valuation and that using this one measure to represent at the same time both contribution to default risk and required shareholder returns can lead to substantial loss of shareholder value. We propose an alternative performance measure distinguishing these two aspects of risk and applicable to the efficient allocation of risk capital.

Keywords: RAROC, Risk Management, Economic Capital, Performance Measurement, Financial Regulation

JEL Classification: G21

Suggested Citation

Milne, Alistair K. L. and Onorato, Mario, Apples and Pears: The Comparison of Risk Capital and Required Return in Financial Institutions (February 2007). Available at SSRN: https://ssrn.com/abstract=962362 or http://dx.doi.org/10.2139/ssrn.962362

Alistair K. L. Milne (Contact Author)

Loughborough University - School of Business and Economics ( email )

Epinal Way
Loughborough
Leicestershire, LE11 3TU
United Kingdom

Mario Onorato

Algorithmics ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 207 4813434 (Phone)
+ 44207 481 3130 (Fax)

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