RISK MANAGEMENT, CAPITAL-BUDGETING, AND CAPITAL STRUCTURE POLICY FOR FINANCIAL INSTITUTIONS - AN INTEGRATED APPROACH

We develop a framework for analyzing the capital allocation and capita l structure decisions facing financial institutions. Our model incorpo rates two key features: (i) value-maximizing banks have a well-founded concern with risk management; and (ii) not all the risks they face ca n be frictionlessly hedged in the capital market. This approach allows us to show how bank-level risk management considerations should facto r into the pricing of those risks that cannot be easily hedged. We exa mine several applications, including: the evaluation of proprietary tr ading operations, and the pricing of unhedgeable derivatives positions . We also compare our approach to the RAROC methodology that has been adopted by a number of banks. (C) 1998 Elsevier Science S.A. All right s reserved.