Capital allocation in large banks - a renewed look at practice

Andreas Ita1

Department of Banking and Finance

University of Zurich
andreas.ita@uzh.ch

February 1, 2016

Abstract
Capital allocation frameworks play an important role in large financial institutions for risk
management and performance measurement. These frameworks are predominately developed by
practitioners and undergo continuous change. Instead of using economic capital, banks rely for
the allocation of equity capital to their business units increasingly on regulatory capital measures
like risk-weighted assets. In my paper, I assess the methods used in nowadays practice from a
theoretical viewpoint. I demonstrate based on simulated asset and equity returns that some of the
commonly used methods provide unreliable results. For example, if RAROC is used in combination
with a single firm-wide cost of equity rate, the capital charge is systematically overestimated for
businesses that are lowly correlated with the overall market, or for businesses with a left-skewed
return distribution. Further, if the cost of equity of listed standalone peers is used as a reference to
determine business unit specific hurdle rates, it is essential to consider differences in leverage, as in
the absence of a leverage adjustment the capital charge is underestimated.

Keywords: Capital allocation; Risk-adjusted Performance; RAROC; Economic profit

JEL-Classification: G32

1
Andreas Ita works for UBS. The views and opinions expressed in this material are those of the
author and are not those of UBS Group AG, its subsidiaries or affiliate companies (”UBS”). Ac-
cordingly, UBS does not accept any liability over the content of this material or any claims, losses
or damages arising from the use or reliance of all or any part thereof.

Electronic copy available at: http://ssrn.com/abstract=2726165

1 Introduction

Capital allocation plays an important role in large diversified financial institutions. For many

banks, capital is a scarce and costly resource that is tightly managed. Capital allocation frame-

works provide bank managements a helpful tool for monitoring the firm-wide use of capital, and

for evaluating and optimizing risk-adjusted performance. Since the financial crisis, risk-adjusted

performance measures are increasingly used to determine variable employee compensation.

The main idea of capital allocation is to attribute each internal business unit an amount

of equity capital that is sufficiently large to absorb even very severe unexpected losses. The

allocated capital is then used as a basis to evaluate a business unit’s risk-adjusted performance.

This is either done by measures that set profits in relation to allocated capital, e.g. Risk

Adjusted Return on Capital (RAROC), or by shareholder value related concepts like Economic

Profit or Economic Value Added (EVA)1 which involve a capital charge that is based on allocated

capital. Because capital allocation frameworks have been mainly developed by practitioners, the

methods and terminologies differ largely across firms. Some banks determine allocated capital

based on the economic capital model as originally developed by Banker Trust in the late 1970’s

and refer to it as Economic Capital. Other banks use approaches that are guided by regulatory

capital rules and use terms like Allocated Capital, Allocated Equity or Attributed Equity.

In my paper, I demonstrate that there are a number of pitfalls in the practical implementation

of capital allocation frameworks, especially when used in combination with exogenous cost of

equity rates. I simulate asset- and equity returns for virtual businesses and firms to compare

the capital charges that result for different capital allocation approaches with the ”true” capital

charge. The capital charge equals the product of a business unit’s allocated capital and the

business specific cost of equity rate. I show that frequently used methods like RAROC fail to

estimate the true capital charge of a business unit if a single firm-wide cost of equity rate is

applied for all business units. This is because the cost of equity depends on systematic risk,

whereas capital allocation is typically based on measures of total risk. Further, the capital charge

is underestimated for business units hold within a diversified group if the cost of equity rates
1
EVA is a trademark of Stern Stewart Management Services

Electronic copy available at: http://ssrn.com/abstract=2726165

are derived from comparable single business line peer firms, without adjusting for differences

in leverage. Many of these observations are not overly surprising from a theoretical viewpoint.

My paper closes, however, a gap in the literature, as I take a renewed look at the approaches

effectively used by major banks nowadays. I assess the accuracy of these methods in a rigorous

way, and I provide specific implementation guidance to practitioners.

Already in the 1980’s, a number of large banks in the US have developed and implemented

firm-wide capital allocation frameworks. By contrast, the academic literature only starts to look

at this topic more than a decade later. James (1996) and Zaik, Kelling, Retting, and James

(1996) study the RAROC system introduced by Bank of America and conclude that Bank of

America resembles the operation of an internal capital market in which capital is allocated to

businesses with the aim of mitigating the costs of external financing. James (1996) concludes

that capital allocation pursues the two main objectives risk management and performance eval-

uation. Saita (1999) focuses on the implementation issues of using value-at-risk measures in

the capital allocation process. In addition, the initial literature discusses whether capital al-

location is meaningful at all, as in a theoretically perfect world capital allocation is pointless.

The justification is found in the seminal paper of Froot and Stein (1998). Capital allocation

is compatible with classical financial theory if capital markets are imperfect. In particular for

banks and other financial institutions, capital allocation has a purpose because such firms face

frictions in accessing capital markets, and as there exist regulatory minimum capital require-

ments that have to be met at all times. Merton and Perold (1993) argue that there are agency

issues for financial firms as they are opaque for outside investors. As opposed to other firms,

the asset holdings of banks are not known in detail, and liquid assets can be redeployed fairly

quickly. Further, the customers of financial firms are also often the largest liability holders,

which demand their claims (e.g. deposits, savings accounts) to be risk free. To maintain the

ability to issue virtually default free claims to their clients, financial firms behave in a risk-averse

fashion and try to hedge or avoid exposures that could negatively affect their capital. For risks

that are non-tradeable or for which hedging causes frictions, banks make the pricing dependent

on their existing portfolio. As a consequence, the contribution of a business to the overall cash

flow volatility of the firm becomes an important factor for capital budgeting.

3
 The link between risk-adjusted performance measures and capital budgeting is frequently

discussed in the literature. Crouhy, Turnbull, and Wakeman (1999) and Milne and Onorato

(2012) show that measuring value creation based on RAROC and using a single firm wide cost

of equity rate is inconsistent with financial valuation theory. Krueger, Landier, and Thesmar

(2015) provide empirical evidence for the distortion of investment decisions if firms use a single

discount rate. By contrast, Stoughton and Zechner (2007) show that frictions make risk man-

agement, capital structure and capital budgeting interdependent, such that EVA and RAROC

based frameworks for performance evaluation and reward schemes are consistent with theoreti-

cal capital budgeting models. They derive optimal hurdle rates. Kimball (1998) highlights that

EVA and RAROC metrics unjustifiably presume that earnings and equity capital can be iso-

lated by lines of business, products and customers, which is in reality often not possible because

they are related.

A more recent stream of the literature comes up with elaborate theoretical solutions for

capital allocation. Myers and Read (2001) suggest an option pricing based method for insurance

companies that allocates capital to different business lines considering marginal default values.

Perold (2005) develops a theory of capital allocation in opaque financial firms. He argues that

financial intermediaries face a trade-off between lower monitoring costs if they hold more capital

and increasing deadweight costs that arise from the taxation of returns to equity and free cash

flow agency costs borne by shareholders. Financial firms should therefore evaluate their projects

based on an adjusted net present value (APV) criterion that takes into account the deadweight

cost of capital that is related to the project’s marginal contribution to firm-wide risk. Erel,

Myers, and Read (2015) suggest a procedure for the computation of APV that allocates the tax

and agency cost of risk capital to lines of business by considering marginal default values that

are derived from the firm’s default put. Stoughton and Zechner (2007) derive optimal hurdle

rates that implement the optimal risk level by providing divisional managers an appropriate

incentive schedule.

My work differs from the above papers, as I focus on the capital allocation approaches effec-

tively used by major global banks today. Similar to Saita (1999), I discuss specific implementa-

tion issues that are relevant for practice. My paper is most closely related to James (1996) and

4
Zaik, Kelling, Retting, and James (1996). Since their field study performed at Bank of America

in the nineties, a lot has changed. Due to the rapid change of the regulatory environment in

which banks operate, capital allocation is continuously evolving, and banks put meanwhile more

focus on regulatory risk measures. This is, however, associated with a number of pitfalls. I ad-

dress these and provide specific guidance. Specifically, I examine which of the approaches used

in practice can be supported from a theoretical viewpoint, and which ones not. Further, I assess

whether there are combinations of capital allocation approaches and cost of equity methods

that are more accurate than others. For my study, I benefit from the increased level of public

disclosure by a few large global banks, as well as from my own practical experience in this field.

The remainder of this paper is organized as follows. Section 2 provides a primer in capital

allocation. Section 3 formulates the problem. Section 4 describes the simulation approach.

Section 5 explains the capital allocation models and the cost of equity methods. The evaluation

method and the properties of the simulated sample are discussed in section 6. Section 7 provides

the results of the model performance evaluation. Lastly, section 8 concludes.

5
2 Capital allocation - A primer

In this section, I provide a primer in capital allocation. First, I describe the main purpose of

capital allocation and risk-adjusted performance measurement. Then, I present the two main

concepts used by banks, and I outline the current industry practice. Lastly, I discuss the usage

of hurdle rates.

2.1 Purpose

Capital allocation is done for multiple purposes. When the first capital allocation frameworks

were developed, bank mangers have mainly been interested in understanding the capital needs

of their different business lines and their firm overall. The newly introduced concept of economic

capital allowed them to answer these questions, and it provided them a basis for deciding the

optimal amount of capital of their institutions. In addition, RAROC models were started to be

used for capital budgeting and for risk-adjusted performance measurement. However, since the

implementation of the Basel capital accord in 1992, the amount of capital banks hold is more

and more stipulated by regulatory rules. As a consequence, the purpose of capital allocation

has shifted towards the use for risk-adjusted performance measurement.

There are two broad categories of risk-adjusted performance measures: residual income mea-

sures and return measures. For residual income measures, e.g. Economic Profit or Economic

Value Added, accounting profits are reduced by a capital charge that consists of the product

of allocated capital and the cost of equity rate. For return measures, e.g. RAROC, profits are

divided by the amount of allocated capital. Both type of measures have in common that they

put profits in relation to risk, and they are therefore regarded as superior compared to tradi-

tional return measures like return on equity. By design, risk-adjusted performance measures

are insensitive to doubtful performance improvements that solely result from more risk taking.

This provides risk-takers, for example traders or divisional managers, appropriate incentives. A

risk taker who decides to pursue a more risky strategy is allocated a higher amount of capital

than an other risk taker that chooses a less risky strategy. Suppose for example that a trader

has the choice between an investment in a treasury bond or a stock. The expected returns are

6
3% p.a. for the treasury bond and 9% p.a. for the stock, and the volatility is 5% p.a. for the

treasury bond and 20% p.a. for the stock, respectively. If capital is allocated in proportion to

the volatility as most simple risk measure, the stock investment requires four times as much

equity capital as the bond investment. However, the expected return is only three times larger,

such that the bond investment provides compared to the stock investment the more attractive

return per unit of allocated capital. Thus, a trader whose performance is assessed based on

a risk-adjusted profitability measure prefers the bond over the stock investment, because the

higher risk of the stock investment is not appropriately compensated. By contrast, a trader who

is measured based on an ordinary profitability measure, e.g. return on equity, prefers the more

risky stock investment and potentially destroys shareholder value.

2.2 Capital allocation frameworks

Most capital allocation frameworks used by banks are either based on statistical concepts or

rely on regulatory capital rules. Some banks try to combine the two perspectives by considering

multiple factors for capital allocation. In the following, I discuss the approaches used in practice.

2.2.1 Economic capital

Economic capital has for a long time been the predominant method for capital allocation.

Its origin goes back to the RAROC methodology introduced by Bankers Trust in the 1970’s.

Economic capital is closely related to Value-at-Risk, but it is more comprehensive. It aspires to

cover the risks of an enterprise in its entirety. Importantly, economic capital is not a coherent

risk measure in the sense of Artzner, Delbaen, Eber, and Heath (1999), because it is not sub-

additive. Nonetheless, economic capital is frequently used in financial firms. A good overview

on nowadays use is provided in the textbook of Klaassen and van Eeghen (2009), who define

economic capital as an estimate of the worst possible decline in a bank’s amount of capital at

a specified confidence level, within a chosen time horizon. Often, economic capital is measured

over a one year time horizon and typical confidence levels are at around 99.95%. Thus, economic

capital determines the amount of equity capital that should be allocated to a business to ensure

that capital is sufficient to cover unexpected shortfalls in the vast majority of cases. Confidence

levels are in practice often set based on targeted credit ratings. Klaassen and van Eeghen (2009)

7
mention that confidence levels between 99.95% and 99.98% are typically chosen for target debt

credit ratings between A and AA for Standard & Poor’s, and A and Aa for Moody’s, respectively.

