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RAROC of a Corporate Loan - “Back of the Envelope”

Calculations
Your boss, the Head of Corporate Finance of a bank, has been approached by an
AA rated corporate borrower for a 3 year $100 million loan. This borrower is
your bank’s very old client and has generated big revenues for you. The
borrower though rated AA, however, has a chance of being downgraded to a
lower rating in six months time by a leading rating agency and your boss
suspects that that fact has prompted them to borrow now at a better spread. The
current discount rate is 5% (i.e. you have to borrow money at 5%, a very high
rate! In reality loan spreads are over Prime Rate or LIBOR) and you have
previously charged this client around 20 basis points over the discount rate. Your
boss does not want to upset the client by refusing the loan and also your bank
stands to make a very good fee on the transaction, of around 0.15%.

Your boss has to get back to the client in two days time and he does not have
time for detailed analysis. He calls you in an gives you this problem: to analyze
the transaction and give him your opinion – whether to make the loan or not.

You analysis tells you that there are 400 publicly traded bonds in the comparable
asset class rated AA (as your borrower) and further over the past one year only 4
bonds out of 400 had their credit risk premium increase by more than the 99%
worst case and that premium was equal to 1.1%. (A credit risk premium is
defined as the change in yield spread between corporate bonds of a particular
credit rating class and the matched duration Treasury bonds). You do some back
of envelope calculations and figure out that the probability of default for AA rate
loans is around 0.1% and find out from a rating agency’s data that the recovery
rate for AA rated loans is around 51.13%.

You now have to make a back of the envelope calculation – so to speak – and get
back to your boss with a report. Your bank has to make a quick decision as to
whether to approve the loan or not and get back to the client with the next two
days. Your bank’s hurdle rate (the IRR) is 10%.

Solution:
Since you need to make a decision fast you need a model of analysis that quickly
calculates, first, the risk capital required for the loan and second, the risk
adjusted return on the capital for this loan. If the risk adjusted capital return on
capital is more than your hurdle rate you would go ahead and make the loan
otherwise you won’t. Historically, two approaches have emerged to measure the
risk capital in a RAROC calculation: one the Bankers’ Trust approach and the
other the Bank of America approach. The original BT approach was to measure
the capital at risk as equal to the maximum adverse change in the market value
of a loan over the next year. The credit risk component was embedded in the
equation as the credit risk premium, that was discounted and the multiplied by
the duration and the loan exposure to get the Dollar capital risk exposure. The
Bank of America approach, more detailed and more prevalent these days
amongst bankers uses experimental and historical approach. However, given the
constraints of time you need to use the BT approach and quickly modify the BT
equation.

Step 1: Calculate the risk capital

You start off by making a rough estimate of the duration of the loan. That turns
out to be 2.7 (please note that this is not an accurate figure). Then you calculate
the expected discounted credit risk premium. This number is estimated by
taking the credit risk premium of the loan – equal to 1.1% - and discounting it by
the prime rate (assumed for simplicity). Then you multiply the expected
discounted credit risk premium with the duration and the loan exposure to get
the Dollar capital risk exposure or the risk capital. This is calculated as
$2,823,194 (please remember that the sign on this is number negative).

Step 2: Calculate the One year adjusted income on the loan.

The one year adjusted income on the loan is calculated by taking the sum of your
fees earned from the transaction, the spread on this loan (assuming, that you
would borrow at 5% and lend to this client at 5.2%) and then subtracting the
Expected Loss on this loan. The expected loss is calculated by multiplying the
probability of default, estimated by you as 0.1%, with the Loss given Default
(LGD), which in turn is obtained by subtracting recovery rate from one. The
expected loss on this loan is $48,870 and the fee earned by you is $150,000 (0.15%
of the loan). The spread of 0.2% translates to $200,000. Therefore, the one-year
adjusted income for you on this loan is $301,130.

Step 3: Calculate the RAROC

The RAROC is calculated by dividing the one-year adjusted net income by the
risk capital. The RAROC of the loan comes out to 10.67% ($310,130 divided by
$2,823,194). This number is higher than the hurdle rate of 10% and thus,
according to you, the bank should go ahead and make the loan.

You approach with your analysis to your boss and tell him that in your opinion
the bank should make this loan. After an hour your boss calls you in and tells
you that though your analysis seems correct at first glance he is not comfortable
making the loan. And he would definitely not make the loan at 20 basis points
spread over the discount rate (i.e. your borrowing cost). He needs to factor in the
risk of a downgrade in the spread and also needs to analyze the effect of a
downgrade on the RAROC of the loan. He asks you to go back and recalculate. He
wants you to be more detailed and thinks “back of the envelope” calculations
won’t suffice in this case.

More detailed calculations in two days?? Is he serious?? Would you rather put in
your papers and try accounting as a career.

Any comments and queries can be sent through our web-based form.

More on Credit Risk & Credit Derivatives Cases >>

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