Short Description - What is RAROC?
RAROC is a
risk-adjusted profitability measurement and management framework for
measuring risk-adjusted financial performance and for providing a consistent
view of profitability across businesses (strategic business units /
divisions). RAROC and related concepts such as RORAC and RARORAC are mainly
used within (business lines of) banks and insurance companies. RAROC is
defined as the ratio of risk-adjusted return to economic capital.
Economic capital is attributed on the basis of three risk factors: market
risk, credit risk and operational risk. The fundamental
approaches to managing these risk factors are described in the management of
risk and capital section. The use of risk-based capital strengthens the risk
management discipline within business lines, as the methodologies employed
quantify the level of risk within each business line and attribute capital
accordingly. This process assists in achieving controlled growth and returns
commensurate with the risk taken.
Economic capital methodologies can be applied across products, clients,
lines of business and other segmentations, as required, to measure certain
types of performance. The resulting capital attributed to each business line
provides the financial framework to understand and evaluate sustainable
performance and to actively manage the composition of the business
portfolio. This enables a financial company to increase shareholder value by
reallocating capital to those businesses with high strategic value and
sustainable returns, or with long-term growth and profitability potential.
Economic profit elaborates on RAROC by incorporating the cost of equity
capital, which is based on the market required rate of return from holding a
company's equity instruments, to assess whether shareholder wealth is being
created. Economic profit measures the return generated by each business in
excess of a bank's cost of equity capital. Shareholder wealth is increased
if capital can be employed at a return in excess of the bank's cost of
equity capital. Similarly, when returns do not exceed the cost of equity
capital, then shareholder wealth is diminished and a more effective
deployment of that capital is sought.
The Value of Risk
Management
Efficient Risk
Management can constitute value in the following dimensions (more or
less in order of significance):
1. Compliance and Prevention
-
Avoid crises in own organization
-
Avoid crises in other organizations
-
Comply with corporate governance standards
-
Avoid personal liability failure
2. Operating
Performance
-
Understand full range of risk facing the organization
-
Evaluate business strategy risks
-
Achieve best practices
3. Corporate
Reputation
-
Protection of Corporate Reputation
4. Shareholder Value
Enhancement
-
Enhance capital allocation
-
Improve returns through Value Based Management
Proactive Risk
Management evaluates the probability of risk occurring, risk event
drivers, risk events, the probability of impact and the impact drivers prior
to the risk actually taking place (figure: Proactive Risk Management - Smith
and Merritt).
History of RAROC
Development of the
RAROC methodology began in the late 1970s, initiated by a group at Bankers
Trust. Their original interest was to measure the risk of the bank’s credit
portfolio, as well as the amount of equity capital necessary to limit the
exposure of the bank’s depositors and other debt holders to a specified
probability of loss. Since then, a number of other large banks have
developed RAROC or (RAROC-like systems) with the aim, in most cases, of
quantifying the amount of equity capital necessary to support all of their
operating activities -- fee-based and trading activities, as well as
traditional lending.
RAROC systems allocate
capital for two basic reasons: (1) risk management and (2) performance
evaluation. For risk-management purposes, the overriding goal of allocating
capital to individual business units is to determine the bank’s optimal
capital structure. This process involves estimating how much the risk
(volatility) of each business unit contributes to the total risk of the bank
and, hence, to the bank’s overall capital requirements.
For performance-evaluation purposes, RAROC systems assign capital to
business units as part of a process of determining the risk-adjusted rate of
return and, ultimately, the economic value added of each business unit. The
economic value added of each business unit, defined in detail below, is
simply the unit’s adjusted net income less a capital charge (the amount of
equity capital allocated to the unit times the required return on equity).
The objective in this case is to measure a business unit’s contribution to
shareholder value and, thus, to provide a basis for effective capital
budgeting and incentive compensation at the business-unit level.
New Basel Capital Accord
- Basel II
In January 2001 the
Basel
Committee on Banking Supervision issued a proposal for a New Basel
Capital Accord (better known as "Basel II") that, once finalized, will
replace the current 1988 Capital Accord. The proposal is based on three
mutually reinforcing pillars that allow banks and supervisors to evaluate
properly the various risks that banks face. These 3 pillars are:
1. minimum capital requirements, which seek to refine the measurement
framework set out in the 1988 Accord (dealing with credit risk, operational
risk and market risk),
2. supervisory review of an institution's capital adequacy and
internal assessment process, and
3. market discipline through effective disclosure to encourage safe
and sound banking practices.
The Basel Committee received more than 250 comments on its January 2001
proposals. In April 2001 the Committee initiated a Quantitative Impact Study
(QIS) of banks to gather the data necessary to allow the Committee to gauge
the impact of the proposals for capital requirements. A further study, QIS
2.5, was undertaken in November 2001 to gain industry feedback about
potential modifications to the Committee's proposals.
In December 2001 the Basel Committee announced a revised approach to
finalizing the New Basel Capital Accord and the establishment of an Accord
Implementation Group. Previously, in June 2001 the Committee released an
update on its progress and highlighted several important ways in which it
had agreed to modify some of its earlier proposals based, in part, on
industry comments.
During its 10 July 2002 meeting, members of the Basel Committee reached
agreement on a number of important issues related to the New Basel Capital
Accord that the Committee has been exploring since releasing its January
2001 consultative paper.
In April 2003 the
Basel Committee on Banking Supervision has issued a third consultative paper on
the New Basel Capital Accord.
Book: Michael K. Ong - The Basel Handbook: A Guide for
Financial Practitioners - 
Book: Donald R. van Deventer, Kenji Imai - Credit Risk
Models and the Basel Accords (Wiley Finance) -
Compare:
Plausibility Theory |
Real Options |
CAPM |
PRVit |
Z-Score
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