2.2.2 Regulatory capital

An increasing number of large banks uses a regulatory capital adequacy view for capital alloca-

tion. Under the Basel III rules, banks are required to underpin their risk-weighted assets with

a certain amount of Common Equity Tier 1 capital (Basel Committee on Banking Supervision

(2010)). The minimum is a Common Equity Tier 1 ratio of 4.5%. In normal times, banks need

to hold another 2.5% of Common Equity Tier 1 as capital conservation buffer and 0-2.5% of

Common Equity Tier 1 as countercyclical buffer. Global systemically important banks (G-SIBs)

are further required to hold at any time between 1% and 3.5% of Common Equity Tier 1 on top

of their capital requirement, depending on their specific bucket (Basel Committee on Banking

Supervision (2013)). As shown in table 1, most of the world’s largest banks reported per end

2014 a Common Equity Tier 1 ratio of 10% or above, and their Common Equity Tier 1 ratio

targets range predominately from 10% to 13%.2 Consequently, a number of these banks apply

for capital allocation an underpinning of their risk-weighted assets with 10% Common Equity

Tier 1 capital. Items that are for regulatory purposes directly deducted from capital are by

some banks additionally considered. Such deduction items are for example related to goodwill

or intangible assets.3 These deduction items are typically capitalized one-to-one with equity

capital, because they increase the amount of shareholder’s equity that is required to achieve a

given capital ratio. To illustrate this, presume a business unit that has 35bn of risk-weighted

assets and 5bn of goodwill. If the bank targets a Common Equity Tier 1 ratio of 10%, it requires

first 35*0.10=3.5bn of equity capital to underpin the asset exposures. And an additional 5bn

of equity capital is required to underpin goodwill. The business unit has therefore an allocated

capital of 8.5bn, which corresponds to the amount of shareholder’s equity that the business unit

would require as a standalone entity that targets a Common Equity Tier 1 ratio of 10%.4
2
Unless specifically stated, the Common Equity Tier 1 ratios mentioned in this paper are so called fully-applied
or fully-phased figures, which means that they show the situation as if the Basel III rules, which are only fully
applicable from 1 January 2019, were already entirely implemented.
3
For a full list of the applicable deductions, see page 21-26 in Basel Committee on Banking Supervision (2010).
4
The regulatory capital of this entity would only amount to 3.5bn, as the equivalent of the goodwill is not
allowable as capital.

8
2.2.3 Industry practice

Disclosure on capital allocation is voluntary, such that the availability of public information is

unfortunately limited to very few banks. From the 30 GSIBs listed in table 1, only 7 banks

provide in their financial reports enough information that allow a high-level summary of their

methods. An overview of the capital allocation frameworks used by these banks is provided

in table 2. Despite the small sample, the comparison across firms is insightful. First, it is

notable that every bank uses a different capital allocation method. Second, regulatory capital

has become at least as important for capital allocation as economic capital. The majority of

banks uses for the allocation of capital a rule that is based on risk-weighted assets, sometimes

in combination with economic capital. Some banks consider in addition regulatory capital

deduction items, e.g. for goodwill and intangible assets. Lastly, the statements of two banks

indicate that their methods have been revised recently, which indicates that capital allocation

methods are still further evolving.

Capital allocation frameworks that allocate capital to business units dependent on their usage

of risk-weighted assets are popular for two reasons. First, such allocation methods are trans-

parent and easy to implement. The senior management of a bank has only to decide on the

specific percentage of Common Equity capital that is allocated per unit of risk-weighted assets.

Second, approaches based on risk-weighted assets are closely aligned with the banks’ regulatory

capital requirements. As the banks are effectively obliged to hold the respective amounts of

equity capital, the internal acceptance of such methods is often claimed to be higher.

2.3 Cost of equity

When risk-adjusted profitability measures are used for capital budgeting, the projected returns

of a project are usually assessed against predefined hurdle rates. These hurdle rates are typically

set by the firm’s central management office and represent the minimum expected return of an

investment. A common reference point for the required return of an investment is the Capital

Asset Pricing Model (CAPM). Perold (2005) mentions that in the presence of deadweight costs,

i.e., if raising equity is costly, banks should apply a surcharge on their CAPM hurdle rates. In

principle, hurdle rates can be specified for individual businesses or even transactions. In reality,

9
many firms use, however, a single firm-wide hurdle rate that is aligned with the firm’s cost of

equity rate. A prominent example is provided by James (1996) for the RAROC framework

developed at Bank of America, where the same corporate wide cost of equity rate is used.

Further, a more recent McKinsey working paper (Baer, Metha, and Samandari (2011)) mentions

that four of the five firms in their study apply a single RAROC hurdle rate for all business units.

3 Problem

There are evidently no right or wrong approaches in capital allocation. However, if capital

allocation frameworks are used for performance evaluation, the application of the cost of equity

ideally results in a capital charge that corresponds to the cost of capital that the respective

business unit would face if it would be an independent entity. I will therefore use this capital

charge as benchmark for my analysis. There are a number of reasons why most frameworks

used in practice lead to capital charges that deviate from this benchmark. I benefit here from

the insights of Klaassen and van Eeghen (2009), who partly address these challenges in their

book. First, capital is usually allocated to business units in proportion to risk-weighted assets or

economic capital. Because the capital allocation rule is already considering the business units’

risks, practitioners regard it often as sufficient to apply a single hurdle rate, e.g. the firm’s CAPM

cost of equity rate. This neglects, however, that the cost of equity only captures the systematic

risk, i.e., the part of total risk that is correlated with the market return and that cannot

be diversified away. The relative amount of systematic risk varies generally across different

businesses. Krueger, Landier, and Thesmar (2015) highlight that using a unique discount rate

across the entire firm is a widespread fallacy that can lead to significant distortion of investment

decisions. Second, economic capital models focus on very high quantiles of the loss distribution,

such that businesses with heavily left-skewed return distributions require more capital that

businesses with normally distributed returns. Milne and Onorato (2012) show that correct

RAROC hurdles vary with the skewness of the asset returns. This applies for example for debt

instruments, which require a relatively high amount of risk capital to cover the infrequent case

of default, but that provide in the vast majority of cases a very stable payout. Third, businesses

that are hold under the roof of a large diversified financial institution require less capital than

10
otherwise identical single business line firms. Deriving the cost of equity from listed pure play

peer firms may therefore systematically underestimate the true capital charge if differences in

leverage are not appropriately considered.

4 Simulation

4.1 Random Sample

To examine possible errors in the estimation of a business unit’s capital charge, one would ideally

know the true capital charge of that business. However, this information is not even known to

company insiders, and that is actually the reason why firms need to rely internally on frameworks

to determine the amount of allocated capital and its associated costs at a business unit level.

It is of course possible to compute and to compare the estimated capital charges that result

for different capital allocation models, but such a comparison is of limited usefulness, as the

most accurate methods cannot be identified. To overcome this limitation, I generate a random

sample for which the properties of the underlying asset returns are known. In this artificial

world, the hypothetical equity returns of the different businesses are well-defined, such that the

true capital charge can be numerically determined. This allows me to compare the results for

a number of different capital allocation approaches used in practice versus a benchmark capital

charge that is theoretically well founded.

4.1.1 Multiple business line firms

My randomly generated sample consists of J = 50 diversified firms that hold up to 8 differ-

ent business units under the same roof. For each firm j = 1, 2, ..., J, the number of busi-

ness units is determined by randomly drawing a number Lj ∈ {2, 3, 4, 5, 6, 7, 8} with equal

probability. The magnitude of each business is determined by randomly drawing a number

Sl,j ∈ {1, 2, 3, 4, 5} ∀ l = 1, 2, ..., Lj , j = 1, 2, ..., J with equal probability. The different business

units belonging to firm j are represented by the assets A1,j , ..., Al,j , ..., ALj ,j . In total, the sim-

ulated sample consists of K = L1 + L2 + ... + LJ different assets. In the following, the variable

k is used to label a specific business in the entire sample of size K, and the variable l is used to

label the same business in the particular firm specific sub-sample of size Lj .

11
4.1.2 Asset returns

The vector M = (M1 , M2 , ..., Mn )0 is a sequence of n independent and identically distributed

(i.i.d.) market return observations that are drawn from a normal distribution with mean µm

and volatility σm .

Mi ∼ N (µm , σm ) ∀ i = 1, 2, ..., n (1)

The vectors X1 , ..., Xk , ..., XK are random sequences of asset return observations Xk = (X1,k , X2,k ,

..., Xn,k )0 that are by construction positively correlated with the sequence of market returns.

Xi,k = Mi βk + Zi,k ∀ i = 1, 2, ..., n, k = 1, 2, ..., K (2)

Xi,k is the i-th return realization of asset k. Mi βk is the systematic component of the asset re-

turn. βk is the asset beta and is defined as βk = Cov(Xk , M)/V ar(M). Zi,k is the idiosyncratic

component of the asset return.

βk is generated randomly. To obtain a sample with realistic properties, I proceed as follows.

First, I specify the parameters for the market return as µm = 0.06 and σm = 0.15. Thereafter,

I compute βk for each asset from the random parameters σk and ρk,m .

βk = Cov(Xk , M)/V ar(M) = σk /σm · ρk,m ∀ k = 1, 2, ..., K (3)

were

σk ∼ a · eN (0,b) ⇔ σk ∼ eN (ln(a),b) , a = 0.03, b = 0.3 (4)

and

ρk,m ∼ N (µρ , σρ ), µρ = 0.60, σρ = 0.10 (5)

The asset volatility σk is assumed to be i.i.d. log-normally distributed. The parameters a and

b determine the location and the scale of the distribution, respectively. ρk,m is the correlation

of the individual asset return sequence and the market return sequence and is assumed to be

i.i.d. normally distributed with mean µρ and standard deviation σρ . Clearly, these assumptions

reflect my arbitrary choices, but they result in simulated asset betas that lie in a range which

12
is realistic for the asset betas of banks.

The idiosyncratic return component is assumed to be i.i.d. skew-normally distributed.

Zi,k ∼ SN (µk , 2k , λk ) ∀ i = 1, 2, ..., n, k = 1, 2, ..., K (6)

SN (·) is the skew normal distribution function introduced by Azzalini (1985), with the param-

eters mean, variance and skewness. The density of the skew normal distribution is defined as

2φ(x)Φ(λx). µk is the mean, 2k the idiosyncratic variance and λk the skewness of the return of

asset k. Because in an efficient capital market idiosyncratic risk is not compensated, µk is in the

following chosen such that E[Zi,k ] = 0. Further, to obtain left-tailed asset returns, I define the

skew parameter to be negative, thus λk ≤ 0. For λk = 0, the skew-normal distribution equals

the normal distribution.

The skew-normally distributed idiosyncratic return component sequence in (6) is generated

from the SKNOR Stata command provided by Kontopantelis (2008), using the tables in Ram-

berg, Tadikamalla, Dudewicz, and Mykytka (1979). The parameters are determined as follows.

2
2k = σk2 − βk2 σm (7)

r
2 λ
µk = −k q k (8)
π 1 + λ2
k

λk ∼ U (c, d), c = −0.85, d = 0 (9)

The idiosyncratic variance 2k is the residual of the total variance and the systematic variance.

µk is set such that E[Zi,k ] = 0. Lastly, the skewness parameter λk is restricted to equally

distributed discrete random numbers from -0.85 to 0 in increments of 0.05. This ensures that

the SKNOR command can be evaluated properly.

Altogether, the above assumptions lead to asset returns that are left-skewed and positively

correlated, which is a realistic property for assets held by financial firms.

13
4.1.3 Equity returns

Equity returns are derived from asset returns. In a first step, the vectors of asset returns are

transformed into corresponding asset value sequences. The vectors A1 = (A1,1 , A2,1 , ..., An,1 )0 , ...,

Ak = (A1,k , A2,k , ..., An,k )0 , ..., AK = (A1,K , A2,K , ..., An,K )0 contain the asset values. The indi-

vidual asset value observations are defined as follows.

