A THEORY OF RISK CAPITAL

We present a theory of risk capital and of how tax and other costs of risk capital should be allocated in a financial firm. Risk capital is equity investment that backs obligations to creditors and other liability holders and maintains the firm’s credit quality. Credit quality is measured by the ratio of the value of the firm’s option to default to the default-free value of its liabilities. Marginal default values provide a full and unique allocation of risk capital. Efficient capital allocations maintain credit quality and preclude risk shifting. Our theory leads to an adjusted present value (APV) criterion for making investment and contracting decisions. We relate our results to capital budgeting procedures used in corporate finance. We also set out practical and policy applications, including implications for risk-based regulatory capital requirements