RAROC

Risk Adjusted Return on Capital

Definitions to Start With
• Liabilities of a Bank( or FI): Refers to money the banks owes to other parties. To
restrict the definition here we will only consider debt and not the equity ‘owned’
to the shareholders:
• Bonds issued by the bank;
• Loans it has taken from other banks;
• Deposits it has accepted from retail or corporate customers;
• Assets: Assets are securities/transactions/loans where other parties owns money
to the bank.
• Loans given to retail/corporate client;
• Equity investment;
• Capital: Difference in value between bank’s assets and liabilities. It may be a
proxy for the networth of the bank
Definitions to Start With(Cont..)
• Regulatory Capital: Capital (some in the form of instruments) that are calculated for
regulatory purposes. It is composed of two categories:
• Tier 1 (Core Capital): Share Capital, Retained Earnings, general risk reserves, other explicit reserves
• Tier 2(Supplementary Capital): revaluation reserves, medium and long term subordinated debt and other hybrid
instruments(partial/full loss absorption capabilities)

• Book Value Capital(BVC): Based on Accounting standards used for financial reporting
purposes and is equivalent to the difference between bank’s assets and liabilities as they
appear on the balance sheet.
• Value recorded on basis of historic cost and need not represent current value

• Fair Value Capital(FVC): The fair value of bank’s assets minus fair value of liabilities. Fair
value implies to present value of future cashflows. FVC is more aligned to market
conditions.(When Books are maintained on a ‘mark-to-market’ basis there is higher
alignment between FVC and BVC.
Definitions to Start With(Cont..)
• Market Capitalisation(MC):It is not uncommon for the market not to have all information
needed in order to value a bank’s asset/liabilities/net worth. Investors valuation are
themselves affected by prevailing market sentiment. Thus MC need not always coincide with
FVC
• Available Capital: In the event all assets and liabilities are traded in market, this is simply the
current market value of assets minus current market value of liabilities as reflected by their
respective market prices.
• However, for most of the assets and liabilities in the banks’ books there are no observed market
price so current value is difficult the assess/measure.
• Adjusted Measures are taken in such cases:
• Adjusted Asset Value : Nominal Value of Asset less Specific provisions less General Provisions
• Specific provision: Amount expected to be defaulted by borrowers( to whom the bank lend) who are already in
financial distress;
• General Provision: Amount expected to be in default by other customers who are expected to default in the next
year

• Capital=Nominal Asset Value – Specific Provision – General Provisions – Liabilities

Relation between Capital, Risk, Bank Profitability and Default

• Example: A Bank ‘B’ has raised USD 5.0 mn from

shareholder(Equity);Raised USD 95.0 mn as bond from the market,
with a maturity of 1 year at a rate of 8%.(Debt). It created assets of
USD 100.0 mn by providing 1.0 mn each to 100 corporates at 10%
each. What are the shareholder returns at the end of 1 year?
• Receives from Assets(assuming no default): USD 110.0 mn
• Pays bond holders: USD 102.8 mn ie;( 95 * (1.08))
• Final Shareholder Equity:USD 7.2 mn
• Shareholder ROE: (7.2-5)/5=44%(!!)
Relation between Capital, Risk,Bank Profitability and Default

• Example: Bank B’s shareholders become greedy. They want higher

ROE. They consider two options
• A)Reduce Capital ratio to 4% instead of 5% B) Keep capitalisation
same but lend to riskier clients and charge higher interest rate.
• A) Keep Shareholder capital at USD 4 mn and raise USD 96 mn as debt
at 8.5%
• Refer Excel: Raroc Example
Economic Capital
• Economic Capital is the net value the bank must have at the beginning
of the year to ensure that there is only a small probability of
defaulting within that year. The small probability is usually below 1%
often targeted at 0.1%. Which is to say that there is a 99% to 99.9%
likelihood of survival of the bank.
• Economic capital is the amount shareholders must pay into the bank
at the beginning of the year so that the bank does not go into default
despite expected or unexpected losses on its asset side.
• Shareholder’s equity acts as a cushion against the default.
Economic Capital
For Credit Risk

• Expected Loss(EL) is the mean loss(based on historical experience) that the bank is
expected to face each year.
• Unexpected Loss(UL) is the standard deviation of historical losses.
• Maximum Probable Loss(MPL) is the confidence level such that there is only a small
probability(p) that losses could be worse than the MPL.
Probability
Density
Red Line is the Expected Function of
Loss of the Portfolio the loss
Purple Line is the
Maximum Probable Loss
of the Portfolio

Debt Equity

Capital Structure of the Bank

Economic Capital
For Credit Risk

• EC ~ MPL- EL
• Amount of EC to be held at the beginning of the year for a loan portfolio depends on:
• the interest rate to be received from the loans(ra) ;
• the interest rate that the bank must pay for its own borrowing (rd)
• A0 is the value of Asset (Loan Exposure)
• EC = MPL*(1 +ra )/(1 + rd) - A0(ra - rd)/(1+ rd )
Risk Adjusted Return on Capital

• Helps the FI to decide on the profitability of a transaction relative to

the risk of the transaction.
• Risk Adjusted Performance Measures(RAPM) allows risk management
to be integrated into the profitability management of the business.
• Erstwhile classical measures of return such as ROA and ROE
inadequate for this purpose.
• ROA is profit divided by value of the assets/portfolio; Does not consider the
risk associated with the assets;
• ROE is profitability divided by book capital.( and some times regulatory
capital)
Risk Adjusted Return on Capital
Revenues – Interest Expenses + Return on
Risk Adjusted
Economic Capital –Operating Cost –Expected
Profit
Losses
RAROC
Risk Adjusted Risk Adjusted
Capital Used to Capital Used to
support the support the
transaction (EC) transaction (EC)

• Revenue= Interest Income on Loan (A0*ra) + Any Fees (F).

• Interest Expense= Amount of interest the bank pays for the amount it debt allocated to this
specific loan (D0*rd); Where A0= D0+EC0
• Operating Expense(OC);
• Expected Loss ( Average loss on comparable loans based on historical experience)(EL)
• RAROC= (A0*ra + F - D0*rd -OC-EL)/EC;
• RAROC= (A0*ra + F – (A0 –EC)**rd -OC-EL)/EC;
 Risk Adjusted Return on Capital
• Example: A loan portfolio with a principal of USD 1 bn pays an annual
interest of 9%. The EC is estimated to by 7.5% of the loan. Thus to fund this
loan the FI must raise an incremental USD 75 mn in equity capital. The FI’s
cost of fund is 6%. EL based on past record is 1%.Operating cost is USD15
mn.

• RAROC= {1000*9% - (1000-75)*6% - 15 – 1000*1%}/75

• RAROC was initially proposed as a tool for capital allocation to departments

or specific transactions. Thus used in ex ante basis.
• However, it is subsequently used for performance measurement. So in the
numerator instead of expected loss, in such ex poste usage, the
actual/realised loss is used.
 RAROC and Shareholder Value
• RAROC is used to set target returns from Business Units. Transactions
where the RAROC is higher than the management determined hurdle
rate (h) are accepted.(RAROC >= h).
• This forms the basis of risk based pricing of loans.
• H*EC + (A0 –EC)**rd + OC + EL = (A0*ra + F )