Ai,k = A0 · (1 + Xi,k ) (10)

For all assets, the initial asset value observation A0 is normalized to 100. Further, each asset

is funded by a combination of debt and equity, whereby I assume that each asset is owned by

a standalone firm that holds no other assets. The amount of equity capital that is required

depends on the riskiness of the specific asset. The remainder of the asset value is debt funded.

Following the purpose of economic capital, I determine the amount of risk capital based on the

maximally expected decrease in the asset value for the confidence level 1 − α = 99.95%. This is

tantamount with defining the amount of debt based on the α-quantile of the asset value vector.

Dk = inf{Ai,k ∈ Ak | F (Ai,k ) ≥ α} (11)

Dk is the amount of debt that a standalone firm uses to fund asset k. F (Ai,k ) is the cumulative

distribution function of the asset value. For the given confidence level, the value of the asset is

with probability α = 0.05% insufficient to repay the amount of debt, i.e., the financial institution

defaults on average only once in two-thousand years.5 This means that the bank’s debt has a

very low default risk, such that the bank is able to issue virtually risk free claims to its clients.

Ei,k = M ax(Ai,k − Dk , 0) (12)

The payout to equity holders is for each asset defined by the positive difference between the

specific asset value realization and the amount of debt. The payout is non-negative, because if

the asset value is lower than the debt amount, the shortfall is borne by the firm’s debt holders.
5
The chosen confidence level is in a magnitude as commonly used by banks, see e.g. Klaassen and van Eeghen
(2009), and comparable with the 99.97% confidence level used by Milne and Onorato (2012).

14
 With the initial value of equity E0,k = A0 − Dk , the vector of equity returns is given by

Ek = {E1,k /E0,k − 1, E2,k /E0,k − 1, ..., En,k /E0,k − 1} (13)

4.2 CAPM Cost of Equity

The cost of equity rate is known from the CAPM and writes as

rk = rf + βEQ,k · ERP (14)

rk is the cost of equity rate for the business represented by asset k, rf is the risk free rate

and ERP the equity risk premium. The latter is defined as ERP ≡ E[µm − rf ]. βEQ,k is the

standalone equity beta for asset k and is computed as follows

βEQ,k = Cov(Ek , M)/V ar(M) (15)

To avoid unnecessary complications, I assume that the component related to the funding of the

assets, i.e., the risk free rate, is separately charged to the businesses and applies for both equity

and debt financing.6 The standalone capital charge for asset k comprises therefore only the

CAPM risk premium in 14 and writes as follows.

(A0 − Dk ) · (βEQ,k · ERP ) (16)

5 Capital allocation models

5.1 Economic Capital

The economic capital of a business unit or firm equals the amount of capital that ensures that

even very severe unexpected losses can be fully absorbed in the vast majority of cases. Consistent

with the earlier assumed default probability α = 0.05%, I compute economic capital based on

a 99.95% confidence level. Thus, for n = 100 000 observations, capital is insufficient in 5 cases.
6
Given the very high confidence level of 99.95% used to determine equity, I assume for simplicity that the
bank can issue debt claims at the risk free rate, even the claims bear a minimal default risk.

15
 The economic capital of a business unit writes as follows.

ECl,j (α) ≡ ECk (α) = inf{Gi,k ∈ Gk | F (Gi,k ) ≥ α} (17)

ECl,j (α) is the standalone economic capital of business unit l belonging to firm j. It equals

by definition to the economic capital of single business line firm k holding the same asset.

F (Gi,k ) denotes the probability that the loss does not exceed the given level. The businesses

loss distribution is provided by the vector Gk , which is defined as

Gk ≡ A0 − Ak (18)

For a diversified firm that holds multiple assets, the overall economic capital can be computed

in a similar way. However, unless the firm’s assets are perfectly correlated, the firm benefits

from diversification effects. The economic capital for firm j in total is given by

ECj (α) = inf{Gi,j ∈ Gj | F (Gi,j ) ≥ α} (19)

with
Lj
X
Gj ≡ wl (A0 − Al,j ) (20)
l=1

Due to diversification effects, the economic capital of the firm is lower than the sum of the

economic capital of the different business units. For the purpose of capital allocation, the

business units’ economic capital is therefore linearly scaled to the amount of the firm’s total

economic capital, using the scalar γ. wl denotes the relative size of the business unit, based on

its magnitude Sl,j and the magnitude of the firm overall.

Lj
X
γ = ECj (α)/ wl ECl,j (α) ≤ 1 (21)
l=1

The allocated capital of a business unit equates the business unit’s scaled economic capital, and

considering its relative size.

ACECl,j ≡ γECl,j (α)wl (22)

16
5.2 Risk-weighted assets

A common approach in practice is to underpin the risk-weighted assets of a business unit with

a percentage of Common Equity Tier 1 capital that is aligned with the bank’s capital target or

regulatory capital requirement.

ACRWAl,j ≡ RWAl,j · χ (23)

ACRWAl,j is the allocated capital for business unit l. It is defined as the product of the business

unit’s risk-weighted assets, RWAl,j , and the supposed Common Equity Tier 1 ratio χ.

The computation of risk-weighted assets for large banks follows a sophisticated procedure.

The Basel III framework offers banks a number of different choices to compute their risk-

weighted assets for credit risk, market risk, operational risk and non-counterparty related

risk, i.e., a bank can choose whether to apply the standardized approach or an advanced ap-

proach. Further, national regulators typically impose additional rules for the computation of

risk-weighted assets. This makes the comparison of risk-weighted assets across banks and coun-

tries difficult, see e.g. Le Lesle and Avramova (2012), among others.

For certain calculation approaches and risk types, e.g. credit risk under the advanced IRB

approach, there is a relatively close link between risk-weighted assets and economic capital,

which also follows from the general definition

RWA = K · 12.5 · EAD (24)

provided in Basel Committee on Banking Supervision (2010). The risk-weighted assets equal

12.5 times the capital requirement K, multiplied with the exposure at default (EAD). While

in particular cases K and economic capital could be equal, they are not in general. There

remain important differences between the two concepts. For example, the risk-weighted assets

calculation has to be performed by using predefined confidence levels that can be different per

risk type. Further, risk-weighted assets are computed on a relatively granular level and then

added-up without allowing for diversification effects across risk types, whereas economic capital

17
takes diversification effects explicitly into account.7 Moreover, as economic capital models

are mainly used internally, banks have a high degree of freedom in their modelling choices

and assumptions. By contrast, the rules for computing risk-weighted assets are prescribed in

reasonable detail by the respective national supervisory authorities.

For my virtual sample, I lack of course the detailed informations that would be needed

to compute risk-weighted assets in a way that is comparable with the extensive bottom-up

calculations applied by banks in practice. I have therefore to emulate risk-weighted assets

in a heavily simplifying way. Nonetheless, the subsequent approach should capture the main

characteristics of heterogeneously computed risk-weighted assets reasonably well.

RWAk = ECk (α̃) · 12.5 · (1 + 0.1k ), k ∼ N (0, 1) (25)

Consistent with the Basel III rules for credit risk, I apply an economic capital model to compute

the required capital, using the regulatory prescribed 99.90% confidence level, i.e., α̃ = 0.1%. As

in (24), the resulting capital requirement is then multiplied with a factor 12.5. To consider the

heterogeneity of the risk-weighted assets calculation across banks, I apply a random factor with

mean 1 and standard error 0.1. Further, I use a normalized value of 1 for EAD.

As shown by figure 1, the capital requirements in my sample resulting from economic capital

and 10% of risk-weighted assets are increasing in the level of risk. I measure the latter based on

expected shortfall, which satisfies the properties of a coherent risk measure. Thus, I do for the

allocation of capital not suffer from a potential issue due to violation of VaR sub-additivity. As a

consequence of the modelled heterogeneity of risk-weighted assets, the capital requirements that

arise from 10% of risk-weighted assets show a greater variety than the capital requirements that

result from economic capital. Moreover, as economic capital considers diversification effects,

the magnitude of increase in the level of risk is for economic capital lower than for risk weighted

assets, i.e., the capital requirements are for economic capital lower on average.
7
Not considering diversification effects is generally regarded as being conservative, but this may not necessarily
always be the case if VaR sub-additivity is violated

18
5.3 Cost of equity methods

Regardless of how capital is allocated, there are multiple ways how the corresponding cost of

equity rates can be determined. In the following, I focus on cost of equity methods that are

commonly used in practice. For convenience, I provide the formal description solely for the

combination with economic capital, and the capital charges exclude the risk free component.

5.3.1 Uniform cost of equity method

Because there is a direct link between risk and allocated capital, banks often apply the same

corporate-wide cost of equity rate across all of their businesses. This approach has its origin in

the RAROC framework and is despite some conceptional shortcomings still frequently used. To

align the total allocated capital with the equity capital of the firm, economic capital is linearly

scaled. The capital charge writes as follows.

Cunif = γECl,j (α)wl,j (βEQ,Gj · ERP ) (26)

γECl,j (α)wl,j is the allocated capital of business unit l belonging to firm j and equals the

business unit’s scaled economic capital. The adjacent factor is the firm’s CAPM risk premium.

5.3.2 Peer based cost of equity method

Some firms use cost of equity rates that are differentiated across businesses. Typically, the risk

premiums for the individual business units are determined based on a CAPM approach that

relies on betas observed from listed peer firms that are active in the same business area, so

called comparables. In that case the capital charge writes as

Cpeer = γECl,j (α)wl,j (β̂EQ,l,j · ERP ), β̂EQ,l,j = βEQ,k (27)

β̂EQ,l,j is the estimated equity beta for business unit l belonging to firm j. βEQ,k is the equity

beta of a listed standalone peer firm that holds the same asset as business unit l. It serves as

a proxy for the business unit’s unobservable equity beta. As diversified firms can afford for the

same default probability a higher degree of leverage, we have βEQ,l,j > βEQ,k in general.

19
5.3.3 Leverage adjusted cost of equity method

It is sometimes recommended to adjust cost of equity rates obtained from listed peer firms for

differences in financial leverage, see e.g. Klaassen and van Eeghen (2009). This can for example

be done based on the leverage formula for risky debt provided in Copeland, Weston, and Shastri

(2005), which describes the relationship between the asset beta and the equity beta as follows.

A A
βEQ = N (d1 ) βA ≈ βA (28)
E E

βEQ is the equity beta, βA the unlevered asset beta, A the asset value and E the firm’s equity

capital. N (d1 ) is the Black-Sholes delta of the call option on the firm’s assets representing

equity. As I use in my application a very high confidence level of 99.95% to determine equity,

debt is virtually risk free and N (d1 ) is close to unity.8 The frequently used leverage formula for

risk free debt provided by Hamada (1972) provides therefore a reasonable alternative.9

Based on above, the leverage adjusted peer equity beta is computed as follows. First, the peer

firm’s equity beta βEQ,k is unlevered based on the leverage of the peer firm, and then relevered

based on the implied leverage of the business unit. The leverage of the peer firm is given by
A0 A0
A0 −Dk , the implied leverage of the business unit by γECl,j (α) . Thus, the leverage adjusted equity

beta write as
∗ A0 − D k
β̂EQ,l,j = βEQ,k (29)
γECl,j (α)

and the capital charge using the leverage adjusted beta is given by

∗
Clev adj = γECl,j (α)wl,j (β̂EQ,l,j · ERP ) = wl,j (A0 − Dk )(βEQ,k · ERP ) (30)

The capital charge for the business unit corresponds to the proportionate capital charge of the

standalone firm. This shows that the diversification benefit does in a perfect world not matter,

because the supposed benefit from lower required capital is fully offset by a higher cost of equity.
8
It can be easily shown that N (d1 ) is always larger or equal than the chosen confidence level.
9
The Hamada formula postulates that βEQ = (1 + (1 − t) D E
A
)βA , or βEQ = E βA if there are no taxes.

20
5.3.4 Weighted cost of equity method

To ensure the additivity of reported Economic Profit figures, practitioners may have a preference

for setting the cost of equity rates for the business units such that the average of the cost of

equity rates weighted by the business units’ share of allocated capital corresponds to the firm’s

overall cost of equity rate. A possible way to implement this is by applying a linear scaling

factor θ on the peer firm CAPM risk premiums that equates the sum of the capital charges per

business unit to the firm’s overall capital charge.

