Risk Management and RAROC

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Analyzing the value of risk. Explanation of Risk-Adjusted Return On Capital. RAROC.



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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.
For performance-evaluation purposes, RAROC systems assign capital to business units. As part of a process of determining the risk-adjusted rate of return and, ultimately, the economic value added of each business unit. The economic value added of each business unit, defined in detail below, is simply the unit's adjusted net income less a capital charge (the amount of equity capital allocated to the unit times the required return on equity). The objective in this case is to measure a business unit's contribution to shareholder value. And, thus, to provide a basis for effective Capital budgeting and incentive compensation at the Business Unit level.

 

Economic Capital and three types of Risk

Economic capital is attributed on the basis of three risk factors:

  • Market risk,
  • Credit risk and
  • Operational risk.

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

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):

  1. Compliance and PreventionProactive Risk Management model

    • Avoid crises in own organization.
    • Avoid crises in other organizations.
    • Comply with corporate governance standards.
    • Avoid personal liability of managers.

  2. Operating Performance

    • Understand full range of risk facing the organization.
    • Evaluate business strategy risks.
    • Achieve best practices.

  3. Corporate Reputation

    • Protection of Corporate Reputation.

  4. Shareholder Value Enhancement

    • Enhance capital allocation.
    • Improve returns through Value Based Management.

Proactive Risk Management

Proactive Risk Management evaluates:

  • The probability of risk occurring,
  • Risk event drivers,
  • Risk events,
  • The probability of impact,
  • Impact drivers, prior to the risk actually taking place (figure: Proactive Risk Management - Smith and Merritt).

Book: John B. Caouette, Edward I. Altman - Managing Credit Risk -

Book: Carol Alexander - Operational Risk: Regulation, Analysis and Management -

Book: Michael K. Ong - The Basel Handbook: A Guide for Financial Practitioners -

Book: Donald R. van Deventer, Kenji Imai - Credit Risk Models and the Basel Accords (Wiley Finance) -

 

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Recent User Comments
adekemi giwa - Nigeria Global Financial Pandemonium "The global financial pandemonium goes beyond the issue of common sense. I think it's high time people started looking inward and listening deeply to the inner voice that serves as the connector and witness to it's creator, who holds the world financial solution in his coffers."    0
Guus P. - Netherlands Banks have managed the wrong risks "Over the last couple of years, financial institutions have been spending an awful lot of money and effort on understanding and managing their market risks, credit risks and operational risks in tremendous detail. At the same time they have completely failed to understand and prepare for far greater systemic risks."    5
Dr JAY - India Meaning of Risk and Risk Events "Interesting reading. Regarding the risk analysis, one could define RISK as: the uncertainity in desired outcomes. In a RISK EVENT (generally the manifestation of a risk), the critical factors are:
1) Probability of Risk Event happening, and
2) Extent of Impact of the Event on the desired results.
There are sub factors to both as in:
- Risk event probability: factors contributing to the risk, timing of the risk, possible diversions, alternate strategies itself
- Degree of Impact: Level of desired outcome achieved due to / in spite of risk, impact reducers possible etc
The awareness level of risks is critical for proactive identification and mitigation strategies, the application experience is required to reduce impact of risk or take suitable evasive avoidance actions or even recoil from the event."		    -1
Stanley - UK Wall Street's Risk Management "In an article in Business Week (2008, #7) called "Fear of a Black Swan", risk management author Nassim Taleb explains why Wall Street failed to anticipate the recent sub-prime mortgage disaster.
According to Taleb, banks have a tendency to sit on time bombs while convincing themselves that they are conservative and nonvolatile. Furthermore he blames the science of risk management for causing this behavior, and business schools and the financial economics establishment for having a vested interest in promoting risk management models and devaluing common sense."		    1



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Copyright 2010 12manage - The Executive Fast Track. V10.4 - Last updated: 20-3-2010. All names tm by their owners.


  └► Enzo Zamboni (Argentina) Managing the risks "Threre are two differents poins of view: 1) The complexity of management of the risks is related with complex quantity, real dates, and information in the industry´s sector, production, markets, etc. 2) The management of the risks in the financial industry is complex in relation to the introduction of new financial instruments, but not in the reality of the markets. It´s necessary to rapidly create new financials instruments for the evaluation and perception of risks."
  └► Franci Lenne (France) Financial management risk "It's now too easy to declare that the management of the risks by financial institutions has not been right. No strategic institutional advisors were able to prevent that event, as their customers are focused on short term management and financial business more than on long term and true economy. The problem is that those financial organizations were sure not to loose, even if the risk occurred, as they expect to be supported by Governments on that specific case. Note that it is what happened! No reason it will not continue, and we will see the continuation of the financial crash all over the world, until we enter in a new era. Let’s hope this era will be there as soon as possible: strategists have to be prepared and shall NOW reinvent the new world business strategy as soon as possible, forgetting previous wrong paradigms."
  └► Abdul Sayeed Khan (saudi Arabia) Risk Management "The CEOs' should have better vision in order to run the companies and mitigate the risk. No matter how much effort is required to improve his vision."
  └► Femi Oni (Nigeria) Just What Has Changed? "In these harsh times witnessed by such evident credit squeeze amongst other issues with attendant step-in reactive approach of central banks across the world, it should be asked that what has changed? Have we come up with anything close to a breakthrough? Something like the big bang! Are we not using the same bail-outs and reliefs and of course Basel II and other frameworks are more that ever before taking the center stage.
Without playing to the gallery I stand to be corrected but its apparent that the world has refused to learn. Despite the deluge of scientific and technological advancements, the citizens of the world have failed to take lessons from the events of the past. Nothing has changed!"
  └► Moses Muiruri (United Kingdom) Risk Management and RAROC "I still think we are all concentrating on a very short termist approach. The future of banking [and of the world] is dependent on how we evaluate risk now and how we build blocks to manage existence of these institutions. How can we by and by be able to run our private lives, even if by trial and error reasonably successfully, [our primitive ancestors did it even better], and fail in managing our financial institutions? Our basic intuitions are far superior than any risk management solution!"
  └► Balachandran Nair (India) Risk Management needs Information "I think risk management is all about letting every individual in the organisation into the loop. The Management Information System, particularly in banks, generally works on information disseminated on a need-to-know basis. Its time that management realized that the more informed an employee is, the better will he/she be equipped to handle risk issues."

  └► Maynard Bester (South Africa) Risk Exposure "In my opinion, if you cannot put a financial value to your risks, the CFO will not even look at it - the problem i'm facing how to quantify process-related risks."

  └► Vikram Shende (India) Inefficient Risk Management "In the growing market scenario no risk was anticipated of sudden failure, it was calamity / accident to economy and the community was not prepared."