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Economic term "capital" is used for distinguishing accounting from regulatory capital and it is not always the same as risk capital that is different from cash capital in the manner – that it is the amount available to invest.
Financial institutions are the institution of public trust and the banking system is related to depositors' confidence on the accessibility of the saving where risk capital is the smallest amount that can be invested to ensure the value of the firm’s net asset against a loss in value relative to the risk-free investment of those net assets.
For example- If a start-up firm gives $50 mn debt securities and $50 mn in common stock, it has $100 mn of cash capital but only $50 is risk capital.
Banks and other financial organizations work in the manner to allocate risk capital in a limited manner and they determine it as the present value cost of acquiring complete insurance against negative returns on the firm’s net assets.
The value of default put is equal to the cost of insurance for the firm’s debt and other liabilities (as per Merton and Perold (1993)).
A business allocates more funds to risk capital to reduce the business’s net value.
Efficient allocation is made on the marginal default value – that is the derivative of the value the firm opts as default, concerning the change in the scale of business.
Capital held by non-financing firms can be of three types – operating, risk, and signaling (as defined by Shimpi).
Operating capital is the fund that is needed for operating performance, and risk is the additional stock of funds that is assigned for the coverage of the consequence of risk occurrence that works as a buffer.
Risk is an additional stream of funds used for covering the consequences reflected in the value of insurance policies or derivative contracts.
Efficient risk capital assets allocations should meet two requirements –
No risk-shifting – It should be allocated in the manner that a marginal change in the composition of the portfolio of the business does not affect the credit quality of the firm’s liabilities.
No internal arbitrage - Secondly, there is no internal arbitrage as the risk capital should be allocated to add value at the margin just by shifting risk capital from one firm to another.
Such requirements are general and do not require restrictions on the joint probability distribution of the returns.
More capital reduces possible debt overhang and risk-shifting problems, and it makes costs of bankruptcy or financial distress more remote.
Costs incurred by creditors to monitor and to protect their interests are reduced.
Any expansion of a risky business should consider increasing the risk capital, imposing additional default risk on customers, counterparties, and creditors to operate at a lower credit quality that could feedback the risk capital allocation.
To know if the business or the product or a contract is safe or not, one should depend on the firm’s portfolio.
The method used for the purpose include
Analyze the need
Consider the available sources
Establish the required volume
A well-defined risk management system allows a company to react effectively to any kind of harm caused by its actions to the environment and society.
The ultimate risk bearer is the stakeholders and a sustainable company should know how to cover the calculated risks.
For example – In the case of Deep Water Horizon oil spill or the Fukushima nuclear disaster – the severity of risk was
countable – lost revenue, destroyed value, and increased costs, and it had an uncountable impact on the environment.
The company should always be prepared to provide funds to lower the impact to stop harm to the environment and socio-economic losses.
The source is captured as debt or equity. Some sources may not be directly captured in the balance sheet but sometimes are visible. These reflect the contingency funding.
The second is the amount of risk capital allocation, which distinguishes between post-loss, pre-loss, and ongoing loss funding.
The pre-loss refers to capital reserves and bank credit.
The post-loss funds are injected through a bank loan for situations like asset loss.
The third is the consideration of the ultimate bearers of the consequence of the risk.
The fourth is the innovations of the financing mechanism.
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