RAROC approach for risk evaluation

Banks, across the world, use different techniques to evaluate the probable risks through sensitivity analysis, scenario analysis, break-even analysis etc. The most commonly used approach is the Risk Adjusted Return on Capital (RAROC). The banking as well as Non-banking financial institution and also large numbers of businesses are utilizing RAROC metric to calculate Return on risk-adjusted capital (RORAC). Under RAROC framework, each type of risks is measured to determine both the expected and unexpected losses using VaR or worst-case type analytical model. Key to RAROC model is the evaluation of revenues, costs and risks on transaction or portfolio basis over a defined time period.

The formula used to calculate RAROC is; 

RAROC= (Revenue-expenses-expected loss+ income from capital) ÷ (Capital) 

If the RAROC is more than minimum acceptable rate of return, you would go ahead and make the loan otherwise you won’t.

Revenues in the above equation refer to banks revenues in the form of interests, and transaction related fees. ‘Income from capital’ term included although some income would already be included in revenue, this is because allocating capital to a business line or transaction is different from investing the capital in the business line or transaction. The part of the capital is presumably invested somewhere, and ROC (return on capital) should reflect any extra income from that investment.

The formula used to calculate income from capital is;

Income from capital= Capital charges × risk free rate of return

Capital charge means an amount of money equal to how much a business has tied up in assets multiplied by the weighted average cost of those assets.The risk-free rate of return: Since the capital is supporting a risky business line or transaction, it (hypothetically) should be invested in something risk free. Accordingly, it is ascribed income at the risk-free rate.

Expected loss is the average loss expected over a specified period of time. Under RAROC framework, the risk of loss and expected default rate of the rating category of the borrower is actually recovered from borrowers as risk premium. The pricing of loans normally linked to risk rating or credit quality. It means borrowers with weak financial position are treated as high credit risk category and loans to them are priced high. For determining the probability of default rate banks use historical data of past behaviour of the loan portfolio for a period of previous five years or so. The value of collateral, market forces, perceived value of accounts, future business potential, portfolio/industry exposure, variability of income on allocated capital and strategic reasons may also play important role in pricing.  Interest rate however be changed according to changes in rating / value of collaterals over time.

This begins with a clear differentiation between expected and unexpected losses. The expected losses are covered by reserves and provisions and unexpected losses require capital allocation.  International banks usually allocate enough capital so that the expected loan loss reserve or provision plus allocated capital cover 99% of the loan loss outcomes.

The RAROC model was originally developed by a group at Bankers Trust during the late 1970s. Bankers Trust adopted the model for retail lending, deposit businesses and in derivative market activity.  Later on this model of Banker Trust grew in popularity and number of other banks also developed similar model serving  with the aim  of calculating the amount of equity capital necessary to support all of their operating activities — fee-based and trading activities, as well as traditional lending. The other banks gave their systems different names like return on risk-adjusted capital (RORAC), risk-adjusted return on risk-adjusted capital (RARORAC) etc.to the model developed by them. Nevertheless, the most commonly used present term for Capital Budgeting and Performance Evaluation model is still RAROC.