Today, virtually all major banks and financial institutions (FIs) have developed risk-adjusted return on capital (RAROC) models to evaluate the profitability of various business lines, including their lending. The RAROC concept was first introduced by Bankers Trust in the 1970s. The recent surge among banks and other FIs to adopt proprietary forms of the RAROC approach can be explained by two major forces: (1) the demand by stockholders for improved performance, especially the maximization of shareholder value, and (2) the growth of FI conglomerates built around separate business units (or profit centers).1
These two developments have been the impetus for banks to develop a measure of performance that is comparable across business units, especially when the capital of the bank is both costly and limited.
WHAT IS RAROC?
In terms of modern portfolio theory (MPT), RAROC can best be thought of as a Sharpe ratio for business units, including lending. Its numerator, as explained below, is some measure of adjusted income over either a future period (the next year) or a past period (the previous year). The denominator is a measure of the unexpected loss or economic capital at risk (VAR) as a result of that activity. Thus:
In this chapter, we concentrate on the measurement of RAROC in terms of lending, although, as noted earlier, it can ...