RAROC - Risk Management - Basel II

     Short Description - What is RAROC?

RAROC is a risk-adjusted profitability measurement and management framework for measuring risk-adjusted financial performance and for providing a consistent 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.

Economic capital is attributed on the basis of three risk factors: market risk, credit risk and operational risk. The fundamental approaches to managing these risk factors are described in the management of risk and capital section. The use of risk-based capital strengthens the risk management discipline within business lines, as the methodologies employed quantify the level of risk within each business line and attribute capital accordingly. This process assists in achieving controlled growth and returns commensurate with the risk taken.

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 with high strategic value and sustainable returns, or with long-term growth and profitability potential.

Economic profit elaborates on RAROC by incorporating the cost of equity capital, which 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 generated by each business in excess of a bank's 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 is 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 Prevention

    - Avoid crises in own organization

    - Avoid crises in other organizations

    - Comply with corporate governance standards

    - Avoid personal liability failure

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

History of RAROC

Development of the RAROC methodology began in the late 1970s, initiated by a group at Bankers Trust. Their original interest 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-like systems) with the aim, in most cases, of quantifying 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 overriding 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.

New Basel Capital Accord - Basel II

In January 2001 the Basel Committee on Banking Supervision issued a proposal for a New Basel Capital Accord (better known as "Basel II") that, once finalized, will replace the current 1988 Capital Accord. The proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face. These 3 pillars are:
1. minimum capital requirements, which seek to refine the measurement framework set out in the 1988 Accord (dealing with credit risk, operational risk and market risk),
2. supervisory review of an institution's capital adequacy and internal assessment process, and
3. market discipline through effective disclosure to encourage safe and sound banking practices.
The Basel Committee received more than 250 comments on its January 2001 proposals. In April 2001 the Committee initiated a Quantitative Impact Study (QIS) of banks to gather the data necessary to allow the Committee to gauge the impact of the proposals for capital requirements. A further study, QIS 2.5, was undertaken in November 2001 to gain industry feedback about potential modifications to the Committee's proposals.

In December 2001 the Basel Committee announced a revised approach to finalizing the New Basel Capital Accord and the establishment of an Accord Implementation Group. Previously, in June 2001 the Committee released an update on its progress and highlighted several important ways in which it had agreed to modify some of its earlier proposals based, in part, on industry comments.

During its 10 July 2002 meeting, members of the Basel Committee reached agreement on a number of important issues related to the New Basel Capital Accord that the Committee has been exploring since releasing its January 2001 consultative paper.

In April 2003 the Basel Committee on Banking Supervision has issued a third consultative paper on the New Basel Capital Accord.

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)

Compare: Plausibility Theory  |  Real Options  |  CAPM  |  PRVit  |  Z-Score

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