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The Allocation of Economic Capital in Opaque Financial Conglomerates

Mierzejewski, Fernando (2008): The Allocation of Economic Capital in Opaque Financial Conglomerates.

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Abstract

The capital structure of firms that face restrictions on liquidity (i.e. that cannot hedge continuously) is affected by the agency costs and moral-hazard implicit in the contracts they establish with stockholders and customers. It is demonstrated in this paper that then an optimal level of capital exists, which is characterised in terms of the actuarial prices of the involved agreements. The capital principle so obtained explicitly depends on risk and expectations and it can be naturally applied to allocate balances inside multidivisiona corporations. In particular, an optimal decentralised mechanism is defined, which stimulates the exchange of information between central and divisional administrations. A novel model of capital is thus formulated, which extends the classic theoretical framework (sustained by the well-known proposition of Modigliani and Miller and the model of deposit insurance of Robert Merton) and integrates the financial and actuarial theoretical settings.

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