Internal capital market studies in empirical banking: Biases due to usage of assets instead of risk capital?

•Banks allocate risk-bearing capacity across subunits.•Researchers typically only observe the corresponding assets or loans.•The quality of this approximation depends on business activities.•Using assets, instead of RWA, as a proxy variable may lead to biased parameter estimates.•The empirical internal capital market studies in banking should control for business risk.

Unlike industrial companies, banks allocate “risk-taking potential” across subunits, instead of investment budgets or assets. Researchers typically do not have access to this data on risk-bearing capacity across subunits and use (changes in) assets or loans instead. Based on unique data from Germany, where banks disclose both assets and corresponding risk capital, we analyze whether the approximation potentially introduces an econometric bias in empirical banking studies on internal capital markets. We provide empirical evidence that the quality of the approximation is correlated with variables capturing the risk and business models of segments.