Risk Management and RAROC

Knowledge Center

   

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

Contents

Premium

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 Special Interest Group


Special Interest Group (445 members)


Risk Management and RAROC Forum  

Recent topics

  List of Typical Project Risks      
 
  Environmental Risk Factors by Saunders      
 
  Introducing a Loss Event Database      
 

Best Practices - Risk Management and RAROC
  Risk Versus Uncertainty
     
 
  Meaning of Risk and Risk Events
     
 
  Banks have managed the wrong risks
     
 
  Enterprise Risk Management
     
 
  Risk Management in the Electrical Energy Sector
     
 



All you need to know about management


  What are the Main Procedures of Operational Risk Management?
     
 
  Global Financial Pandemonium
     
 

Expert Tips - Risk Management and RAROC
 

The Levels of Risk

 
 
 

Critical Success Factors of RM

 
 
 

Strategic versus Financial Risk Management

 
 
 

Pitfalls of Traditional Risk Analysis

 
 
 

Taking Risk Management from Control and Compliance into a Competitive Advantage

 
 
 

Why Society is More Risky than Before

 
 
 

How to Link Risk Management and Strategy?

 
 
 

Moral Intensity: When Will a Decision Be Seen as Unethical?

 
 
 

Align Your Risk Management Strategy with Investors' View on Risk

 
 



Advance yourself in business administration and management



Resources - Risk Management and RAROC

Enterprise Risk Management and Integrated Risk Management

 

Open Capital Allocation Using RAROC and EVA

 

The Risk Management Process in Steps

 

Enterprise Risk Management: Theory and Practice

 

Measuring and Managing Operational Risk in the Financial Sector

 

IT Risks

 

Operational Risk Management

 

How to Apply the COSO Enterprise Risk Management Integrated Framework

 

Risk Management in Agricultural Lending

 

The Six Basic Questions of Risk Management

 

Risk Management Diagram

 
 

News about Risk Management


     
 

News about Raroc Method


     
 

Videos about Risk Management


     
 

Videos about Raroc Method


     
 

Presentations about Risk Management


     
 

Presentations about Raroc Method


     
 

Books about Risk Management


     
 

Books about Raroc Method


     
 

More about Risk Management


     
 

More about Raroc Method


     



Accelerate your management career



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

Return to Management Hub: Decision-making & Valuation  |  Finance & Investing  |  Knowledge & Intangibles  |  Strategy


More Management Methods, Models and Theory

Special Interest Group Leader

















About 12manage | Advertising | Link to us / Cite us | Privacy | Suggestions | Terms of Service
© 2018 12manage - The Executive Fast Track. V14.1 - Last updated: 16-10-2018. All names ™ of their owners.