Lj
P
wk (A0 − Dk )(βEQ,k · ERP )
(A0 − DGj )(βEQ,Gj · ERP ) k=1 1
θ= Lj
= Lj
= (31)
P P γ
γECl,j (α)wl,j (β̂EQ,l,j · ERP ) γ wl,j ECl,j (α)(β̂EQ,l,j · ERP )
l=1 l=1

1
The scaling factor collapses to γ as in the nominator the capital charge of the firm equals the sum

of the capital charges of the respective standalone businesses, and as ECl,j (α) ≡ A0 − Dk , and

wl,j ≡ wk by definition.10 Further, the business unit’s CAPM risk premiums in the denominator

are estimated from the betas of listed standalone peer firms, such that β̂EQ,l,j ≡ βEQ,k .

Cweight = γECl,j (α)wl,j θ(β̂EQ,l,j · ERP ) = wl,j (A0 − Dk )(βEQ,k · ERP ) (32)

Because the scaling factor θ for the CAPM risk premiums equals the inverse of the scaling factor

γ used to scale economic capital, they cancel out, and the capital charge for the weighted cost

of equity method above collapses to the proportionate standalone capital charge. Thus, the

leverage adjustment is indirectly applied by the weighting rule. As we will see later, in a perfect

world without frictions, the weighted cost of equity method corresponds to the benchmark

capital charge, and the method is equivalent with the leverage adjusted cost of equity method.

5.3.5 Endogenous cost of equity method

Many of the approaches used in practice do not appropriately consider that according to theory

the CAPM risk premiums are solely driven by systematic risk. I evaluate therefore additionally
10
The proof that the capital charge of the diversified firm equals the sum of the capital charges of the respective
standalone businesses is provided in the appendix.

21
an ad-hoc approach that directly allocates the systematic risk of a firm to the business units.

Specifically, the capital charge of the firm is allocated in proportion to the product of the

business unit’s economic capital and the estimated business specific correlation with the market

return, in the following denoted by ρ̂l,m . The capital charge is then given as follows.

ECl,j (α)wl,j ρ̂l,m

Cendog = Lj
(A0 − DGj )(βEQ,Gj · ERP ) (33)
P
ECl,j (α)wl,j ρ̂l,m
l=1

This approach has some similarities with the well established RAROC methodology, but it takes

into account systematic risk only. The capital charge of the firm is thus allocated to the business

units according to their contribution to the firm’s non-diversifiable cash flow variability. Because

the capital charge can be computed directly, the cost of equity rates are not required. They

are determined endogenously and can if needed be recovered from the business units’ capital

charges and allocated capital.

5.4 Example of application

In the following, I illustrate the different approaches based on an arbitrarily chosen firm from

the simulated sample. The selected firm consists of 3 distinct business lines.

Table 3 illustrates the computation of the capital charge if capital is allocated based on a rule

that considers the business units’ scaled economic capital. Business unit 1 has only a moderate

risk profile, e.g. the lowest asset volatility and the least negative skew. This results in the lowest

economic capital amongst the 3 business units. The allocated capital of 1.618bn corresponds to

the standalone economic capital of 8.113bn, weighted with the business unit’s relative size of

30% and scaled to the level of the firm’s overall economic capital, using the scalar γ = 0.665.

Due to the only moderate risk profile, the allocated capital contributes to 27% of the firm’s

equity capital, compared to the business unit’s relative size of 30%. Business unit 2 is largest in

terms of size, but has a rather moderate risk profile too. It is allocated 2.184bn or 36% of the

firm’s equity capital, compared to its relative size of 40%. By contrast, business unit 3 is more

risky. Because of the higher asset volatility and the more pronounced skewness, it is allocated

2.192bn or 37% of the firm’s equity capital, compared to its relative size of 30%.

22
 To compute the capital charges, allocated capital is multiplied with the respective cost of

equity rates, excluding the risk free component. For the uniform cost of equity method, the

firm’s CAPM risk premium of 10.3% is applied across all business units. For the peer based

cost of equity method, the CAPM risk premiums are obtained from virtual standalone peer

firms and range from 6.2% to 7.5%. Notably, the risk premium for business unit 3 is lowest,

despite the business unit’s comparably high risk profile. This is due to the low correlation of the

business unit’s asset return with the market return, which leads to a low amount of systematic

risk. For the leverage adjusted cost of equity method, the peer based CAPM risk premiums

are adjusted for differences in leverage. For the weighted cost of equity method, the peer based

CAPM risk premiums are scaled such that the sum of the business units’ capital charges equals

the firm’s overall capital charge. Lastly, for the endogenous cost of equity method, the capital

charges are directly determined by allocating the firm’s total capital charge in proportion to

the business unit’s systematic risk. In this case, the CAPM risk premiums are recovered by

dividing the resulting capital charges by the amount of allocated capital. For most methods,

the capital charges are in a similar magnitude. Only for the peer based cost of equity method

and the uniform cost of equity method, there are notable deviations.

Table 4 illustrates the computation of the capital charges if capital is allocated based on risk-

weighted assets. The business units are allocated an amount of equity capital that equals 10%

of their risk-weighted assets. Business unit 1 has 25.623bn risk-weighted assets, which results in

an allocated capital of 2.562bn, or 25% of the firm’s overall equity capital. For business unit 2

and business unit 3, the allocated capital amounts to 38% and 37% of the firm’s equity capital,

respectively. For the chosen 10% capital underpinning of risk-weighted assets, the business

units are allocated a significantly higher amount of capital than before. However, the CAPM

risk premiums are due to the higher amounts of equity capital materially lower, such that the

capital charges are overall not much different from those in table 4. This is of course no surprise

and consistent with the seminal insights of Modigliani and Miller (1958). Moreover, the capital

charge for the peer based cost of equity method is now consistent with the benchmark capital

charge that will be discussed in the next section.

23
6 Evaluation method and simulated sample

In this section, I define the benchmark capital charge and the evaluation measures, and I discuss

the properties of the simulated sample.

6.1 Benchmark capital charge

The benchmark capital charge is defined as the product of the equity capital and the CAPM risk

premiums that a business unit would have as an independent entity. This definition is motivated

by two aspects. First, it is for performance measurement often aimed to assess internal business

units as if those were independent entities, see e.g. Kimball (1998). Second, this definition

ensures that the sum of the capital charges for the different business lines equals the firm’s

overall capital charge.

In the absence of regulations, banks are free in their capital structure choices. In such situa-

tion, economic capital provides a meaningful reference for the economically required capital of

a bank, and the benchmark capital charge writes as follows.

Cbenchm,k = wk (A0 − Dk )(βEQ,k · ERP + d) (34)

The first part of the product on the right hand side is the prorated amount of equity capital

required for the business on a standalone basis. The second part relates to the cost of equity,

which consists of the CAPM risk premium and an assumed deadweight cost d associated with

equity financing. The addition of a deadweight cost is consistent with the view of Perold (2005)

that banks should apply a surcharge on their hurdle rates if raising equity is costly. However,

it is less clear if and on what basis banks take such deadweight costs into account. From a

theoretical viewpoint, the concept of implied cost of equity which is commonly used in the

accounting literature (e.g. Botosan (1997), Gebhardt, Lee, and Swaminathan (2001), Claus and

Thomas (2001), among others) could provide a solution. As the implied cost of equity is defined

as the discount rate that equates the present value of the firm’s future cash flows to the current

market value, it implicitly considers all factors that investors regard as relevant for the pricing

of a stock, hence, also any deadweight costs for which shareholders want to get compensated.

24
 Nowadays, banks have to meet regulatory minimum capital requirements that are usually

higher than what their internal economic capital models suggest. To emulate the real world

environment in which banks operate, I assume in the following that the equity capital required by

a bank is prescribed by the higher of i) a regulatory minimum capital requirement as percentage

of risk-weighted assets, and ii) a regulatory minimum leverage ratio requirement as a percentage

of assets. Consistent with existing banking regulations, the capital requirement has to be

satisfied at the firm level only, i.e., it is not applicable at the level of a specific business unit.

The equity capital for single business line and multi-business line firms write as

A0 − Dk∗ = max(RWAk · χ, ψA0 ) (35)

and
∗
A0 − D G j
= max(ΣRWAj · χ, ψA0 ) (36)

∗ denote the amount of debt if equity is determined based on regulatory

respectively. Dk∗ and DG,j

rules. RWAk measures the risk-weighted assets of a bank that performs only a single business.

ΣRWAj is the total of risk-weighted assets for bank j and equals the sum of the risk-weighted

assets of the different business units. χ is the minimum Common Equity Tier 1 ratio, i.e., the

percentage of risk-weighted assets to be underpinned with equity capital. ψ is the minimum

leverage ratio, i.e., the percentage of assets to be underpinned with equity capital.

The benchmark capital charge re-writes as follows.

Cbenchm,k = wk (A0 − Dk )(βEQ,k · ERP + d) + φ(Dk − Dk∗ )d (37)

φ is an indicator variable with value 1 if Dk∗ < Dk , i.e., when the regulatory rules are binding,

and value 0 otherwise. The first term is the same as in (34) and relates to the amount of capital

that is needed to cover the shortfall risk of the business units’ assets. The second term relates to

the additional deadweight costs that apply on the firm’s overall equity capital. Thus, deadweight

costs become in the presence of binding regulatory capital requirements more weighty.

25
6.2 Evaluation measures

To evaluate the model accuracy, the different capital allocation methods are applied on the

simulated sample. For each model, the resulting capital charges are then compared with the

respective benchmark capital charges. Scatter plots provide a powerful tool for a first visual

examination. To evaluate the accuracy of the different capital allocation methods more for-

mally, I use the mean absolute error (MAE) and the mean square error (MSE) as evaluation

criteria. Both measures are frequently used in the literature for this purpose. In addition, I

perform a regression through the origin to evaluate the regression coefficient as a measure for

the unbiasedness of a method. For an unbiased model, the coefficient for the estimated capital

charge regressed on the benchmark capital charge has to equal unity.

While the above measures allow to quantify the accuracy of the different capital allocation

methods, they do not reveal the source of estimation errors. For practitioners, it would, however,

often be useful to understand in which situations a model performs particularly good or bad. For

this purpose, I regress the relative model errors (estimation error divided by allocated capital)

on the main determinants of the capital charge, namely the volatility of the asset, the correlation

of the asset return with the market return, the skewness of the asset return, and the number of

business units as a proxy for diversification effects. For an ideal model, the forecasting errors

are purely random and not explainable by any of these factors. This can be formally tested

by the F-statistics of the joint regression. The impact of the individual determinants is known

from the sign and the statistical significance of the coefficients in individual regressions.

6.3 Simulated sample

The summary statistics for the simulated sample, grouped by the 50 virtual firms, are reported

in table 5, with the overall statistics shown at the end of the table. The summary statistics

for allocated capital, benchmark capital charge and modelled capital charges at a business unit

level are given in table 6. The benchmark capital charge is identical for all approaches, with

a mean of 0.142. The amount of allocated capital depends on the chosen capital allocation

approach. If economic capital is used, the mean of the business units’ allocated capital is 1.132.

If allocated capital is determined as 10% of the business unit’s capital, the mean is 2.057.

26
 The distribution of asset betas is shown in figure 2. As common for banks, the mean asset beta

is with 0.123 significantly lower than the asset betas for other industries. Empirical studies on

bank asset betas are rare, but the few available ones come up with numbers in this magnitude,

e.g. Baker and Wurgler (2013) find for US banks an asset beta of 0.074 and Damodaran reports

on his homepage unlevered betas of 0.33 for banks and 0.07 for financials.11 . The distribution

of equity betas is shown in figure 3. Due to the impact of leverage, equity betas are higher

than asset betas. For the single business line peer firms, the standalone equity betas lie in a

range from 0.597 to 1.971, with a mean of 1.334. For the multi business line firms, diversification

effects permit in the absence of regulatory constraints a higher amount of leverage, which reflects

in equity betas ranging from 1.353 to 2.579, with a mean of 2.202.

