RISK ADJUSTED RETURN ON CAPITAL (RAROC)
Table of Contents
- • Definitions
- • Introduction
- • RAROC and Economic Capital (Unexpected Losses)
- • Objectives of Using RAROC
- • The Relationship Between Basel Requirements and RAROC
- • Calculating RAROC
- • Credit Facility Feasibility Study
| Term | Definition |
|---|---|
| Expected Loss (EL) | The average expected loss a bank may face from its credit portfolio. |
| Unexpected Loss (UL) | The difference between worst-case loss and expected loss, covered by economic capital. |
| Probability of Default (PD) | The probability that a borrower will fail or delay in meeting their obligations. |
| Loss Given Default (LGD) | The amount the bank may lose if the borrower defaults. |
| Exposure at Default (EAD) | The total exposure amount at the time of default. |
| Credit Risk | Risks arising from a borrower's inability or unwillingness to meet their obligations. |
| Regulatory Capital | Total capital elements defined by the central bank for capital adequacy, comprising Tier 1 and Tier 2 capital. |
| Core Capital (Tier 1) | Includes Common Equity Tier 1 (CET1) plus Additional Tier 1 (AT1) capital. |
| Economic Capital | The capital needed to absorb unexpected losses within a defined timeframe and confidence level. |
Introduction
One of the most important causes of major financial crises is the increase in banking risks on one hand and poor management of these risks on the other. Additionally, the growing openness of financial markets globally and the subsequent introduction of new financial instruments and their expanded use has increased the volume and diversity of banking risks.
This led to the need for measures that link profitability with risk, which is what the Risk Adjusted Return on Capital (RAROC) model achieves. It provides a clear picture of the risks surrounding a bank and the amount of capital needed to face unexpected risks.
RAROC is part of the Risk Adjusted Performance Measures (RAPM) family and was developed by Banker Trust in the late 1970s when the bank faced problems related to evaluating commercial currencies associated with activities characterized by different types of risks.
The RAROC measure serves as a tool that helps link the return on capital from bank activities on one hand with investment risks on the other. It is considered one of the best standards applied by financial institutions, providing an economic basis for measuring all relevant risks consistently. It is a tool that helps banks make sound decisions regarding the balance between return and risk related to various types of assets.
RAROC can be relied upon in banking risk management as it enables the bank to conduct risk assessment operations, allocate capital to face these risks, and as a preventive measure against surrounding risks, enabling the bank to predict the level of financial and economic performance while maintaining the bank's financial soundness.
RAROC and Economic Capital (Unexpected Losses)
Economic capital represents protection for the bank from unexpected risks and is critical for allocating capital to face the various risks the bank encounters. Therefore, the RAROC measure shows the amount of economic capital against these activities in addition to determining the return on capital.
Through loss distribution over a specified time period, the bank can determine the Expected Credit Loss (EL) as the average of previous years' losses. The Worst-case Loss (WL) represents losses that could occur under the worst conditions, estimated at a certain confidence level (95% or 99%). The reason for calculating at a specific confidence level is that maintaining capital to face all possible risks is costly. If the confidence level is 95%, this means there is a 5% probability that actual losses will exceed economic capital.
The Unexpected Loss (UL) represents the difference between worst-case loss and expected loss.
RAROC Formula:
RAROC = (Revenues − Costs − Expected Losses + Return on Capital) / Economic Capital
Objectives of Using RAROC
- 1Determining the required capital (economic capital) to face unexpected risks.
- 2Ability to price products more effectively with better returns than competitors.
- 3Comparing two investments with returns and profits of different dimensions.
- 4Allocating capital to investments where expected return exceeds the risk-free rate.
- 5Reducing the probability of default to the desired level.
- 6Expressing the mechanism of linking risks with returns.
- 7Considered one of the fundamental pillars in an integrated risk management framework.
The Relationship Between Basel Requirements and RAROC
The main objective of risk calculation models is to provide the bank with a more accurate method to determine the capital required to face various risks. For a bank to be able to use different models for calculating the required capital — as stipulated by the Basel Committee — it must first effectively and efficiently use these models (including RAROC) to manage its credit portfolio.
The Basel Committee's directives encourage banks to use more advanced models in measuring risks and allocating appropriate capital to face them. RAROC is among the most widely used measures globally, granting the bank the ability to manage credit portfolios, manage risks, and allocate capital more effectively in facing potential financial crises, thereby maintaining the bank's financial soundness.
The RAROC measure helps banks gradually transition from a traditional standardized risk measurement system to a Risk-Based Measure and early warning system, thereby reducing the volume of unexpected losses (UL) and minimizing the probability of future default.
Calculating RAROC
RAROC is calculated for the corporate credit portfolio, distinguishing between loans based on tenure: short-term facilities (up to 12 months) and long-term facilities (up to 12 years).
RAROC Components
1. Revenues
All revenues collectible from customers on facilities, whether from interest rates or fees.
2. Costs
All expenses affecting facilities, whether cost of funds or operating costs.
3. Expected Credit Losses (ECL)
Amounts provisioned to cover losses from customer default: ECL = EAD × PD × LGD.
4. Risk-Free Return
The opportunity cost of investing the amount as a facility instead of a risk-free investment (government securities).
5. Economic Capital
The capital required to face unexpected credit losses, calculated as: Economic Capital × Risk-Free Rate.
ECL Component Estimation
- PD (Probability of Default): Obtained from systems such as Moody's, credit scoring, or Xplanr. Can be Through-the-Cycle (TTC PD) or Point-in-Time (PIT PD).
- EAD (Exposure at Default): The value of the exposure or credit to be granted.
- LGD (Loss Given Default): Varies based on collateral type and coverage ratio, using the IRB Foundation Approach methodology.
Credit Facility Feasibility Study
Based on the RAROC calculation result, it is possible to predict whether to grant a facility or modify the client's request. This is done by comparing the RAROC result with the bank's acceptable risk level (Hurdle Rate):
The facility is approved if RAROC > Hurdle Rate. Otherwise, facility components can be adjusted to match the Hurdle Rate by:
- • Reducing the requested facility amount.
- • Raising the interest rate.
- • Requesting additional collateral from the client.
Note: The Hurdle Rate is set at 25% based on market best practice.
Get more from RMPF
Subscribe for new articles, news, and event invites (double opt-in).