Risk Management and Value Creation in ... - Arabictrader.com

Capital Budgeting in Banks 241
try to determine a bank’s economic profitability by calculating the return on
economic capital. Doing so is often summarized under the abbreviation
RAPM (Risk-Adjusted Performance Measures), or better known as RAROC
(Risk-Adjusted Return on Capital), which is their most famous representative.
Many of the leading institutions around the globe calculate such a
modified return on equity 12 measure and take a purely economic perspective
by trying to link it to a market-determined minimum required return 13 (socalled
hurdle rate) to find out whether a transaction adds value to the bank
or not. Wills et al. (1999) 14 find that out of fifty-five selected leading banks
worldwide, 59% have established an “economic capital /RAROC process”, 15
12% plan to do so, and 29% do not use such an approach.
Even though it is crucially important to determine the returns (or net
revenues in dollar terms) in all of the mentioned performance measures in
an economically correct way, 16 this book will not address the problem of
how accounting measures have to be calculated and transformed 17 to arrive
at such numbers. However, it is worthwhile to mention that the correct
allocation of expenses and costs as well as the transfer pricing method
employed are critically important in finding correct approximations. 18 Any
inaccurate allocation will lead to the wrong management incentives, because
all of the mentioned approaches have in common that the rates of return are
much more critical for banks than for industrial companies. For industrial
companies, uncertainties associated with the modeling of future cash flows
are so large that modeling the appropriate rate of return is, in most of the
cases, of second order. However, getting the rates of return right for banks
is much more critical because—given the narrow margins in the banking
industry—a small error can have a very large impact. 19
The focus of this chapter will be to rather closely examine RAROC and
its currently hypothesized linkage to value creation in banks. After defining
this risk-adjusted performance measure, we will investigate its (implicit)
assumptions, its advantages and shortcomings, and whether it can be used
12 See Grübel et al. (1995), p. 616.
13 See, for example, Schröck (1997), pp. 93+.
14 Wills et al. (1999), p. 88.
15 In their study, Wills et al. (1999) use the two expressions interchangeably.
16 Returns are best calculated on a mark-to-market basis rather than on an accrualbased
accounting measurement. See Wilson (1992), p. 114.
17 For instance, accounting measures typically do not consider the time value of money
and risk associated with a transaction. Additionally, they are subject to management
manipulation in order to “window dress” external reporting.
18 For the difficulty of allocation and issues with transfer pricing systems in banks,
see, for example, Kimball (1998), p. 41.
19 See Merton and Perold (1993), p. 17.