Risk capital gives financial firms the cushion they need to protect liability holders from unexpected losses. Simply put, risk capital is your home-run money — funds that are invested in high-risk, high-reward investments. It reduces debt overhang that could limit borrowing capability and makes the costs of bankruptcy or firm distress more remote.
But there’s a catch — adding risk capital can only benefit firms’ balance sheets if it is allocated efficiently, according to a study co-authored by Isil Erel, Academic Director of the Risk Institute and Distinguished Professor of Finance at The Ohio State University Fisher College of Business.
The study, “A Theory of Risk Capital”, was co-written by Erel, Stewart C. Myers at MIT Sloan School of Management, and James A. Read Jr. at The Brattle Group Inc. in Cambridge, Mass. In the study, Erel, Myers, and Read focus on diversified firms with safe and risky businesses in their portfolios. The firms have customers and counterparties who are not willing to bear significant default risk.
Know if your company’s risk capital really working for you — here are the four things you need to know and be doing.
1) Risk capital must be allocated
- To assess profitability,
- To make investment decisions,
- To price products and services, and
- To set compensation.
2) Efficient risk capital allocation has to do two things: 1) there can be no risk that changes in the business portfolio that would affect the credit quality of the firm’s liabilities, and 2) firms have to avoid shifting risk capital from one business to another.
3) Of course, your business is doing all that already, so what do you really need to focus on? Your marginal default rate in order to allocate the risk capital.
The marginal default rate is the derivative of the value of the firm’s option to default with respect to a change in the business size, according to the study. The required amount of capital depends on the target credit quality and on the risk of the business portfolio. Businesses with the largest marginal default values should receive the most risk capital and be charged most of the costs of the risk capital.
4) Risk capital can help expand your business, but keep in mind that riskier businesses need free passes to expand, which will increase the default risk. These risky businesses might also operate at a lower credit quality.
To mitigate the effects on credit quality of the overall business, businesses shouldn’t use risk capital that’s fixed in the short term.
Remember, any asset or activity with uncertain returns requires risk capital. By focusing on marginal default values, credit quality, and risk within the business portfolio, firms can us risk capital efficiently to help improve their bottom lines.
If you want to dig deeper into this (and other) of the latest risk research, the full paper and accompanying translation are available on our website.