RAROC and Profit Planning

Module D: Balance Sheet Management

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

Bank Financial Management: RAROC and Profit Planning

CAIIB SUPER NOTES

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

Contents
Coverage:
1. Profit Planning
2. Risk

Aggregation

and

Capital Allocation
3. Economic

Capital

and

RAROC

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

1.

PROFIT PLANNING

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

Profit Planning
Essentially involves Balance Sheet Management covering credit,
investment and non-fund based income
Income arises from three sources (Need to be maximized):
Interest Income
Fee Based Income
Treasury Income

Expenses(Need to be minimized):
Interest Expenses
Operating Expenses (Staff Costs and other costs)
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CAIIB Super-Notes

Sirf Business

2.

RISK AGGREGATION AND CAPITAL

ALLOCATION
M S Ahluwalia

CAIIB Super-Notes

Sirf Business

Risk Aggregation and Capital Allocation

Most commonly used approach to estimate aggregate risk exposure is

RAROC (Risk Adjusted Return On Capital)
Key is matching of revenues, costs and risks on transaction or portfolio basis over a
defined period

Expected losses are covered by reserves and unexpected losses require capital
allocation

Second approach is EaR

Similar to RAROC but depends less on capital allocation and more on cash flows or
variability in earnings
Ignores the value changes in Assets and Liabilities due to changes in market

interest rates

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

3.

ECONOMIC CAPITAL AND RAROC

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CAIIB Super-Notes

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Economic Capital and RAROC

Risk Capital: Economic capital required to support the banks
financial risk
Pricing of products should be a buffer against expected losses

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CAIIB Super-Notes

Sirf Business

Risk Capital
RAROC is part of family of risk adjusted performance
measures (RAPM)
Risk Capital (RC) = VAR
RAPM = Profit/RC

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

RAROC Methodology
Risk Management: Includes measurement of portfolio
exposure, the volatility and correlations of risk factors
Capital Allocation: Requires choice of a confidence level and
horizon for the VAR measure
Performance Measurement: Adjustment of performance to
Risk Capial
Can be based on RAPM Method
EVA = Profit (Capital x k) (Higher the EVA, better the project/product)
M S Ahluwalia

CAIIB Super-Notes

Sirf Business

Do you have any questions or queries or some feedback to give?

Just mark an email to super.msahluwalia@yahoo.com

M S Ahluwalia

CAIIB Super-Notes

Sirf Business

M S Ahluwalia, amongst other things, is a visual artist, blogger,

blog designer and of course an MBA and Banker from New
Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

M S Ahluwalia

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