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Risk Adjusted Return on Capital (RAROC) for a credit loan portfolio Considering soverign risk. Presented by Fernando Hernandez Consultant and instructor for Latin America.
RiskAdjustedReturnon Capital (RAROC) for a credit loan portfolioConsideringsoverignrisk Presentedby Fernando Hernandez Consultant and instructor forLatinAmerica
Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. • The concept was developed by Bankers Trust in the late 1970s. • the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel II. RAROC Definition
Broadly speaking, in business enterprises, risk is traded off against benefit. • RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, that is it is a buffer against heavy shocks. Definitions
Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. • This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate. Economic capital
RAROC = (EAD * LevRatio * WACC) – BUExp – CorpExp – ExpLoss (EAD / CPC) EAD = Exposure at default (Howmuchmoneyisexposedtocredit default) LevRatio = Leverage Ratio (Total liabilities / Total Assets) WACC = Weightedaveragecost of capital (what’sthecost of raisingfunds) BUExp = Business Unit Expense (Expenses allocated at the BU level) CorpExp = Corporate expense (Expenses allocated at thecentralizedlevel) ExpLoss = Expectedloss (Ifcustomer defaults howmuchmoneyislost) CPC = Credit loan portfolio / Capital (a measure of therelativesize of the loan portfolio) Formula forour RAROC
LossGiven default • Probability of default Where do risks come from in thismodel
Howmuchmoneyisbeingrecuperatedifcustomer defaults • More than usual, thisis a verysmallpercentage of the loan • Basedonhistoricalinformation LossGiven Default
Theprobabilitythatthecustomerwillnotcompletelypaytheexposure at default amount (EAD) • Definedby a lambda factor • Dependson 2 keyelements: • Customer’srisklevel (regulatory) • Country risk factor (sovereignrisk) Probability of default