Research Summary

Risk Capital and Capital Allocation

by Kenneth A. Froot


For the principal financial firms, proper risk control is imperative, and capital allocation exerts an impact on a variety of decisions related to: accounting for the profitability of individual businesses; entering or divesting businesses; determining profit-related employee compensation; choosing from among alternative organizational forms; and managing overall risk. Historically a top-down concern, principally of the CFO/treasurer, with the growing importance of off-balance sheet (derivatives) positions, these issues have also fallen squarely into the domain of the "risk manager," a bottom-up perspective. Of central importance is the need for a unifying framework to reconcile the two perspectives that can be applied on a firmwide basis. The determinants of the costs of risk capital and possible approaches for measuring and allocating these costs to the individual businesses that comprise a firm are receiving particular emphasis in the Global Financial System project. Principal researchers in this area are Andre F. Perold, Kenneth A. Froot, and Robert C. Merton.