1 Background

1.1 Ministry of Finance & Corporate Affairs adopted EASE Reforms Index that independently
measures progress on the Public Sector Banks (PSB) Reforms Agenda. The Index measures
performance of each PSB on 107 objective metrics across 6 themes and provides all PSBs a
comparative evaluation, showing where banks stand vis-à-vis benchmarks and peers on the
Reforms Agenda. The Index enables banks to identify their strengths & areas for improvement
and encourages them to learn from each other.

1.2 In Theme 3 of EASE 3.0, “Institutionalizing Prudent Banking “consists of 9 Action Points and
72 metrics. Under Action Point AP no 12 “Credit Scoring, Rating and Pricing Model” there were
five metrics which requires Banks to have a RAROC Framework.

1.3 The RBI in its Risk Assessment Report (RAR) had also mentioned that Bank does not have
RAROC Model in place. Hence, RAROC Framework was devised to implement the RAROC Model

1.4 Further, based on the inputs received from the fields, business verticals and M/s BCG
(Consultant on the subject matter), review of the RAROC framework was carried out

1.5 RMD had simplified the Domestic RAROC template & new template for foreign currency
exposure (Domestic & Foreign branches). This simplified template along with Standard
Operating Procedure was communicated to branches/offices

2 Introduction
Over the past decades, the Indian banking sector has witnessed multiple positive and negative
changes and banks have been facing challenges in terms of profitability, stiff competition from
new entrants, slowdown in credit off-take and increased capital requirement under Basel III
capital regulation. In addition, there has been an increased emphasis on risk based pricing and
risk based performance measurement from the Ministry/RBI through various guidelines/letters.

Taking cognizance, the Bank seeks to:

➢ Improve the decision-making capabilities in lending decisions by accurate assessment of
credit risk involved and appropriate risk-based pricing at transaction and borrower level.

➢ Enhance its performance measurement framework to enable assessment of risk adjusted

performance of branches, business units, products to drive efficient capital allocation.

Risk Adjusted Return on Capital (RAROC), an approach of strategic risk management practices,
can be leveraged in credit decision making (accept/reject decisions etc), optimizing risk-
adjusted return which leads to increased profitability (optimizing ROI/concession), risk-
adjusted performance assessment, for allocation of risk capital to business units and individual
transactions, active portfolio management and for maximization of shareholders value.

Classification: Internal
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3 Scope of the framework
Borrower wise: Borrowers irrespective of the rating grades fulfilling the following criteria:

✓ MSME advances (Fund + Non-Fund) exposures of Rs.1 Cr and above

✓ Corporate advances (Fund+ Non-Fund) exposures of Rs.5 Cr and above or sales turnover
of Rs 100 Cr and above.

✓ Agriculture advances (Fund+ Non-Fund) exposures of Rs.5 Cr and above or sales turnover
of Rs 100 Cr and above.

The following exposure/s as a standalone facility to a borrower are exempted for RAROC
computation:
i) Exposure to Central/State government
ii) Exposure against fixed deposit

The RAROC Computation is done at the time of Review/Renewal, Fresh Sanction and
Enhancement of limit.

Account/Product/Business Unit level: For Risk Adjusted Performance Measurement or Risk

Adjusted Profitability purposes, all the performing/standard accounts are subjected to Ex -
Post RAROC computation based on actual values of income, expenditure and capital related
parameters. These account/product/business unit level computation shall be system based
and automated. MFTP cell at Finance & Account Department is computing product level RAROC
for product profitability purpose.

For Risk Adjusted Profitability purposes or Risk Adjusted Performance Measurement, MFTP cell
at Finance & Account Department shall compute RAROC for all the performing/standard
accounts based on actual values of income, expenditure and capital related parameters.
4 Operational Guidelines for Computing RAROC using Excel Template
Managing our loan portfolio in a way that optimizes our shareholders’ return through adequate
pricing is an important function. It is desired that profitability is commensurate to the risks and
capital charge associated with the assets. The traditional measure of performance i.e. ROA, ROE
also do not encompass risk-based performance measurement. Hence Risk adjusted returns over
capital is calculated.
RAROC is computed as below:
𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝑹𝒊𝒔𝒌 𝑨𝒅𝒋𝒖𝒔𝒕𝒆𝒅 𝑹𝒆𝒕𝒖𝒓𝒏
𝑹𝑨𝑹𝑶𝑪 =
𝐑𝐞𝐠𝐮𝐥𝐚𝐭𝐨𝐫𝐲 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
In denominator, Regulatory Capital is used as a proxy of Economic Capital.
Also, RAROA (Risk Adjusted Return on Asset) is computed as below:
𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝑹𝒊𝒔𝒌 𝑨𝒅𝒋𝒖𝒔𝒕𝒆𝒅 𝑹𝒆𝒕𝒖𝒓𝒏
𝑹𝑨𝑹𝑶𝑨 =
𝐀𝐯𝐠. 𝐎𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠

Classification: Internal
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4.1 Terminologies used in RAROC Model
Risk Adjusted Return or Risk Adjusted Income
= [(Net Interest Income + Non-Interest Income + Yield on Capital – Cost of Deposit -
Operating Cost – Expected Credit Loss)]

Net Interest Income: Net Interest Income (NII) is computed as Interest income less Interest
expenses.

Non-Interest Income: This component includes all other income received from the account
like commissions, fees, processing charges & commitment charges etc.

Yield on Capital: Yield on capital is incorporated in the total Risk adjusted income. The
average SLR yield earned by our bank for FY 2023 (6.35%) is considered while arriving Yield
on Capital.

Cost of Deposit (COD): Avg. Utilization × Cost of Deposit

(1-CRR)

Operating Cost: Operating expense is calculated as total operating cost of the bank as a
percentage of advances and investment. Share of fund based and non-fund-based advances in
operating expense comes to 2.03% for fund-based and 0.25% for non-fund-based advances as
on 31.03.2023. The computation of operating cost is being carried out by RMD annually based
on audited financials. Detailed methodology for computing operating expense is given in
Appendix-A

Probability of Default (PD): We have used blended PD, which is a combination of

• The internal rating wise average 7 years observed default rates and
• One-year cumulative default rates for long term external ratings (annual static
pools) published in CRISIL Default Study.

Expected Credit Loss: the loss that we would expect from an exposure or a portfolio over a
given period. In our Model Expected Credit Loss (ECL) has been considered instead of EL and
is computed as:
Expected Credit Loss = PD x LGD x EAD.
Taxes: Risk Adjusted Income is adjusted at corporate tax rate (25.17%). Risk Adjustment
Income is adjusted with a multiplier of (1- Tax rate).
Regulatory Capital= Risk Weighted Assets x Capital Charge
As per BASEL III capital regulation regulatory capital requirement is 11.50% however, we have
use 12.50 % (targeted capital as per ICAAP) of Credit Risk Weighted Assets as proxy of
economic capital requirement.
Credit Risk Weighted Assets= (Total Exposure- Eligible Financial Collateral) x Risk Weight.

Classification: Internal
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4.2 Calculation of RAROC using RAROC Excel Template

The simplified RAROC Template for Domestic & Foreign Currency Loans and Overseas Exposure
are:
▪ RAROC template for Domestic & Foreign Currency Loan (including
FCL/FCTL/PCFC/REBA)
▪ RAROC Template for Dubai Branch - Foreign Currency Loans.
▪ RAROC Template for Sydney Branch - Foreign Currency Loans.

The template is designed to compute two RAROCs and RAROAs i.e. Existing risk adjusted returns
based on actual information/figures for last 12 months and Proposed risk adjusted return based
on estimates for next 12 months. In case of Review/Renewal/Enhancement proposals, existing as
well as proposed risk adjusted returns can be computed for better decision making using a single
template.

These templates have been designed in a manner to accommodate input as free hand entry as
well as through dropdown buttons. Some rows has been disabled/freezed for the user as same is
not applicable for particular facility or needed to be updated from the back-end.

In cases, where number of facilities exceeds the number of facilities accommodated in the
template, the input value to be entered as under:
➢ Working Capital: If a borrower is enjoying WC (limit and sub-limit) at two places, the
component of similar characteristics (limit & sub limit, outstanding etc.) can be clubbed
together.
➢ Term/Demand loan: Term loan with similar characteristics (tenure, ROI etc.) can be
clubbed together.
➢ Letter of Credit: where more than one LC is issued, it can be clubbed together on the
basis of their tenure/type.
LC with maturity <= 1 year (CCF- 20%)
LC with maturity >1 year (CCF- 50%)
Stand by Letter of Credit (CCF- 100%)
➢ Bank Guarantees: More than one BG’s can be clubbed together on basis of their type i.e.
Performance (CCF- 50%) or Financial (CCF-100%).
In case of Input of values in existing facilities, the actual/realised value of data from CBS
needs to be taken. For proposed utilisation, Input values should be in line with the actual
utilisation done by the borrower in previous year.

