Risk Management and RAROC

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Analyzing the value of risk. Explanation of Risk-Adjusted Return On Capital. RAROC.

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What is RAROC? Description

RAROC is a risk-adjusted framework for profitability measurement and profitability management. It is a tool for measuring risk-adjusted financial performance. And it provides a uniform 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.
 

History of RAROC

Development of the RAROC methodology began in the late 1970s, initiated by a group at Bankers Trust. Their original idea 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 look-alike systems). Their aim is in most cases to quantify 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 main 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.


Economic Capital and three types of Risk

Economic capital is attributed on the basis of three risk factors:

  • Market risk,
  • Credit risk and
  • Operational risk.

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 that provide high strategic value and sustainable returns, or with long-term growth and profitability potential.
 

Economic Profit

Economic profit elaborates on RAROC by incorporating the cost of equity capital. This 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 which is generated by each business line in excess of the 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 should be 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 PreventionProactive Risk Management model

    • Avoid crises in own organization.
    • Avoid crises in other organizations.
    • Comply with corporate governance standards.
    • Avoid personal liability of managers.
  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

Proactive Risk Management evaluates:

  • The probability of risk occurring,
  • Risk event drivers,
  • Risk events,
  • The probability of impact,
  • Impact drivers, prior to the risk actually taking place (figure: Proactive Risk Management - Smith and Merritt).

Book: John B. Caouette, Edward I. Altman - Managing Credit Risk -

Book: Carol Alexander - Operational Risk: Regulation, Analysis and Management -

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) -




Risk Management and RAROC Forum (10 topics) Help
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Anybody knows about the model of environmental factors by Malcolm Saunders? Please enter a short explanation, anything is welcome, thanks....
     
  Introducing a Loss Event Database
Hi everyone! My problem is that I would like to introduce a loss database or loss event database at our company. I would like to soon run the first workshops, where I will explain and describe what is the loss database and it's purpose to the ...
     
  List of Typical Project Risks
Anyone have a good list of typical risks to consider when creating a project risk plan. Thanks......
     
  Enterprise Risk Management
In the modern day risk has become an integral part of every corporate. Enterprise risk is managing all risk, irrespective of the type. Enterprise risk management take appreciation of any different risks that are inherent within corporations. I...
     
  Risk Versus Uncertainty
In the management of risk, what is the distinction between risk and uncertainty? Thanks.....
     
  What are the Main Procedures of Operational Risk Management?
What are the main procedures involved in operational risk management?...
     
  Risk Management in the Electrical Energy Sector
Can anyone tell me the ideal risk management system that can be used in an electrical energy supply industry....
     
  Global Financial Pandemonium
The global financial pandemonium goes beyond the issue of common sense. I think it's high time people started looking inward and listening deeply to the inner voice that serves as the connector and witness to it's creator, who holds the world financi...
     
  Banks have managed the wrong risks
Over the last couple of years, financial institutions have been spending an awful lot of money and effort on understanding and managing their market risks, credit risks and operational risks in tremendous detail.
At the same time they have compl...
     
  Meaning of Risk and Risk Events
One could define RISK as: the uncertainity in desired outcomes.
A RISK EVENT is generally the manifestation of a risk. Its critical factors are:
1. Probability (the probability of the risk event happening), sub factors:
1A. Fa...
     



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Resources - Risk Management and RAROC Premium
Open Capital Allocation Using RAROC and EVA - RAROC, EVA
Enterprise Risk Management: Theory and Practice - Enterprise Risk Management
Measuring and Managing Operational Risk in the Financial Sector - Financial Sector,Operational Risk
IT Risks - List of Typical Risks of IT Projects
Operational Risk Management - Risk Management
The Six Basic Questions of Risk Management - Initial Understanding of Risk Management, Risk Management Introduction
Risk Management Diagram - Risk Management
 

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Compare with: Plausibility Theory  |  Strategic Risk Management  |  Real Options  |  CAPM  |  PRVit  |  Z-Score
 

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