Risk Management and RAROC
Analyzing the value of risk. Explanation of Risk-Adjusted Return On Capital. RAROC.
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.
Economic Capital and three types of Risk
Economic capital is attributed on the basis of three risk factors:
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 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):
Proactive Risk Management
Proactive Risk Management evaluates:
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