The input sheet of template is divided into following three section for better clarity of
the users:
i) Section A: Common Information (related to borrower)
ii) Section B: Inputs required for all proposals except fresh sanction.
iii) Section C: Inputs required for all Proposals

Standard operating Procedures (SOP) manual for computing RAROC using Excel Templates is
attached in Appendix C.
Note:

Classification: Internal
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 ➢ In case of Term Loan Facility, processing charges needs to be annually amortized
throughout the life of term loan.
➢ For Bank Guarantee Facility, if commission is collected on upfront basis, then commission
corresponding to one year only should be considered.
➢ One time charges like syndication charges, TEV cell charges etc. needs to annually
amortized over the life of term loan
➢ For Line of Credit (LOC) facility, RAROC to be computed at the time of availment.
➢ Lead Bank Charges, Syndication charges and TEV cell charges are to be considered at
borrower level not at facility level.
➢ In case of inter changeability of limits or Capex LC as a sub limit of Term Loan, sub limit
and remaining main limit should be considered as separate facilities.

Hurdle Rate
The common approach in setting RAROC hurdles required that the risk adjusted return on capital
exceeds the cost of capital of the Bank. The Bank’s capital is comprised of equity and debt. So
Weighted Average Cost of Capital (WACC) has been considered as Hurdle of RAROC i.e. minimum
required level of RAROC.
RAROC >= WACC
Hurdle Rate for FY 2023-24 is 12.20% and to be updated annually based on annual audited
financials of the bank.

4.3 RAROC Target

The respective credit verticals shall set the RAROC Target individually based on their business
mix, prospective growth and business targets for their vertical however the RAROC target
should not be below RAROC Hurdle.

4.4 Interpretation of RAROC

There can be following three outcomes of the RAROC Model:
A. RAROC is above the hurdle rate
Such proposals should normally be accepted as the income on a risk adjusted basis is more
than the cost of capital and thus it will do value addition to the shareholders more than
their expectation.

B. RAROC is Positive but below the hurdle rate

Risk Adjusted income expected from proposal is not adequate to meet the shareholders
expectation to full extent. Borrowers coming under this category can be accepted after
careful consideration by the sanctioning authority.

It can be either by addition of non-risk-based income #viz. mutual fund commission

income/income from other third-party products or by obtaining financial collateral which
will reduce the requirement of capital and help achieving RAROC up to the hurdle rate.

C. RAROC is Negative
In this case the risk adjusted return is negative and such proposal may deteriorate the
shareholders’ value. If the sanctioning authority is expecting non-risk-based income# (by

Classification: Internal
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 selling Insurance/Mutual Fund products to earn commission), which will be added to income
without involving additional capital.

Note: To reckon the amount of expected non risk-based income such as Third-party product
commission etc. the process notes to mention details of the product and source of fund to
procure the product.
#Denotes the commission received by the bank and not the selling price of the product.

Proper justification to be given in case of Negative RAROC and steps taken for improving
RAROC to be recorded in the note. In case of Negative RAROC, a proper justification and
steps to be taken for improving RAROC to be recorded in the Process Note.

4.5 Incorporation of RAROC in Process Note

It is proposed to incorporate the RAROC output with suitable interpretation in process note
of all eligible sanctions. While processing the proposals, it is required to incorporate the
information in process note as per following:

A. For all eligible Fresh Sanction proposal, Proposed RAROC (Ex-Ante RAROC) to be
computed as per estimated interest income based on justifiable utilization of working
capital limit for next one year. In case of Term Loan, interest income should recognize
based on reducing balance (monthly, quarterly as the case may be) for the next one year.
Proposed concession in ROI, if any, must be considered while estimating interest income.

B. In case of all eligible Review/Renewal/Enhancement proposals, following two RAROCs to

be computed:

➢ Existing RAROC (Ex Post RAROC): Existing RAROC to be computed based on actual
interest/non-interest income realized from the existing facilities during the last one year.

