Chapter 13

Risk-Adjusted Return on Capital

Models

Definition of RAROC

AdjustedIncome
CapitalatRisk

RAROC =
If RAROC > Hurdle rate then value adding.
ROA =
RORAC =
AdjustedIncome
AssetsLent

AdjustedIncome
Risk basedCapital Re quirement

EVA = economic value added = Adjusted

income ROE x K. Invest if 0.
Saunders & Allen Chapter 13

The Numerator: Adjusted Income

= Spread (direct income on loan) +

+ Fees (directly attributable to loan)
- Expected Loss (EDF x LGD)
- Operating Costs (allocated to loan)
Then multiply the entire amount by 1 the
marginal tax rate.
Saunders & Allen Chapter 13

The Denominator: Capital at Risk

Market-based approach (BT model)
Measure the maximum adverse change in the
market value of the loan resulting from an
increase in the credit spread
Use duration model to measure price effects.

Experientially-based approach (BA model)

Calculate UL using a multiple x LGD x
exposure x standard deviation of default rates.
Saunders & Allen Chapter 13

The Market-based Approach to

Measuring Capital at Risk
L

-DL

(Dollar capital risk

the
exposure or loss
the
amount)

(Duration
of the loan

R/(1+RL)

(13.9)

(Risk amount or

(Expected discounted change in

loan exposure)

credit premuim or risk factor on

loan)

If DL=2.7, L=$1m, R=1.1%, R=10%, then:

L = -$ 27,000

Saunders & Allen Chapter 13

Figure 13.1 Estimating the change in the risk premium.

Frequency

1% of All AAA Bonds

Risk
Premium
(R )

1%

1.1%

Saunders & Allen Chapter 13

3.5%

Risk
Premium
(R )

The Experientially-based Approach to

Capital at Risk Measurement
If 99.97% VAR (AA rating) and normal
distribution, then the multiplier is 3.4.
But, most banks use a large multiplier
because loan distributions are not normal.
BA uses multiplier = 6.
If LGD=.5, Exposure=$1m, Loan
=.00225, then UL=6 x .00225 x .5 x $1m
= $27,000 (same as market-based approach)
Saunders & Allen Chapter 13

Calculating the RAROC of the

Loan Example

Spread = .2% x $1m = $2,000

Fees = .15% x $1m = $1,500
EL = .1% x $.5m
= ($500)
Tax rate = 0%
Adjusted Income = $3,000
RAROC = $3,000/$27,000 = 11.1%
If cost of capital < 11.1% then make loan.
Saunders & Allen Chapter 13

The RAROC Denominator and Correlations

Ri RF = i (Rm - RF)
(13.15)
where Ri = the return on a risky asset,
RF = the risk-free rate,
Rm = the return on the market portfolio,
i = the risk of the risky asset,
and
(13.16)
i = im/2m = imim/2m = imi/m
where im = covariance between the returns on risky asset i and the market portfolio m,
m = standard deviation of the return on the market portfolio,
im = correlation between the returns on the risky asset i and
the market
portfolio
Ri - RF
imi
RAROC

Rm - RF
m
= Hurdle Rate

(13.18)

Saunders & Allen Chapter 13

Incorporating Unsystematic Risk

Equation (13.18) is the traditional Sharpe ratio for a loan. But, if all
idiosyncratic risk is diversified away, then no need for RAROC.
RAROC deals with untraded and unhedgeable assets (loans).
Banks specialize in info-intensive relationship lending that cannot be
hedged in capital markets. Risk of loan should be divided into: (1)
liquid, hedgeable market risk component and (2) illiquid, unhedgeable
component.
The correlation of the unhedgeable component with the banks
portfolio will determine the loans price. So different banks (with
different portfolio correlations) will have different pricing (credit risk).
Froot & Stein (1998): Loans hurdle rate =market price of the loans
traded risk + bank shareholders cost of capital to cover nontradeable
risk. The second term is idiosyncratic.
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