7 Model performance

This section evaluates the performance of the different capital allocation methods under varying

assumptions. The numerical evaluation results are reported in tables 7 and 8. Scatter plots of

the resulting capital charges versus the benchmark capital charge are provided in figures 4 - 6.

7.1 Frictionless, unregulated world

In a frictionless world without regulatory constraints, economic capital is a natural choice for

the allocation of capital to business units, although capital allocation loses strictly speaking its

purpose. Nonetheless, it is insightful to study first the different methods in an unconstrained

setting. The results are given in panel A of table 7. The leverage adjusted peer cost of equity

method and the weighted cost of equity method perform best and estimate the capital charge

precisely accurate. By contrast, the peer based cost of equity method performs only poorly and

suffers from a material downward bias. The discussion of the detailed results follows below.

The uniform cost of equity method applies the same firm-wide cost of equity rate across

all business units. This approach neglects that the CAPM risk premiums depend not only

on the business units’ overall risk, but also on the correlation of the returns with the market

return. With MAD and MSE of 0.017 and 0.023, respectively, the uniform cost of equity method
11
see http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html

27
performs poorly. The MAD amounts to 12% of the sample average benchmark capital charge of

0.142 and is therefore economically significant. The slope is with 0.978 not materially different

from unity, which indicates that the method is on average not materially biased. Further,

the high F-statistics of 75.69 for the joint regression of the relative model errors reveals that

the estimation errors are not random. The negative and individually significant coefficient

for correlation means that the method systematically underestimates the capital charge for

businesses with a high correlation with the market return. Further, the negative coefficient

for skewness indicates that the method overestimates the impact of tail risks. The use of the

uniform cost of equity rate is therefore despite its widespread application not advisable.

The peer based cost of equity method suffers from a material downward bias, such that the use

of the method is not recommendable. MAD and MSE are with 0.051 and 0.059 high. As visible

from the scatter plot in figure 4, the estimated capital charges are always below the 45 degree

line which represents the true capital charge, and the slope is with 0.671 materially different

from one. A bank using the peer based cost of equity method underestimates the true capital

charge of a business unit on average by more than one third. A plausible explanation for this

material downward bias is the diversification benefit for multi-business line firms that causes

disparities in the amount of financial leverage. Because diversified firms require less capital,

the cost of equity rates obtained from comparable single business line peers are too low for the

business unit’s implicit amount of leverage. The significant negative coefficient for number of

business units (#bus) points clearly into this direction. By contrast, the leverage adjusted cost

of equity method eliminates these deficiencies entirely. The capital charge is identical with the

benchmark capital charge, such that MAD and MSE collapse to zero.

The weighted cost of equity method is also consistent with the benchmark capital charge

and results in MAD and MSE of zero. The simple weighting rule allows therefore to achieve

the same outcome as the leverage adjustment. Moreover, the weighted cost of equity method

ensures that the business units’ capital charges add-up to the firm’s overall capital charge, which

is often desirable from a practical viewpoint, i.e., for the consistent measurement and reporting

of Economic Profit. The weighting method is also advantageous if there exist only imperfect

comparables for the business units. The forced consistency with the firm’s observable cost of

28
equity serves in such case as a corrective for potential estimation errors.

The endogenous cost of equity method performs despite its ad hoc style surprisingly well. The

method is with MAD and MSE of 0.009 and 0.019, respectively, even best among the models

that are not equivalent to the benchmark capital charge. As shown in figure 4, the estimated

capital charges follow the 45 degree line relatively closely, which is also reflected in a slope very

close to unity. Further, the F-statistic of the relative error regressions is with 29.17 lower than

for most other models, but errors are clearly not random. I obtain significant coefficients for

asset volatility and correlation. A closer inspection of the data reveals that the endogenous cost

of equity method is vulnerable to situations in which asset volatility, skewness and correlation

vary largely across business units. The capital charge tends for example to be underestimated

for business units with a high asset volatility and a low correlation if at the same time other

business units have a high asset volatility, a high skewness and a normal correlation. Despite this

shortcoming, the method performs in most cases reasonably well, and as a further advantage,

it does not rely on the availability of suitable listed peer firms as comparables.

7.2 Regulated world without frictions

In a regulated world, banks are facing mandatory minimum capital requirements. First, I

assume that for all banks a 10% Common Equity Tier 1 ratio requirement applies at firm level.

Consistent with this requirement, I assume that the banks rely on a capital allocation rule which

attributes the business units an amount of equity capital that equals 10% of their risk-weighted

assets. The results are shown in panel B of table 7. The main implications are as follows.

For the peer based cost of equity method, the downward bias disappears and MAD and MSE

collapse to zero. This is due to the fact that all firms are now by assumption subject to the same

capital structure policy, such that there is no longer a diversification benefit for multi-business

line firms. This means that the peer based cost of equity method, the leverage adjusted cost of

equity method and the weighted cost of equity method estimate the benchmark capital charge

precisely accurate. For the uniform cost of equity method, MAD and MSE increase to 0.021

and 0.028, respectively. This is as expected, because risk-weighted assets are a more dispersed

risk measure than economic capital. Lastly, because the endogenous cost of equity method does

29
not rely on allocated capital, MAD and MSE remain for this method unchanged at 0.009 and

0.019, respectively.

Panel C shows the results if a complementary leverage ratio requirement is introduced. It is

for analytical purposes set such that it is binding for 50 percent of the single business line peer

firms, but it is not applicable for the banks operating the capital allocation frameworks. For

the uniform cost of equity method and the endogenous cost of equity method, the introduction

of the leverage ratio has no impact, as the cost of equity rates are not derived from peer firms.

The leverage adjusted cost of equity method continues to perform well, with MAD and MSE of

almost zero. For the peer based cost of equity method and the weighted cost of equity method,

MAD increase from zero to 0.011 and 0.013, and MSE from zero to 0.022 and 0.019, respectively.

The deviations from the benchmark capital charge are in both cases due to the higher amount

of capital hold by the peer firms affected from the minimum leverage ratio. This leads to lower

cost of equity rates for these firms, and as they are used as a proxy for the business units’ cost

of equity rates, the cost of equity is underestimated for the latter. For the weighted cost of

equity method, the weighting rule is no longer offsetting the differences in leverage entirely, as

the magnitude of the leverage adjustment becomes dependent on whether the leverage ratio is

binding for the peer firms or not. As shown in the left half of figure 6, the capital charge tends

to be underestimated if the leverage ratio is binding, and overestimated if it is not binding.

Panel D shows the results if the minimum leverage ratio requirement is set such that it is

binding for 50 percent of the diversified firms operating a capital allocation framework, but as-

sumed to be non-binding for the single business line peer firms. Again, the results are unaffected

for the uniform cost of equity method and the endogenous cost of equity method. Further, for

the leverage adjusted cost of equity method and the weighted cost of equity method, MAD and

MSE are zero. The results for the peer based cost of equity method are with MAD and MSE

of 0.010 and 0.021, respectively, not materially different from panel C. However, the slope is

now with 1.058 above unity and indicates that the model overestimates the benchmark capital

charge. As also visible from the scatter plot in the right half of figure 6, peer based cost of equity

rates are no longer a good proxy for the business units’ cost of equity rates if the minimum

leverage ratio requirement is binding for their parent firms.

30
7.3 Frictions

Table 8 provides the results in the presence of assumed deadweight costs d = 0.02. The dead-

weight costs are identical for all banks and considered in the modelled capital charges, as well as

in the benchmark capital charge. The magnitude of the assumed deadweight costs is material.

For a bank with a CAPM cost of equity rate of 10%, a deadweight cost of 0.02 implies a 17%

reduction in market value. This is perhaps at the upper end of what is realistic for a large bank.

Nonetheless, the impact of the deadweight costs is generally only small. For the economic cap-

ital based models (panel A), the impact of deadweight costs is not material. MAD and MSE

slightly increase for the leverage adjusted cost of equity method, as the leverage adjustment is

applied on the entire cost of equity rate and thus erroneously up-scales the deadweight costs.

For the capital allocation models based on risk-weighted assets (panel B), the impact is marginal

likewise. MAD and MSE increase solely for the endogenous cost of equity method. Also in the

case where the leverage ratio is binding for around 50 percent of the peer firms (panel C), the

impact is small. There are minor increases in MAD and MSE for the leverage adjusted cost of

equity method and the endogenous cost of equity method. If the leverage ratio is binding for

around 50 percent of the firms using a capital allocation framework (panel D), MAD and MSE

increase moderately for all methods. Altogether, deadweight costs have a surprisingly small

impact on the accuracy of the capital allocation approaches.

8 Conclusions

The insights of my study translate into the following recommendations. First, firms should

for risk-adjusted performance measurement use differentiated cost of equity rates. The use of a

single firm-wide cost of equity rate across all business units is inappropriate, despite the fact that

capital is allocated in proportion to the business units’ risks. Second, cost of equity rates derived

from standalone peer firms need to be adjusted for differences in leverage. A direct use of peer

cost of equity rates is only justifiable if the peer firms have a similar capital structure. Instead

of an explicit leverage adjustment, firms can, however, equivalently impose a rule that requires

the business units’ capital charges to sum up to the firm’s overall capital charge. Third, my

ad-hoc approach of allocating the firm’s overall capital charge according to their contribution to

31
the firm’s non-diversifiable cash flow variability performs surprisingly well. This approach may

in particular be useful if it is difficult to find suitable single business line peers for all business

units. Fourth, deadweight costs associated with equity capital have only a small impact on the

performance of the different capital allocation approaches.

Altogether, my paper shows that capital allocation continues to be driven by developments

in practice. Since the field study performed by James (1996) at Bank of America, the industry

practice has significantly changed. And in view of ongoing regulatory changes, capital allocation

methods are likely to further adapt to new realities. It may therefore be useful for researchers

to have from time to time a renewed look at practice.

32
Appendices

A Proof

In the following, I prove that the capital charge of a diversified firm equals the sum of the

capital charges for the standalone firms performing the same businesses. The amount of capital

required for a business is assumed to be a function of its inherent risks. For simplicity, I focus

only on the component of the capital charge that is related to the risk premium.

Claim:

N
Cov(EG , M ) X Cov(Ei , M )
Cα (σG , λG ) · · ERP ≡ wi · Cα (σi , λi ) · · ERP
V ar(M ) V ar(M )
i=1

Cα (σ, λ) is the quantile function that determines the amount of equity capital for the confidence

level 1 − α. σ and λ are the parameters for the volatility and the skewness of the asset return.

In the following, M and Xi denote stochastic variables for the market return and the i-th asset

return, respectively. A0 is the initial asset value. Ei is the return to equity holders for the

standalone firm holding asset i, which is derived from the stochastic asset return. Similarly,

EG is the return of a diversified firm holding multiple assets. Di is the return on debt for the

standalone firm holding asset i. If the variables are used without subscripts, they relate to asset

return, debt and equity in general.

1.

The proof starts with the following identity

Cα (σ, λ) A0 − Cα(σ, λ)
X≡ E+ D
A0 A0

which states that the debt and equity returns, weighted by their respective shares of the capital

structure, need to equal the asset return. Consequently, it needs also to hold that

Cα (σ, λ) A0 − Cα(σ, λ)
Cov(X, M ) ≡ Cov( E+ D, M )
A0 A0

33
or
Cα (σ, λ) A0 − Cα(σ, λ)
Cov(X, M ) = Cov(E, M ) + Cov(D, M )
A0 A0

For debt with virtually no default risk, it is reasonable to assume that the covariance with the

market return is zero

Cov(D, M ) = 0

such that the identity can be rewritten as

A0
Cov(E, M ) = Cov(X, M )
Cα (σ, λ)

2.

After substituting for Cov(E, M ), the claim re-writes as

N
A0 Cov(XG , M ) X A0 Cov(Xi , M )
Cα (σG , λG )· · ·ERP ≡ wi ·Cα (σi , λi )· · ·ERP
Cα (σG , λG ) V ar(M ) Cα (σi , λi ) V ar(M )
i=1

which simplifies to
N
Cov(XG , M ) X Cov(Xi , M )
≡ wi
V ar(M ) V ar(M )
i=1

3.

