Content area
Full Text
Risk Adjusted Return on Capital ("RAROC") has been an established discussion topic within Financial Institutions Performance Measurement forums, well ahead of Basel II and SR 99-18. These discussions, which focused on methodologies to determine Risk Adjusted Capital, were often predicated on the assumption that the process to determine "Returns" is well understood. While the process of determining returns may well be straightforward, we know that implementation of underlying methodologies can reflect varying levels of complexity, therefore driving different pricing behaviors.
With the move towards Basel II, Basel IA and SR 99-18, the latter two being US versions of economic capital, the need to more accurately understand the impact of these "Return" determination methodologies on Risk Adjusted Returns on Economic Capital is heightened. Recognizing that Economic Capital is a form of Risk Adjusted Capital, for the remainder of this article we will use the familiar RAROC acronym.
What then is Return? At the simplest level, it is Revenues less Expenses. While revenue recognition is sufficiently complex to warrant separate discussions, this article we will limit our focus to the expense side of "Return" and its impact on RAROC models. Expenses associated with product delivery and services include direct and indirect costs and also the costs of funding the asset or liability product.
Expense assignment methodologies can range from high-level allocation (top of the house), to standard costing, on to Activity Based Costing. Optimal cost assignment complexity should generally be determined through analysis of perceived value to be derived from higher levels of complexity in cost assignment. In this article we explore the relative impacts of FTP and cost assignment to "return" and how these tie into RAROC.
What exactly is RAROC (Risk Adjusted Return on Capital)? RAROC is the ratio of risk-adjusted returns to economic capital. Both subjects, "risk adjusted return" and "economic capital", are potentially complex topics, for purposes of this article let's consider how RAROC is used in practice and the drivers that influence results. In practice, RAROC is most commonly used at product origination and less frequently at the portfolio or existing level.
The objective of applying RAROC at loan origination is to assess the projected risk adjusted return and required capital for the purpose of determining whether pricing for that level...