Theory of Risk Capital in Financial Firms

This paper develops a concept of risk capital that can be applied to the financing, capital budgeting, and risk management decisions of financial firms. The development focuses particularly on firms that act as a principal in the ordinary course of business. Principal activities can be asset-related, as in the case of lending and block-positioning; liability-related, as in deposit-taking and writing of guarantees (including insurance, letters of credit, and other contingent commitments); or both, as in the writing of swaps and other derivatives for customers.