XG is the asset return of the overall firm and is defined as

XG ≡ w1 · X1 + w2 · X2 + ... + wn · Xn

Thus, Cov(XG , M ) on the left-hand slide can be written as

N
Cov(XG , M ) Cov(w1 · X1 + w2 · X2 + ... + wn · Xn , M ) X Cov(Xi , M )
= = wi ·
V ar(M ) V ar(M ) V ar(M )
i=1

such that indeed

N N
X Cov(Xi , M ) X Cov(Xi , M )
wi · ≡ wi
V ar(M ) V ar(M )
i=1 i=1

34
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37
 Table 1: G-SIB disclosure
This table shows for the 30 G-SIBs per 31 December 2014 the number of operative segments, the current
and targeted Common Equity Tier 1 ratio, and whether the institutions provide in the external disclosure
a qualitative description of their capital allocation approach (disclosure=yes/no). The number of operative
business segments (#Segments) is based on the number of business lines considered for segment reporting
under IFRS and US-GAAP, respectively. Segments like Corporate Center, Non-Core and other are not
counted as operative segments. CET1 reported is the Basel III Common Equity Tier 1 capital ratio under
the advanced approach and under a fully-phased-in view (fully-applied, look-through, end-point 2019).
CET1 target is the bank’s stated CET1 ratio target. Information is extracted from 2014 annual reports,
4Q14 reports and result presentations available on the investor relations homepage of the respective firms.
Bank #Segments CET1 reported CET1 target Disclosure
HSBC 4 11.1% 12%-13% no
JP Morgan Chase 4 10.2% 11%-12%+ no
Barclays 4 10.3% 11%+ yes
BNP Paribas 3 10.3% - no
Citigroup 2 10.6% - no
Deutsche Bank 4 11.7% 11% yes
Bank of America 5 9.6% - yes
Credit Suisse 2 10.1% 10% yes
Goldman Sachs 4 11.1% - no
Mitsubishi - 11.6% - no
Morgan Stanley 3 10.7% - yes
Royal Bank of Scotland 3 11.2% 13% yes
Agricultural Bank of China 3 9.1% - no
Bank of China 5 - - no
Bank of New York Mellon 2 9.8% - no
BBVA - 10.4% 10% no
Group BPCE 2 11.7% ≥ 12% no
Group Credit Agricole 6 13.1% - no
ICBC Ltd. 3 no no no
ING Bank 5 11.4% >10% no
Mizuho FG 7 10.2% >8% no
Nordea 3 - >13% no
Santander 4 9.7% 10%-11% no
Societe Generale 7 10.1% >10% no
Standard Chartered 4 10.7% 11%-12% no
State Street 2 11.5% - no
Sumitomo Mitsui FG 4 11.5% 10% no
UBS 5 13.4% >13% yes
Unicredit Group 8 10.0% >10% no
Wells Fargo 3 10.4% - no

38
 Table 2: Overview of approaches used by major banks
This table provides an overview over the capital allocation methods used by 7 major banks. Only for the selected institutions, sufficient qualitative disclosure on their capital
allocation frameworks was available. As disclosure on capital allocation is voluntary, the other G-SIBs did not provide information at the same level of details.
Bank Name Approach Description
Bank of America Allocated Capital Economic capital & regulatory The Corporation periodically reviews capital allocated to its businesses and allocates capital annually during the
capital strategic and capital planning processes. We utilize a methodology that considers the effect of regulatory capital
requirements in addition to internal risk-based capital models. The Corporation’s internal risk-based capital models
use a risk-adjusted methodology incorporating each segment’s credit, market, interest rate, business and operational
risk components. Source: Annual report 2014, page 32, available on http://investor.bankofamerica.com/phoenix.
zhtml?c=71595&p=irol-reportsannual#fbid=8lndNjlQEfb
Barclays PLC Allocated Equity 10.5% of risk-weighted assets & Allocated equity has been calculated as 10.5% of CRD IV fully loaded risk weighted assets for each business, adjusted
deduction items for CRD IV fully loaded capital deductions, including goodwill and intangible assets, reflecting the assumptions the
Group uses for capital planning purposes. The excess of allocated Group equity, caused by the fully loaded CRD IV
CET1 ratio being below 10.5% on average in the period, is allocated as negative equity to Head Office. Allocated
tangible equity is calculated using the same method, but excludes goodwill and intangible assets. Source: Annual
report 2014, page 243, available on https://www.home.barclays/annual-report-2014.html#downloads
Credit Suisse Economic Capital Economic Capital at 99.97% Our capital management framework relies on economic capital, which is a comprehensive tool that is also used for
risk management and performance measurement. Economic capital measures risks in terms of economic realities
rather than regulatory or accounting rules and is the estimated capital needed to remain solvent and in business, even
under extreme market, business and operational conditions, given our target financial strength as reflected in our
long-term credit rating. Source: Annual report 2014, page 108, available on https://www.credit-suisse.com/tw/

39
en/about-us/investor-relations/financial-disclosures/financial-reports/finacial-reports-2014.html
Deutsche Bank Active Equity 10% of risk-weighted assets & Under the new methodology, the internal demand for regulatory capital is derived based on a Common Equity Tier
deduction items 1 ratio of 10% at a Group level and assuming full implementation of CRR/CRD 4 rules. Therefore, the basis for
allocation, i.e., risk-weighted assets and certain regulatory capital deduction items, is also on a CRR/CRD 4 fully-
loaded basis. Source: Annual report 2014, page 153, available on https://www.db.com/ir/en/content/reports_
2014.htm
JP Morgan Allocated Capital regulatory capital & economic Equity for a line of business represents the amount the Firm believes the business would require if it were operating
risk measures independently, considering capital levels for similarly rated peers, regulatory capital requirements (as estimated
under Basel III Advanced Fully Phased-In) and economic risk measures. Capital is also allocated to each line of
business for, among other things, goodwill and other intangibles associated with acquisitions effected by the line of
business. Source: Annual report 2014, page 350, available on http://investor.shareholder.com/jpmorganchase/
annual.cfm
RBS Notional Equity 12% of risk-weighted assets & For the purposes of computing segmental return on equity, notional equity is calculated as a percentage of
deduction items the monthly average of segmental RWAs. Previously, notional equity was allocated at 10% of RWAs after
capital deductions (RWAe). This has been revised to 12% of RWAs across all businesses. Source: Annual
report 2014, page 126, available on http://investors.rbs.com/
UBS Attributed Equity Risk-weighted assets, Leverage Tangible equity is attributed to our business divisions by applying a weighted-driver approach. This approach
ratio denominator, Risk-based combines phase-in Basel III capital requirements with internal models to determine the amount of capital required
capital & deduction items to cover each business division’s risk. Risk-weighted assets (RWA) and leverage ratio denominator (LRD) usage are
converted to their common equity tier 1 (CET1) equivalents based on capital ratios as targeted by industry peers.
Risk-based capital (RBC) is converted to its CET1 equivalent based on a conversion factor that considers the amount
of RBC exposure covered by loss-absorbing capital. In addition to tangible equity, we allocate equity to support
goodwill and intangible assets as well as certain Basel III capital deduction items. Source: Annual report 2014, page
274, available on https://www.ubs.com/global/en/about_ubs/investor_relations/annualreporting/2014.html
 Table 3: Example capital allocation using economic capital
This table provides an example for the allocation of capital using economic capital. The example is based on an arbitrarily
chosen firm from the simulated sample. The virtual firm (j = 10) has 3 different business units which account for relative sizes
of 30%, 40% and 30%, respectively. In the absence of regulatory rules, the equity capital of a bank is assumed to be given by its
overall economic capital ECj (α) = 5.994. Allocated capital (AC) equals a business units’ scaled economic capital γECl,j (α)wl ,
with γ = 0.665. wl is the relative size of the business. The capital charge (cap charge) equals the product of allocated capital
and the cost of equity rate. For simplicity, I take for the latter only the CAPM risk premium RP = βEQ,l,j · ERP and I assume
that the risk free rate is separately charged to the business units. βEQ,l,j is obtained from regressions of the simulated equity
returns on the market return, and ERP = 0.06 by assumption. Cost of equity rates in italics are computed endogenously.
Business unit 1 Business unit 2 Business unit 3
Relative Size 30% 40% 30%
Asset Volatility 0.027 0.028 0.040
Skewness -0.360 -0.472 -0.636
Correlation 0.528 0.548 0.423
Economic Capital 8.113 8.214 10.991
Model AC RP cap charge AC RP cap charge AC RP cap charge
Benchmark - - 0.172 - - 0.245 - - 0.203

40
Uniform 1.618 0.103 0.167 2.184 0.103 0.226 2.192 0.103 0.227
Peer based 1.618 0.071 0.115 2.184 0.075 0.163 2.192 0.062 0.135
Leverage adjusted 1.618 0.107 0.172 2.184 0.112 0.245 2.192 0.093 0.203
Weighted 1.618 0.106 0.172 2.184 0.112 0.245 2.192 0.092 0.203
Endogenous 1.618 0.109 0.176 2.184 0.114 0.249 2.192 0.088 0.193
 Table 4: Example capital allocation using risk-weighted assets
This table provides an example for the allocation of capital using risk-weighted assets. The example is based on an arbitrarily
chosen firm from the simulated sample. The virtual firm (j = 10) has 3 different business units which account for relative sizes
of 30%, 40% and 30%, respectively. The bank’s equity capital of 10.238 results from 10% of the firm’s risk-weighted assets of
RWAj = 102.376. Allocated capital (AC) equals 10% · RWAl,j . The capital charge (cap charge) equals the product of allocated
capital and the cost of equity rate. For simplicity, I take for the latter only the CAPM risk premium RP = βEQ,l,j · ERP and I
assume that the risk free rate is separately charged to the business units. βEQ,l,j is obtained from regressions of the simulated
equity returns on the market return, and ERP = 0.06 by assumption. Cost of equity rates in italics are computed endogenously.
Business unit 1 Business unit 2 Business unit 3
Relative Size 30% 40% 30%
Asset Volatility 0.027 0.028 0.040
Skewness -0.360 -0.472 -0.636
Correlation 0.528 0.548 0.423
RWAl,j 25.623 38.695 38.058
Model AC RP cap charge AC RP cap charge AC RP cap charge
Benchmark - - 0.172 - - 0.245 - - 0.203

41
Uniform 2.562 0.061 0.155 3.870 0.061 0.234 3.806 0.061 0.230
Peer based 2.562 0.067 0.172 3.870 0.063 0.245 3.806 0.053 0.203
Leverage adjusted 2.562 0.067 0.172 3.870 0.063 0.245 3.806 0.053 0.203
Weighted 2.562 0.067 0.172 3.870 0.063 0.245 3.806 0.053 0.203
Endogenous 2.562 0.069 0.178 3.870 0.064 0.249 3.806 0.050 0.193
 Table 5: Summary statistics per firm
This table shows the minimum and maximum value statistics for the 50 simulated multi-business line firms
in the sample. The mean, minimum and maximum statistics over the entire sample are provided at the
end of the table. Equity is the shareholder’s equity of a diversified firm, and Beta firm the equity beta
for the respective firm. #BU is the number of the firm’s business units. Rel Size is the relative size of a
business unit, measured as its relative share of the firm’s assets. Beta SA is the standalone equity beta for
the respective business. Asset Vol, Skew and Corr are the asset volatility, the skewness and the correlation
of the asset return with the market return, respectively.

