RAROC - Risk Management - Basel II
Risk-Adjusted Return On Capital - RAROC
Summary of Risk Management. Abstract
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.
The Value of Risk Management
Management can constitute value in the following dimensions (more or
less in order of significance):
- 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 bankís credit portfolio, as well as the amount of equity capital necessary to limit the exposure of the bankís 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 bankís 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 bankís overall capital requirements.
New Basel Capital Accord - Basel II
In January 2001 the
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:
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)
T I P : Here you can discuss and learn a lot more about Credit Risk Management and RAROC.
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