Once we have thought about measuring both risk and capital, the next most important issue is concerns pricing: what is the cost of the capital being deployed? When can we feasibly use a pricing system to help allocate capital?

Our discussion of these issues will proceed in two parts. First, we need to be clear about the building blocks of capital pricing and allocation for the more traditional warehouse case in which risks are driven by balance sheet exposures. This is an area where there has been a tremendous foundation built, both conceptual and practical, at major firms. There are a variety of approaches across banks, and I won’t attempt to summarize them here. Rather my goal is to layout a more conceptual framework based on a few building blocks.

7 We still also face the issue of illiquidity of balance-sheet assets. See Stephen Kealhofer, “Liquidity, Liquidity Crises and Bank Capital Regulation,” discussion paper, 2001 for a discussion of these issues.
8 In the above VaR simulations, we counted profits as they were received, and we assumed that in expectation, profits accrete continuously over time.