Credit Risk Management Committee — Risk Adjusted Performance Measures (RAPM)
Introduction
Major financial crises stem primarily from increasing banking risks and inadequate risk management. The liberalization of financial markets and the introduction of new financial instruments has increased both the volume and variety of banking risks. This led to the development of Risk Adjusted Performance Measures (RAPM) — measures that link profitability to risk exposure.
Key Risk Adjusted Performance Measures
1. Sharpe Ratio (SR)
Developed by William Sharpe, this metric represents "average returns exceeding the risk-free rate." A higher SR value indicates more attractive risk-adjusted returns. A portfolio of purely risk-free investments has a zero SR.
2. Information Ratio (IR)
Measures portfolio returns above a benchmark index against tracking error volatility. It "measures the portfolio's ability to generate excess returns compared to the benchmark."
3. Risk-Adjusted Performance (RAP)
Uses benchmark returns and risk metrics to adjust portfolio values to match benchmark volatility levels for measuring risk-weighted performance.
4. RAROC (Risk-Adjusted Return on Capital)
Connects return on capital from banking activities to investment risks. Considered one of the best standards implemented by financial institutions — provides an economic basis for measuring all risk types and facilitates sound asset return-risk balancing decisions.
RAROC Components
Revenues
All income from facilities including interest rates and fees.
Costs
Expenses including cost of funds and operating expenses.
Expected Credit Losses (ECL)
Calculated as: EAD × PD × LGD
Return from Capital
Opportunity cost of allocating funds to risk-free investments.
Economic Capital
Capital required for unexpected credit losses.
RAROC is approved when values exceed the bank's Hurdle Rate. Adjustments involve: reducing facility amounts, raising interest rates, or requiring additional collateral.
Prepared by: Khaled Al-Najjar, Alaa Issa, Fatna Sayam, Hossam Ramadan, Nadia Kanaan, Nadim Mousous
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