➢ Proposed RAROC (Ex Ante RAROC): Applicable in case of concessions and computation
will be based on the proposed ROI but utilization level for estimating interest income to
be considered in the line of actual utilization of the existing facilities during previous
year.

C. RAROC output to be presented in the following format at borrower level as well as facility
level along with the interest rate to be charged to meet the Hurdle rate i ncluding
interpretation and justification for AMBER/RED RAROC Zone in the process note:

RAROC Hurdle Rate RAROC Zone

(%)
GREEN AMBER RED

(RAROC >= Hurdle) (RAROC< Hurdle & Positive) RAROC is Negative

Existing
RAROC

Proposed
RAROC

Classification: Internal
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 Facility Proposed RAROC Proposed ROI Min ROI to achieve
Hurdle Rate

D. Justification in Case of RAROC falling under AMBER/RED Zone:

Justification to be incorporated in terms of value of connection with the party based on
following parameters:
• CASA accounts and balances
• Low cost deposits
• Income from Cross Selling of Third-Party products
• Others, if any
• Road map to achieve the hurdle rate

4.6 Verification/Validation of RAROC computation

Users of the RAROC Template need to take extra precautions while inputting the required
information and have to ensure that same is rechecked by a second official before putting up
to the sanctioning committees. If RAROC appears to be too low or too high, all the inputs
need to be relooked. Similarly, if there is a high variation in Ex Ante (based on estimates)
and Ex Post (based on actuals) RAROCs, it warrants a closure scrutiny of estimates with proper
justifications.

Risk officers are expected to evaluate the risk-reward trade-off associated with the borrower
and record their comments on proposed pricing for better informed decision making.

4.7 Delegation for ROI concession proposals with negative RAROC

In case of negative RAROC where ROI concession is involved, the delegation of sanctioning
concession shall be as under:

➢ For delegated authority up to ZLCC, the ROI concession shall be approved by the next higher
authority.
➢ For CAC-III and higher delegated authority, the ROI concession can be approved by the
respective authority only.

4.8 RAROC Related MIS

a) Management and Reporting of RAROC Data
All credit verticals shall maintain the database of RAROC computed using Excel Template
of borrowers pertaining to their verticals in prescribed format. The format is attached as
Appendix B.

MFTP Cell at Finance & Account Department shall maintain the account/product/Unit level
RAROC computed for profitability proposes.

b) Inclusion of RAROC in CRM 360°view

To get 360°view of borrowers, the following fields are incorporated in the CRM solution:

Classification: Internal
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 ✓ Borrower’s RAROC (%)
✓ Date of RAROC Calculation

The credit verticals are required to provide the RAROC related information to Digitisation
Vertical on at least monthly basis for updating the same in CRM portal.

5 Risk based pricing and RAROC

Depending on the product and the internal policy governing the credit process, decisions
regarding loan pricing sometimes be overridden by the sanctioning authorities of the bank. In
case of retail loans, where bank is price setter, there are few or no cases of concessions given
in rate of interest to the borrowers. However, in the case of wholesale/corporate segment,
the bank tends to behave like price taker and the delegated authorities sanction concession in
card rates depending upon the market competition and credit risk mitigations offered by
corporates.

Risk based pricing is a methodology to bring risk sensitivity in lending decisions by deciding the
rate of interest of a loan based on the perceived risk of the borrower. It enables the Bank to
price low for good customers and charge higher for risky customers. Using the risk-based
pricing framework, the bank can decide its interest rate in a more scientific manner. This
would enable the bank to avoid overpricing of good customers and under-pricing of bad
customers.

Risk based pricing method where premiums (credit risk, tenure and strategic premiums) are
added to benchmarks like MCLR/RLLR/EBLR does not give any clarity on how much maximum
concession can be accorded to the borrower so that the business/transaction can do some
value addition to the shareholders.

Risk Adjusted Return on Capital (RAROC) metric can be used as a tool for decision making to
arrive at the optimal level of concession/rate of interest to achieve a targeted economic value
addition to the shareholders of the Bank.

6 RAROC Computation for Profitability or Performance Measurement

Regardless of the role played by the Bank as a price setter or price taker, the process cannot
be considered complete until feedback about the final outcome of the taken decisions has
been provided to management. The measurement of performance can be extended down to
the customer/transaction level through the analysis of profitability. Such an analysis aims to
a broad and comprehensive view of all the costs, revenue and risks originated by each
customer/transaction.

