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

Capital Budgeting in Banks 245
(Risk-Adjusted Net Income) – (Cost of Economic Capital) =
= Economic Profit (6.2)
where Cost of Economic Capital = Economic Capital × Hurdle Rate
and
Hurdle Rate
= Appropriate rate of return for the
investment as determined, for example,
by the CAPM and required
by the (equity) investors = R h E
. 38
This assumes that the risk-adjusted net income is a (good) proxy for the
free cash flows to the shareholders at the end of period 1 39 and that the
economic capital equals the equity investment in the transaction. We will
discuss the latter part of this assumption in more detail in the next section.
Note that economic profits are neither accounting profits nor cash flows.
They rather represent the contribution of a transaction to the value of the
firm by considering the opportunity cost of the capital that finances the
transaction. 40 If the economic profit is larger than zero, this value contribution
is positive, otherwise negative (i.e., value is destroyed).
Given this transformation of RAROC into economic profits, it is easy
to show—by rearranging the terms—that to find out whether a transaction
creates or destroys value, it is sufficient to compare the calculated RAROC
with the hurdle rate. 41 As long as the RAROC of a transaction exceeds the
shareholders’ minimum required rate of return (i.e., the cost of equity or
hurdle rate), then a transaction is judged to create value for the bank. 42
Otherwise, it will destroy value.
Advantages of RAROC
One of the most obvious advantages of RAROC is that it is the only performance
measure and capital-budgeting tool that reflects the bank’s concern
with total risk by using a risk measure (economic capital) that is—as we
38 Note again that the CAPM (beta) does not consider the risk and the costs associated
with default. See Crouhy et al. (1999), p. 5.
39 Uyemura et al. (1996) suggest four adjustments to reported bank accounting earnings
to transform them into a proxy for free cash flows: (1) actual charge-offs instead
of loan loss provisions, (2) cash taxes rather than tax provisions, (3) exclusion of
securities gains and losses, (4) consideration of nonrecurring events as an adjustment
to either earnings or capital.
40 What that opportunity cost should be will also be addressed below.
41 See, for example, Schröck (1997), p. 154.
42 See Zaik et al. (1996), p. 87.