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Risk-Adjusted Return on Capital (RAROC)

Instructor: Sanghamitra Das

Sanghamitra has a master's in Finance and has a professional working and teaching experience of over a decade.

John Longman is a treasury manager in one of the leading banks. He is asked to assess the return on the assets of the banks given that the markets are overshadowed with high default rates. At this point, John uses RAROC which helps him make the right decision. Read on to know how.

Risk Adjusted Return on Capital (RAROC)

RAROC or Risk Adjusted Return on Capital employed is a common approach to compute expected return on capital employed. This is an effective mode of finding the expected return on assets employed for banks and financial institutions. For effective risk management, banks use RAROC among others as a tool to control risks particularly ensuing from its lending business. This is often calculated as:

RAROC= (Revenues - Costs - Expected Losses)/ Economic Capital

There are two fundamental drivers of RAROC areas as follows:

a) Risk Management

b) Performance Evaluation

Risk Management

Commercial lending institutes such as banks acting as financial intermediaries that accept deposits from public and lend it out to borrowers. The borrowers, in turn, repay the amount borrowed along with an additional sum known as the interest. This interest is fixed by the bank in a way that it covers the cost of operations, the cost of sourcing funds, and the yield for the shareholders of the bank's equity. But the whole operation of borrowing and lending may not be running as smoothly as expected.

A bank may face external or internal fluctuations or disruptions in its daily operations which are known as risks. These risks could be related to macro (industry related) or micro (firm specific) factors in which the firm operates. A financial institution is exposed to operational, credit and market risks in its daily course of business.

Operational risk is the risk which is not inherent in the business. It relates to human error, fraud, or breakdown of systems and processes.

Credit risks primarily arise from the risk of default of borrowers when the borrower fails to make required payments back to the financial institution.

Market risk is appears in forms of fluctuation in prices in the financial markets and the possibility for an investor to experience losses

Performance Evaluation

Banks reward executive performances with bonuses and incentives, but evaluating performances becomes challenging. RAROC plays an important role by measuring performances against the amount of risk undertaken via the business unit under the particular executive. Even though this is practiced by some banks measuring the performance of a business unit through profit may not truly indicate positive changes in the value of the overall business of the institution.

One of the ways in which RAROC directly simplifies the performance evaluation process is by incorporating risks and pricing the products of the business units. Thus RAROC can profile risk based business units which in turn help to ascertain the risk exposure of the business as a whole.

Components of the RAROC equation

Revenues in the equation refer to banks revenues in the form of interests, and transaction related fees. Therefore for the loan or the credit portfolio that the bank holds the annual revenue would be an annualized value of the banks interest earning.

Expected loss is the predicted loss of the business based on industry averages over a period of time. This is the risk of loss and is actually recovered from borrowers as risk premium. Expected loss can be calculated as: 'EL = PD * LGD * EAD'

In the expected loss (EL) equation, EAD stands for exposure at default which is the risk of exposure in the amount owing to the bank at a possible default.

PD is the probability of default and it indicates the possibility that the loan amount will not be repaid. This probability is required to be calculated for each borrower. To ascertain the chances that a particular borrower will default banks sometimes consider internal ratings system or external ratings houses for validating the creditworthiness of the borrower. Usually PD beyond 50% and above is considered risky.

LGD or the loss given default is the fractional loss due to default. LGD is usually calculated as 1-RR or Recovery Rate Percentage which is the portion of debt that can be recovered.

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