Risk management using risk-adjusted return on capital (RAROC) system

Risk management using risk-adjusted return on capital (RAROC) system

Riskmanagement using risk-adjusted return on capital (RAROC) system

Organizationsneed to take a systematic and critical approach to minimize exposureto risk (McNeil, Frey, &amp Embrechts, 2015). To do so they have toadopt a risk management system with set up policies, procedures, andpractices. The risk management system will then be used to analyze,evaluate and minimize risk. The information gathered by the systemtogether with other corporate information is then analyzed by riskmanagers to come up with a risk management decision. Some goodexamples of risk management strategies are transfer of risk to thirdparties through insurance, and the reduction of the risk negativeeffects.

Riskmanagement systems differ from one organization to another. Forexample, a bank’s risk managementsystem is quite different as compared to that of a construction firmthat has high-risk investments. A bank’s risk management systemwould be more focused on minimizing risks through the use offinancial tools and instruments. It would also be focused on thetrading techniques and thorough financial analysis. On the otherhand, a construction firm’s risk management system would be focusedon reducing vulnerabilities associated with accidents at the site,and contractor indemnity insurance.

Anyorganization aims to make a return on investment (ROI), and this iswhere the risk-adjusted return on capital (RAROC) comes in (McNeil etal., 2015). Through the use of this financial tool decision makersare able to compare the returns on different projects and theaccompanying associated risk. It is calculated as follows

Where

Incomefrom capital= (capital charges)*(risk free rate) Expectedloss= average anticipated loss over the measurement period

Inthe Banking sector where I work, we use RAROC to determine the costbenefit associated with giving out student loans. For example, someof the students might pass on immediately after leaving college whilesome may default entirely. This tool helps us in the analysis of thecorrect amount of loans to award and the risk associated.

Benefitsof a RAROC system

Oneof the benefits of a RAROC system is that it accurately incorporatesthe risk of a financial institution by using economic capital. Thisis the amount of capital that places aside for the purpose ofcovering the risk associated with a certain business.

Thesecond advantage is that RAROC calculates an organization’seconomic profit by using the opportunity cost of capital. This is animprovement from Return on Assets (ROA) and Return on Equity (ROE)ratios, which determine the value of a business at a certain periodin time.

Another benefit of RAROC is that it is practical and veryeasy to understand. Many financial institutions have in turn adoptedit in the implementation of systematic pricing of various loans andsecurities that would otherwise be difficult to comprehend.

ARAROC system also eliminates the need for financial institutions tocalculate beta, which is a necessary function in the calculation ofthe hurdle rate return for Capital Asset Pricing Model (CAPM). Thisratio assumes the hurdle rate can be used throughout all theschedules of an institution. Limitations of a RAROCsystem

ARAROC system takes a static view of the risk associated with credit.It is important for decision makers to note that the outcome of aRAROC calculated year-by-year is very different from the actual lifecycle RAROC.

ARAROC system is unable to provide accurate rankings of business unitssince it does not apply the use of valuation models for thecalculation of expected returns.

Thethird limitation of RAROC is that it does not adjust hurdle rates asthe requirements of capital schedule increase. As a consequence, itexperiences similar challenges to other profitability ratios.

Reference

McNeil,A. J., Frey, R., &amp Embrechts, P. (2015). QuantitativeRisk Management: Concepts, Techniques and Tools: Concepts, Techniquesand Tools.Princeton university press.