Financial Firms Gain Unprecedented Control Over Capital Allocation and Risk Measurement
Financial firms utilize internal risk measurement models to assess risk and determine the amount of capital needed for protection. By integrating these models into their capital allocation strategies, firms aim to optimize their capital structure effectively. This aligns with the goal of maximizing shareholder value by ensuring returns on investments surpass the cost of capital. However, due to the complex nature of financial markets, accurately quantifying expected returns and determining the cost of capital can be challenging. The traditional signals used by non-financial firms to evaluate cost of capital are not as useful for financial firms due to the dynamic nature of their funding activities. As firms develop more sophisticated risk measurement techniques, it becomes evident that the risk calculated by these models is often less than the actual amount of capital firms choose to hold for protection.