Risk Management, Capital Budgeting, and Capital Structure Policy for Financial Institutions: An Integrated Approach

A framework is developed for analyzing the capital allocation and capital structure decisions facing financial institutions. The model incorporates 2 key features: 1. Value-maximizing banks have a well-founded concern with risk management. 2. Not all the risks they face can be frictionlessly hedged in the capital market. The approach helps demonstrate how bank-level risk management considerations should factor into the pricing of the risks that cannot be easily hedged. Several applications are examined, including: 1. the valuation of proprietary trading operations, 2. pricing of unhedgeable derivatives positions. This approach is also compared to the RAROC methodology that has been adopted by a number of banks.