Firm Stats Equity Beta firm #BU Rel Size Beta SA Asset Vol Skew Corr
1 min 7.706 1.867 5.000 0.067 1.072 0.027 -0.391 0.484
max 7.706 1.867 5.000 0.333 1.551 0.045 -0.003 0.671
2 min 5.056 2.080 5.000 0.111 0.822 0.022 -0.564 0.365
max 5.056 2.080 5.000 0.278 1.971 0.036 -0.091 0.751
3 min 4.699 2.347 7.000 0.036 1.177 0.014 -0.438 0.509
max 4.699 2.347 7.000 0.179 1.703 0.055 -0.031 0.764
4 min 5.462 2.162 6.000 0.056 0.908 0.025 -0.520 0.429
max 5.462 2.162 6.000 0.222 1.653 0.048 -0.134 0.721
5 min 4.261 2.517 5.000 0.067 1.152 0.026 -0.460 0.239
max 4.261 2.517 5.000 0.267 1.475 0.046 -0.121 0.630
6 min 5.083 2.076 6.000 0.133 1.208 0.019 -0.344 0.514
max 5.083 2.076 6.000 0.200 1.607 0.038 -0.107 0.658
7 min 7.844 2.154 4.000 0.133 1.390 0.033 -0.326 0.576
max 7.844 2.154 4.000 0.333 1.716 0.041 0.001 0.746
8 min 4.539 2.560 8.000 0.045 1.043 0.014 -0.304 0.238
max 4.539 2.560 8.000 0.182 1.832 0.061 -0.024 0.813
9 min 5.233 2.511 7.000 0.100 0.860 0.025 -0.394 0.280
max 5.233 2.511 7.000 0.200 1.660 0.121 -0.030 0.660
10 min 5.994 1.723 3.000 0.300 1.025 0.027 -0.636 0.423
max 5.994 1.723 3.000 0.400 1.242 0.040 -0.360 0.548
11 min 6.036 2.325 7.000 0.048 1.078 0.023 -0.333 0.496
max 6.036 2.325 7.000 0.238 1.645 0.056 0.017 0.729
12 min 4.234 2.549 8.000 0.037 0.830 0.023 -0.389 0.396
max 4.234 2.549 8.000 0.185 1.904 0.048 -0.068 0.702
13 min 4.837 2.079 2.000 0.333 1.281 0.020 -0.147 0.567
max 4.837 2.079 2.000 0.667 1.864 0.025 -0.039 0.754
14 min 9.251 1.728 2.000 0.333 1.174 0.043 -0.154 0.250
max 9.251 1.728 2.000 0.667 1.374 0.087 -0.039 0.580
15 min 6.371 2.061 6.000 0.091 1.080 0.029 -0.563 0.502
max 6.371 2.061 6.000 0.273 1.535 0.044 -0.021 0.653
16 min 5.243 2.211 5.000 0.118 0.898 0.029 -0.322 0.247
max 5.243 2.211 5.000 0.235 1.445 0.050 -0.074 0.662
17 min 4.983 2.295 7.000 0.118 1.218 0.021 -0.533 0.490
max 4.983 2.295 7.000 0.235 1.756 0.036 0.020 0.742
18 min 3.801 2.306 6.000 0.095 0.801 0.021 -0.554 0.360
max 3.801 2.306 6.000 0.238 1.517 0.028 -0.092 0.672
19 min 6.820 1.971 3.000 0.333 1.124 0.015 -0.538 0.489
max 6.820 1.971 3.000 0.333 1.572 0.062 -0.201 0.652
20 min 6.487 2.001 4.000 0.200 0.993 0.021 -0.342 0.196
max 6.487 2.001 4.000 0.333 1.387 0.081 -0.045 0.563
21 min 6.745 2.403 7.000 0.059 1.146 0.023 -0.553 0.425
max 6.745 2.403 7.000 0.294 1.738 0.075 -0.042 0.610
22 min 6.063 2.197 8.000 0.048 0.983 0.023 -0.534 0.436
max 6.063 2.197 8.000 0.238 1.577 0.049 0.018 0.667
23 min 4.910 2.310 6.000 0.105 1.231 0.024 -0.392 0.536
max 4.910 2.310 6.000 0.263 1.760 0.033 -0.047 0.741
24 min 4.998 1.706 5.000 0.067 0.893 0.023 -0.551 0.387
max 4.998 1.706 5.000 0.333 1.315 0.044 -0.163 0.563

42
 Table 5: Summary statistics per firm (con’t)

Firm Stats Equity Beta firm #BU Rel Size Beta SA Asset Vol Skew Corr
25 min 6.998 2.128 3.000 0.250 1.442 0.030 -0.364 0.629
max 6.998 2.128 3.000 0.500 1.572 0.038 -0.262 0.668
26 min 6.331 1.678 3.000 0.143 0.974 0.024 -0.549 0.450
max 6.331 1.678 3.000 0.429 1.215 0.038 -0.207 0.550
27 min 5.356 1.836 3.000 0.167 1.001 0.021 -0.491 0.466
max 5.356 1.836 3.000 0.500 1.459 0.039 0.008 0.718
28 min 6.328 2.067 4.000 0.167 1.257 0.026 -0.345 0.564
max 6.328 2.067 4.000 0.333 1.685 0.034 0.009 0.691
29 min 4.488 2.438 7.000 0.080 0.918 0.017 -0.379 0.414
max 4.488 2.438 7.000 0.160 1.476 0.039 -0.125 0.650
30 min 6.120 2.110 7.000 0.105 1.006 0.027 -0.636 0.446
max 6.120 2.110 7.000 0.211 1.585 0.043 -0.009 0.699
31 min 5.112 2.225 4.000 0.167 1.087 0.015 -0.357 0.472
max 5.112 2.225 4.000 0.500 1.687 0.056 -0.103 0.764
32 min 8.391 1.996 3.000 0.250 1.255 0.033 -0.465 0.546
max 8.391 1.996 3.000 0.417 1.648 0.043 -0.028 0.717
33 min 5.143 2.331 6.000 0.063 1.051 0.018 -0.219 0.225
max 5.143 2.331 6.000 0.250 1.576 0.053 0.020 0.703
34 min 5.425 2.249 7.000 0.037 1.100 0.018 -0.334 0.470
max 5.425 2.249 7.000 0.185 1.534 0.053 -0.067 0.628
35 min 4.892 1.933 4.000 0.154 0.869 0.018 -0.444 0.396
max 4.892 1.933 4.000 0.385 1.497 0.037 0.018 0.673
36 min 5.785 2.240 6.000 0.105 1.226 0.020 -0.488 0.553
max 5.785 2.240 6.000 0.263 1.758 0.060 -0.051 0.759
37 min 6.009 2.249 5.000 0.071 0.963 0.019 -0.488 0.436
max 6.009 2.249 5.000 0.286 1.635 0.042 -0.208 0.716
38 min 7.073 1.789 3.000 0.286 1.161 0.023 -0.419 0.520
max 7.073 1.789 3.000 0.429 1.448 0.039 -0.056 0.627
39 min 7.720 1.924 5.000 0.143 1.031 0.024 -0.353 0.476
max 7.720 1.924 5.000 0.286 1.482 0.051 -0.061 0.677
40 min 7.965 2.003 4.000 0.200 1.312 0.029 -0.252 0.576
max 7.965 2.003 4.000 0.400 1.589 0.045 -0.013 0.688
41 min 5.575 1.994 6.000 0.111 0.967 0.013 -0.548 0.429
max 5.575 1.994 6.000 0.278 1.741 0.038 -0.043 0.723
42 min 5.703 2.181 8.000 0.036 1.158 0.020 -0.417 0.532
max 5.703 2.181 8.000 0.179 1.794 0.051 0.002 0.795
43 min 6.178 1.784 2.000 0.333 1.312 0.023 -0.207 0.544
max 6.178 1.784 2.000 0.667 1.737 0.033 -0.104 0.741
44 min 5.088 2.289 6.000 0.087 0.597 0.019 -0.341 0.288
max 5.088 2.289 6.000 0.217 1.717 0.041 -0.047 0.688
45 min 3.386 2.537 8.000 0.053 0.794 0.017 -0.588 0.280
max 3.386 2.537 8.000 0.211 1.553 0.037 -0.110 0.706
46 min 8.801 1.353 2.000 0.500 0.940 0.028 -0.310 0.425
max 8.801 1.353 2.000 0.500 1.176 0.046 -0.194 0.566
47 min 4.830 2.441 5.000 0.111 0.944 0.025 -0.380 0.201
max 4.830 2.441 5.000 0.278 1.587 0.077 -0.119 0.702
48 min 7.355 1.766 3.000 0.222 1.241 0.017 -0.233 0.590
max 7.355 1.766 3.000 0.444 1.680 0.039 -0.046 0.718
49 min 5.629 2.579 8.000 0.091 1.160 0.028 -0.346 0.560
max 5.629 2.579 8.000 0.182 1.678 0.042 -0.011 0.724
50 min 4.779 2.217 5.000 0.125 1.214 0.014 -0.469 0.515
max 4.779 2.217 5.000 0.250 1.684 0.041 0.042 0.709
Total mean 5.616 2.202 5.826 0.193 1.334 0.033 -0.221 0.569
min 3.386 1.353 2.000 0.036 0.597 0.013 -0.636 0.196
max 9.251 2.579 8.000 0.667 1.971 0.121 0.042 0.813

43
 Table 6: Descriptive statistics
This table provides the sample statistics for the 259 simulated business units. Economic capital
and risk-weighted assets are reported at the beginning of the table. Panel A shows allocated
capital, the benchmark capital charge and the capital charges for the different models if eco-
nomic capital is used for capital allocation. Panel B shows allocated capital, the benchmark
capital charge and the capital charges for the different models if allocated capital equates 10%
of the business units’ risk-weighted assets. Panel C shows the same information for the case
in which for 50 percent of the peer firms a minimum leverage ratio constraint applies. Panel
D covers the case in which the minimum leverage ratio is binding for 50 percent of the firms
operating the capital allocation frameworks. The benchmark capital charge is for all cases
identical, as in the absence of deadweight costs variations in the amount of allocated capital
are compensated by changes in risk premiums.
Variable Mean Std. Dev. Min. Max. N
Economic Capital 9.245 2.766 3.851 17.699 259
Risk-weighted assets 20.572 13.765 2.240 90.024 259
Panel A: Economic capital
Allocated Capital 1.132 0.872 0.113 6.131 259
Benchmark Cap. Charge 0.142 0.098 0.017 0.669 259
Cap. Charge Uniform 0.142 0.094 0.015 0.636 259
Cap. Charge Peer based 0.091 0.073 0.010 0.505 259
Cap. Charge Leverage adjusted 0.142 0.098 0.017 0.669 259
Cap. Charge Weighted 0.142 0.098 0.017 0.669 259
Cap. Charge Endogenous 0.142 0.102 0.012 0.787 259
Panel B: 10% of risk-weighted assets
Allocated Capital 2.057 1.376 0.224 9.002 259
Benchmark Cap. Charge 0.142 0.098 0.017 0.669 259
Cap. Charge Uniform 0.142 0.096 0.015 0.643 259
Cap. Charge Peer based 0.142 0.098 0.017 0.669 259
Cap. Charge Leverage adjusted 0.142 0.098 0.017 0.669 259
Cap. Charge Weighted 0.142 0.098 0.017 0.669 259
Cap. Charge Endogenous 0.142 0.101 0.012 0.787 259
Panel C: leverage ratio binding for peers
Allocated Capital 2.057 1.376 0.224 9.002 259
Benchmark Cap. Charge 0.142 0.098 0.017 0.669 259
Cap. Charge Uniform 0.142 0.096 0.015 0.643 259
Cap. Charge Peer based 0.131 0.098 0.010 0.669 259
Cap. Charge Leverage adjusted 0.145 0.098 0.018 0.669 259
Cap. Charge Weighted 0.142 0.104 0.012 0.669 259
Cap. Charge Endogenous 0.142 0.101 0.012 0.787 259
Panel C: 10% leverage ratio binding for firm
Allocated Capital 2.197 1.415 0.224 9.002 259
Benchmark Cap. Charge 0.142 0.098 0.017 0.669 259
Cap. Charge Uniform 0.142 0.096 0.015 0.643 259
Cap. Charge Peer based 0.152 0.102 0.017 0.669 259
Cap. Charge Leverage adjusted 0.142 0.098 0.017 0.669 259
Cap. Charge Weighted 0.142 0.098 0.017 0.669 259
Cap. Charge Endogenous 0.142 0.101 0.012 0.787 259

