Evaluating Earnings at Risk

I. Derive Risk Adjusted Income

Adjust returns by subtracting for expected losses.
Derive expected losses from actuarial profiles by sector, by borrower, and related criteria
Compare projected risk-adjusted returns to expected stockholder returns
II. Deriving Allocated Risk Capital
Use of regulatory risk-based capital standards
Matching by asset size
Benchmarking by comparing a line of business with a standalone business
Gauging the perceived level of risk of the business unit:
Derive the volatility in earnings (earnings-at-risk) or the maximum expected loss (value-at-risk)
given a specific confidence level over a fixed time period that losses will not exceed
the amount indicated, based on stationarity of the distribution of historical returns

Risk Capital = ( )
s
rfir
n,
where: s = standard deviation of net revenues,
rfir = the risk-free rate of interest
n = the number of time periods of a loan

III. Measuring Earnings-at-Risk Capital:

A. Use historical data for past 24-30 months to estimate revenues obtained directly from loans
B. Use historical data for past 24-30 months to estimate direct esxpenses from offering services
and associated expected losses
C. Use the total of 48-60 observations for revenues minus expenses and losses to
estimate one standard deviation of earnings. This is earnings-at-risk
D. Estimate risk capital as one standard deviation of earnings, divided by the risk-free
interest rate.
1. Historical Net Revenue Stream
Example:
Period Revenues Expenses Net Revenue
1 $6.00 $2.00 $4.00
2 $4.30 $1.30 $3.00
3 $5.90 $1.40 $4.50
4 $6.00 $1.00 $5.00
5 $7.40 $2.20 $5.20
6 $5.90 $1.30 $4.60
7 $5.40 $1.50 $3.90
8 $6.30 $2.00 $4.30
9 $7.30 $2.30 $5.00
10 $7.70 $3.00 $4.70
11 $6.20 $1.10 $5.10
12 $7.40 $2.00 $5.40
13 $8.00 $3.00 $5.00
14 $5.70 $1.20 $4.50
15 $7.40 $3.00 $4.40
16 $6.40 $1.60 $4.80
17 $6.70 $1.70 $5.00
18 $7.00 $1.50 $5.50
19 $7.70 $2.40 $5.30
20 $7.80 $2.70 $5.10
21 $6.30 $1.30 $5.00
22 $7.30 $1.90 $5.40
23 $7.10 $1.40 $5.70
24 $9.40 $3.10 $6.30
25 $9.20 $3.20 $6.00
26 $8.60 $2.80 $5.80
27 $7.90 $2.40 $5.50
28 $7.80 $1.90 $5.90
29 $8.70 $3.20 $5.50
30 $8.00 $1.60 $6.40
 7.09 2.03 5.06 Mean
1.1679 0.6999 0.7323 Standard Deviation
2. Allocated Risk Capital
Risk-Free Rate: 5.50%
n= 12
s= 0.7323
Risk Capital: $159.78 = (0.7323)÷ (5.50%) x(12.00)
3. Derive the Risk Adjusted Return on Capital (RAROC)
and Economic Income Estimate for the Most Recent Month
a. Net Revenue $6.40
b. RORAC 4.01% = ($6.40)÷ ($159.78)
c. Annual RORAC 48.07% = (4.01%)x (12.00)
d. Economic Income: amount above the opportunity cost net of the capital charge
Opportunity cost: 12.00% (also known as the hurdle rate, or required rate of return)
Economic Income: $4.80 = $6.40 - ((12.00%)÷ (12.00))x $159.78