Traditionally, Banks are using major ratios like Return on Assets (ROA), Return on Equity (ROE)
and Return on Capital Employed (ROCE) for performance measurement. These measures give
a clear accounting position of profitability, but it disregards the effect of risk components like
the proportion of risky assets and the solvency situation. In other words, these measures do
not reflect the actual sustainable performance as they expose the bank to unexpected losses.
Therefore, there is a requirement of Risk Adjusted Performance Measure (RAPM) which should
be sensitive to risk parameters.

Classification: Internal
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 Risk Adjusted Return on Capital (RAROC) is considered as an RAPM tool as it accounts for risk
in measuring the performance of the bank and it helps to analyses the risk adjusted return of
its Portfolios/Borrowers/Facilities/Business units. RAROC is a measure to find out how much
return, capital will provide given the level of risk associated with it.

7 Role of Various Verticals at central office

7.1 Risk Management Department

As an owner department of the RAROC Framework, RMD shall have the following
responsibility:
- Annual Review of RAROC Framework
- Improvement/Maintenance of RAROC Excel Template
- Independent verification/validation of RAROC computed using Template
- Guidance/Clarification to end users of the Template
- Determining the RAROC Hurdle Rate
- Periodic updation of the template
- Any changes in the template with approval of CRM

7.2 Credit Verticals (LCV, MCV and MSME)

The RAROC approach allows senior management to better understand where shareholder
value is being created and where it is being destroyed. It promotes risk-adjusted
profitability reporting & incentive compensation schemes, proactive allocation of
resources and better product pricing.

The Credit Verticals shall ensure to include the RAROC computation and its interpretation
in all eligible proposals pertaining to their verticals. Also,
- Maintain the data base of RAROC computed using Excel Template of borrowers
pertaining to their verticals in prescribed format. The format is attached as
Appendix B.
- Provide the RAROC related information to Digitisation Vertical on at least monthly
basis for updating the same in CRM portal.

7.3 Finance & Account Department

For Risk Adjusted Profitability purposes or Risk Adjusted Performance Measurement, MFTP
cell at Finance & Account Department shall compute RAROC for all the
performing/standard accounts based on actual values of income, expenditure and capital
related parameters. These account/product/business unit level computation shall be
system based and automated.

The department can decide the frequency and granularity of computation however the
minimum frequency of computation shall be at least annual. Apart from maintaining the
RAROC based profitability data, the department shall carry out the following activities:

▪ Defining RAROC threshold at Business Unit Level, Branch Level, Customer Level and
Product Level based on actual RAROC. (EASE Requirement)

Classification: Internal
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Appendix-A: Computation of Operating Cost (based on 31.03.2023 financials)

For Domestic RAROC Template

Rs. in Crores

A Total Deposit 11,06,089.97

B Funded 7,85,302.85
C Non-Funded 91,315.43
D Total Advances 8,76,618.28
E NSLR Investment 74,955.45
F SLR Investment 2,61,082.14
G Operating Expenses* 20,295.52

H Op Expenses apportioned to NFB (Judgemental) 0.25%

I=C*H Op Expenses apportioned to NFB (in Crore) 228.29

J Op Expenses apportioned to SLR (Judgemental) 1.00%

K= F*J Op Expenses apportioned to SLR 2,610.82

L = (G-I-K) Left Out portion of Op Expenses 17,456.41

L
Op Expenses apportioned to FB & Non SLR
M=( ) 𝐋𝐞𝐟𝐭 𝐎𝐮𝐭 𝐎𝐩 𝐄𝐱𝐩 2.03%
B+E (𝐓𝐨𝐭𝐚𝐥 𝐅𝐁 𝐀𝐝𝐯+𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐍𝐒𝐋𝐑)

* Operating Expenses is net of ATM/POS related expenses & Rent on SDV lockers

Rs. in Crores
Credit Exposure as Share in Operating Cost
Amount
on 31.03.2023 Operating Cost Recovered
I Fund Based 7,85,302.85 2.03% 15,935.41
II Non Fund Based 91,315.43 0.25% 228.29
III NSLR Investment 74,955.45 2.03% 1,521.00
IV SLR Investment 2,61,082.14 1.00% 2,610.82
N Actual Operating Cost 20,295.52
O Under-Recovery = (Total Op Expenses – Actual Op Cost) NIL

Classification: Internal
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