44
 Table 7: Model performance
This table provides the result from the evaluation of the different methods under varying conditions. Panel
A reports the results in a theoretical perfect world without frictions and deadweight costs, in which economic
capital is used for capital allocation. Panel B shows the results in a regulated world without deadweight costs
in which risk-weighted assets are used for capital allocation. Panel C shows the results if a minimum leverage
ratio constraint is binding for approximately half of the peer firms in the sample, but not for the firms operating
the frameworks. Panel D reports the results if the minimum leverage ratio is binding for approximately half
of the firms operating the capital allocation frameworks, but not for the peer firms. The different methods are
assessed based on the following criteria: mean absolute deviation (MAD), mean square error (MSE) and slope
of regression through origin. For the latter, a coefficient of 1 indicates that the method is unbiased. Further,
the relative estimation errors (estimation error/allocated capital) are regressed on the explanatory variables asset
volatility (vol), skewness (skew), correlation (corr) and number of business units (#bus). F-test shows the F-
statistics of the joint regressions. Coefficients that are individually significant with a p-value lower than 0.01 are
reported together with the respective coefficient sign in brackets.
Panel A: Unregulated world
MAD MSE Slope F-test indiv. signif.
Economic Capital & Uniform 0.017 0.023 0.978 75.69 skew(-), corr(-)
Economic Capital & Peer based 0.051 0.059 0.671 81.54 corr(+), #bus(-)
Economic Capital & Leverage adjusted 0.000 0.000 1.000 - -
Economic Capital & Weighted 0.000 0.000 1.000 - -
Economic Capital & Endogenous 0.009 0.019 1.005 29.17 vol(-), corr(+)
Panel B: Risk-weighted assets binding
MAD MSE Slope F-test indiv. signif.
10% RWA & Uniform 0.021 0.028 0.982 47.70 skew(-), corr(-)
10% RWA & Peer based 0.000 0.000 1.000 - -
10% RWA & Leverage adjusted 0.000 0.000 1.000 - -
10% RWA & Weighted 0.000 0.000 1.000 - -
10% RWA & Endogenous 0.009 0.019 1.006 29.22 vol(-), corr(-)
Panel C: Minimum leverage ratio binding for half of peers
MAD MSE Slope F-test indiv. signif.
10% RWA & Uniform 0.021 0.028 0.982 47.70 skew(-), corr(-)
10% RWA & Peer based 0.011 0.022 0.944 32.29 vol(+)
10% RWA & Leverage adjusted 0.003 0.004 1.013 39.85 vol(-)
10% RWA & Weighted 0.013 0.019 1.016 22.63 vol(+)
10% RWA & Endogenous 0.009 0.019 1.006 29.22 vol(-), corr(+)
Panel D: Minimum leverage ratio binding for half of firms
MAD MSE Slope F-test indiv. signif.
scaled 10% RWA & Uniform 0.021 0.028 0.982 47.70 skew(-), corr(-)
scaled 10% RWA & Peer based 0.010 0.021 1.058 5.07 vol(-)
scaled 10% RWA & Leverage adjusted 0.000 0.000 1.000 - -
scaled 10% RWA & Weighted 0.000 0.000 1.000 - -
scaled 10% RWA & Endogenous 0.009 0.019 1.006 29.22 vol(-), corr(+)

45
 Table 8: Model performance in presence of frictions
This table provides the result from the evaluation of the different methods in the presence of deadweight costs associated
with equity, e.g. related to frictions like taxation of returns to equity or free cash flow agency issues. I assume for all
banks an identical deadweight cost d=0.02 that applies as surcharge on the banks’ CAPM cost of equity rates. Panel A
reports the results in an unregulated world in which economic capital is used for capital allocation. Panel B shows the
results in a regulated world in which risk-weighted assets are used for capital allocation. Panel C shows the results if a
minimum leverage ratio constraint is binding for approximately half of the peer firms in the sample, but not for the firms
operating the frameworks. Panel D reports the results if the minimum leverage ratio is binding for approximately half of
the firms operating the capital allocation frameworks, but not for the peer firms. The different methods are assessed based
on the following criteria: mean absolute deviation (MAD), mean square error (MSE) and slope of regression through origin.
For the latter, a coefficient of 1 indicates that the method is unbiased. Further, the relative estimation errors (estimation
error/allocated capital) are regressed on the explanatory variables asset volatility (vol), skewness (skew), correlation (corr)
and number of business units (#bus). F-test shows the F-statistics of the joint regressions. Coefficients that are individually
significant with a p-value lower than 0.01 are reported together with the respective coefficient sign in brackets.
Panel A: Unregulated world, deadweight costs d=0.02
MAD MSE Slope F-test indiv. signif.
Economic Capital & Uniform 0.017 0.023 0.983 77.17 skew(-), corr(-)
Economic Capital & Peer based 0.051 0.059 0.718 73.73 corr(+), #bus(-)
Economic Capital & Leverage adjusted 0.013 0.015 1.069 124.3 skew(-), corr(-), #bus(+)
Economic Capital & Weighted 0.001 0.002 0.999 43.48 skew(-), corr(-)
Economic Capital & Endogenous 0.010 0.022 1.008 46.51 vol(-), corr(+)
Panel B: Risk-weighted assets binding, deadweight costs d=0.02
MAD MSE Slope F-test indiv. signif.
10% RWA & Uniform 0.021 0.028 0.991 46.88 skew(-), corr(-)
10% RWA & Peer based 0.000 0.000 1.000 - -
10% RWA & Leverage adjusted 0.000 0.000 1.000 - -
10% RWA & Weighted 0.000 0.000 1.000 - -
10% RWA & Endogenous 0.013 0.025 1.008 64.49 vol(-), corr(+)
Panel C: Leverage ratio binding for half of peers, deadweight costs d=0.02
MAD MSE Slope F-test indiv. signif.
10% RWA & Uniform 0.021 0.028 0.991 46.88 skew(-), corr(-)
10% RWA & Peer based 0.011 0.022 0.957 30.21 vol(+)
10% RWA & Leverage 0.008 0.014 1.029 42.19 vol(-)
10% RWA & Weighted 0.013 0.019 1.013 21.68 vol(+)
10% RWA & Endogenous 0.013 0.025 1.008 64.49 vol(-), corr(+)
Panel D: Leverage ratio binding for half of firms, deadweight costs d=0.02
MAD MSE Slope F-test indiv. signif.
scaled 10% RWA & Uniform 0.023 0.030 0.991 30.11 skew(-), corr(-)
scaled 10% RWA & Peer based 0.011 0.023 1.046 0.754 -
scaled 10% RWA & Leverage adjusted 0.005 0.010 0.989 29.07 vol(+)
scaled 10% RWA & Weighted 0.004 0.008 1.001 20.81 vol(+)
scaled 10% RWA & Endogenous 0.015 0.027 1.009 41.70 vol(-), corr(+)

46
 Figure 1: Risk sensitivity of economic capital and risk-weighted assets
This figure plots the capital requirement resulting from economic capital and risk-weighted assets
against expected shortfall as coherent measure of risk. Expected shortfall measures the conditional
expected losses based on a given confidence level (99.75%). The capital requirements resulting from
economic capital and risk-weighted assets are increasing in the level of risk. Because economic
capital considers diversification effects, the capital requirement is on average lower than for the
risk-weighted assets, and the slope is less positive. Due to the modelled measurement uncertainty
for risk-weighted assets, the capital requirement resulting from 10% of risk-weighted assets shows
a greater variety, which is consistent with the real-world properties of risk-weighted assets that are
calculated by different banks under varying regimes.

Risk sensitivity
economic capital and risk-weighted assets vs. expected shortfall
25 20
capital requirement
10 15
5

0 5 10 15 20
expected shortfall

economic capital risk-weighted assets * 10%

47
 Figure 2: Asset Beta
This figure shows the distribution of the asset betas in the simulated sample consisting of 259
different businesses. The observations range from 0.042 to 0.284, with a mean of 0.123. The asset
betas are obtained for each business from a linear regression of the simulated asset returns on the
simulated market returns.

distribution of simulated asset betas

10
8 6
density
4
2
0

.05 .1 .15 .2 .25 .3

asset beta

Figure 3: Equity Beta

This figure shows the distribution of the standalone equity betas in the simulated sample consisting
of 259 different businesses. The observations range from 0.597 to 1.971, with a mean of 1.334. The
equity betas are obtained for each business from a linear regression of the simulated equity returns on
the simulated market returns, whereby the amount of equity capital is for each business determined
on a standalone basis. The amount of equity capital is chosen such that is with a confidence level
of 99.95% sufficiently large to absorb potential losses from changes in the asset value.

distribution of standalone equity betas

2
1.5
density
1 .5
0

.5 1 1.5 2
equity beta

48
 Figure 4: Economic capital without frictions
This figure shows the scatter plots of the estimated capital charges versus the benchmark capital
charge for the different cost of equity methods if economic capital is used for capital allocation,
assuming a perfect world without friction costs and regulatory capital rules. The 45 degree line in
red shows the points at which the model estimate and the benchmark capital charge are equivalent.
For points above the line, the capital charge is overestimated, for points below the line, the capital
charge is underestimated by the respective model.
economic capital/uniform cost of equity economic capital/peer based cost of equity
.8

.8
.6

.6
capital charge model

capital charge model

.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

model estimate equivalent model estimate equivalent

economic capital/peer based cost of equity economic capital/weighted cost of equity

.8

.8
.6

.6
capital charge model

capital charge model

.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

model estimate equivalent model estimate equivalent

economic capital/endogenous cost of equity

.8 .6
capital charge model
.2 .4
0

0 .2 .4 .6 .8
capital charge benchmark

model estimate benchmark

49
 Figure 5: 10% of risk-weighted assets without frictions
This figure shows the scatter plots of the estimated capital charges versus the benchmark capital
charge for the different cost of equity methods if capital is allocated based on risk-weighted assets,
assuming a regulated world without friction costs. All banks are supposed to maintain a Common
Equity Tier 1 ratio of 10% that is also used for capital allocation. The 45 degree line in red shows
the points at which the model estimate and the benchmark capital charge are equivalent. For points
above the line, the capital charge is overestimated, for points below the line, the capital charge is
underestimated by the respective model.
risk-weighted assets/uniform cost of equity risk-weighted assets/peer based cost of equity
.8

.8
.6

.6
capital charge model

capital charge model

.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

model estimate equivalent model estimate benchmark

risk-weighted assets/leverage adjusted cost of equity risk-weighted assets/weighted cost of equity

.8

.8
.6

.6
capital charge model

capital charge model

.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

model estimate equivalent model estimate equivalent

risk-weighted assets/endogenous cost of equity

.8 .6
capital charge model
.2 .4
0

0 .2 .4 .6 .8
capital charge benchmark

model estimate equivalent

50
 Figure 6: 10% of risk-weighted assets for binding leverage ratios
This figure shows the scatter plots of the estimated capital charges versus the benchmark capital charge if capital
is allocated based on 10% of risk-weighted assets, assuming a regulated world with leverage ratio constraints. For
the scatter plots on the left side, the minimum leverage ratio is calibrated such that it is binding for 50 percent of
the single business line peer firms in the sample, but not for the firms operating the capital allocation frameworks.
For the scatter plots on the right side, the minimum leverage ratio is binding for 50 percent of the firms operating
the capital allocation frameworks, but not for the single business line peer firms. The 45 degree line in red shows
the points at which the model estimates and the benchmark capital charges are equivalent. For points above the
line, the capital charge is overestimated, for points below the line, the capital charge is underestimated. Points in
blue relate to situations in which the minimum leverage ratio is neither binding for the firm owning the specific
business unit, nor for the corresponding single business line peer firm. Points in red relate to combinations where
the minimum leverage ratio is either binding for the firm owning the specific business unit, or for the respective
single business line firm.
peer based cost of equity peer based cost of equity
lev. ratio binding for 50 pct of peers lev. ratio binding for 50 pct of firms
.8

.8
capital charge model

capital charge model

.6

.6
.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

lev. ratio not binding lev. ratio binding lev. ratio not binding lev. ratio binding
equivalent equivalent

leverage adjusted cost of equity leverage adjusted cost of equity

lev. ratio binding for 50 pct of peers lev. ratio binding for 50 pct of firms
.8

.8
capital charge model

capital charge model

.6

.6
.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

lev. ratio not binding lev. ratio binding lev. ratio not binding lev. ratio binding
equivalent equivalent

weighted cost of equity weighted cost of equity

lev. ratio binding for 50 pct of peers lev. ratio binding for 50 pct of firms
.8

.8
capital charge model

capital charge model

.6

.6
.4

.4
.2

.2
0

0 .2 .4 .6 .8 0 .2 .4 .6 .8
capital charge benchmark capital charge benchmark

lev. ratio not binding lev. ratio binding lev. ratio not binding lev. ratio binding
equivalent equivalent

51