Raroc

The attention devoted to bank's capital allocation has mostly focused on risk management and performance evaluation. This paper focuses on the implementation issues involved using RAROC in the capital allocation process.

In particular, this paper deals with the process of capital allocation and its consequences on risk-adjusted performance evaluation.

Risk adjusted return on capital (RAROC) is a risk based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. Note, however, that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee.

Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. Economic capital is a function of market risk, credit risk, and operational risk. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above risk-free.

RAROC system allocates capital for 2 basic reasons

1. Risk management

2. Performance evaluation

For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure (i.e., economic capital allocation is closely correlated with individual business risk).

As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.

Risk Adjusted Return on Capital

Risk capital is the cushion that provides protection against the various risks inherent in a business, so a financial institution can maintain its financial integrity and remain a viable business even in the event of a near-catastrophic, worst-case scenario. The fundamental challenge that underpins the management of risk within a large corporation is ensuring that accurate, timely, and functionally relevant data are delivered throughout the enterprise.

Risk Adjusted Return on Capital - RAROC

In financial analysis, riskier projects and investments must be evaluated differently from their riskless counterparts. By discounting risky cashflows against less risky cashflows RAROC accounts for changes in the profile of the investment.

Notes:

In general, the higher the risk, the higher the return. Thus, when companies need to compare and contrast two different projects or investments, it is important to take into account these possibilities.

Concerns about capital adequacy, along with the Basel risk-based capital requirements, have played some role in the growth of RAROC among commercial banks. But the most powerful impetus to bankers' use of more systematic risk measures is coming from increasingly activist institutional investors. Besides giving senior management an economic basis for evaluating the bank as a portfolio of businesses and for making resource allocation decisions that improve the bank's risk/reward profile, RAROC systems are also expected to produce better performance by holding managers accountable for the amount of investor capital they are putting at risk.

Capital Adequacy

For capital adequacy purposes, the overriding goal of allocating capital to individual businesses is to determine the bank's optimal capital structure--the amount of equity that is required to maintain the bank's internal standard of solvency (i.e., target credit rating) given the overall level of risk. This process involves estimating how much the risk of each business contributes to the total risk of the bank, and hence to the bank's overall capital requirement.

Ultimately, the economic capital based on risk should be compared to the actual capital held by the bank. A sensible risk-based capital adequacy framework should match the measured risk with the financial