The RAROC is designed to allow all the business strearns of a financial

institution to be
evaluated on an equal footing. Each type of risks is measured to
determine both the expected and
unexpected losses using VaR or worst-case type analytical model. Key to
RAROC is the
matching of revenues, costs and risks on transaction or portfolio basis
over a defined time period.
This begins with a clear differentiation between expected and
unexpected losses. Expected losses
are covered by reserves and provisions and unexpected losses require
capital allocation which is
determined on the principles of confidence levels, time horizon,
diversification and correlation.
In this approach, risk is measured in terms of variability of income.
Under this framework, the
frequency distribution of return, wherever possible is estimated and the
Standard Deviation (SD)
of this distribution is also estimated. Capital is thereafter allocated to
activities as a function of
this risk or volatility measure. Then, the risky position is required to
carry an expected rate of
return on allocated capital, which compensates the bank for the
associated incremental risk. By
dimensioning all risks in terms of loss distribution and allocating
capital by the volatility of the
new activity, risk is aggregated and priced.
The second approach is similar to the RAROC, but depends less on
capital allocation and more
on cash flows or variability in earnings. This is referred to as EaR, when
employed to analyse
interest rate risk. Under this analytical framework also frequency
distribution of returns for any
one type of risk can be estimated from historical data. Extreme outcome
can be estimated from
the tail of the distribution. Either a worst-case scenario could be used or
Standard Deviation
1/2/2.69 could also be considered. Accordingly, each bank can restrict
the maximum potential
loss to certain percentage of past/current income or market value.
Thereafter, rather than moving

from volatility of value through capital, this approach goes directly to

current earnings
implications from a risky position. This approach, however, is based on
cash flows and ignores
the value changes in assets and liabilities due to changes in market
interest rates. It also depends
upon a subjecfively-specified range of the risky environments to drive
the worst-case scenario.
28.4 ECONOMIC CAPITAL AND RAROC
The expected loss is a measure of the reserves necessary to guard
against future losses. The
pricing of products should provide a buffer against expected losses and
the the unexpected loss is
a measure of the amount of economic capital required to support the
banks financial risk. This
capital, also called risk capital.
Some activities may require large amounts of risk capital, which in turn
requires higher returns.
This is the essence of risk adjusted return on capital (RAROC) measures.
The central objective is
to establish benchmarks to evaluate the economic return of business
activities. This includes
transactions, products, customer trades, and business lines, as well as
the entire business.
RAROC is also related to concepts such as shareholder value analysis
and economic value
added. In the past, performance was measured by yardsticks such as
return on assets (ROA),
which adjusts profits for the associated book value of assets, or return
on equity (ROE), which
adjusts profits for the associated book value of equity. None of these
measures is satisfactory for
evaluating the performance of business lines, however, as they ignore
risks.

RAROC Methodology
Risk Management: Includes the measurement of portfolio exposure, the
volatility and
correlations of the risks factors.

Capital Allocation: This requires the choice of a confidence level and

horizon for the VAR
measure, which translates into an economic capital.
Performance Measurement: This requires the adjustment of
performance for the risk capital.
Performance measurement can be based on RAPM method. For
instance. Economic Value
Added (EVA) focuses on the creation of value during a particular period
in excess of required
return on capital. EVA measures the residual economic profit as
EVA = Profit - (Capital x k)
Where profits are adjusted for the cost of economic capital, with k
defined as a discount rate.
Assuming the whole worth is captured by the EVA, the higher the EVA,
the better the product or
project.
Banking Industry in India
The past decade or so has been historically momentous for the banking
industry in India. Starting
with Narsimham committee report of 1991, Indian banking has seen a
total change in the
scenario during the last 18 years. The process of deregulation which
was set in motion has
brought in sea change in Indian banking. Regulated interest rates,
directed investment/credit have
become thing of the past. The Reserve Bank of India has been more
concerned about prudential
norms and disclosure requirements.
During the last decade, several new private sector banks have come into
existence. They have
diverse ownership pattems. Similarly foreign banks have been given
clearances for expansion.
These measures have resulted in a keen competition in the banking
sector. The new entrants have
brought modem technology, new products, and aggressive marketing.
Public sector banks and
old private sector banks had to take cognizance of these developments
and change their ways.
Profitability has become the most important parameter in banks'
functioning.
Indian banks have shown that they are alive to the changing
environment and have geared up to

face the new challenges. They have realised that the bottom-line is very
critical and
demonstrated their will and skills in changing colours.

ECONOMIC CAPITAL AND RAROC

The expected loss is a measure of the reserves necessary to guard
against future losses. The
pricing of products should provide a buffer against expected losses and
the the unexpected loss is
a measure of the amount of economic capital required to support the
banks financial risk. This
capital, also called risk capital.
Some activities may require large amounts of risk capital, which in turn
requires higher returns.
This is the essence of risk adjusted return on capital (RAROC) measures.
The central objective is
to establish benchmarks to evaluate the economic return of business
activities. This includes
transactions, products, customer trades, and business lines, as well as
the entire business.
RAROC is also related to concepts such as shareholder value analysis
and economic value
added. In the past, performance was measured by yardsticks such as
return on assets (ROA),
which adjusts profits for the associated book value of assets, or return
on equity (ROE), which
adjusts profits for the associated book value of equity. None of these
measures is satisfactory for
evaluating the performance of business lines, however, as they ignore
risks.