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

246 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
determined in the last chapter—extremely relevant for banks. Additionally,
RAROC (implicitly) calculates the economic profit of a transaction by including
the opportunity cost of capital—which is a dramatic improvement
over other traditional bank measures used to determine the value contribution
of a transaction.
Moreover, many users praise the practical easiness of RAROC because
it is straightforward both to implement and to communicate and can, therefore,
form the basis of a bankwide risk-management culture. 43 This is also
due to the fact that RAROC—before being applied—splits a bank’s activities
into those risks that can be managed (influenced) by a specific unit,
transfer pricing all other risks out to other specialized units within the bank.
This strengthens employees’ performance incentives and insulates them from
risks beyond their control. For instance, RAROC leaves the Credit Department
with illiquid credit risk and specific operational risk 44 because it assumes
that all (hedgable) interest rate and currency risk is sold to the bank’s
Treasury unit. 45 However, if the Treasury unit decides not to sell off these
hedgable risks in liquid markets, it will be allocated (economic) capital and
has to earn a fair return on it.
Furthermore, using RAROC avoids having to calculate the external beta
for each transaction (in order to determine the required hurdle rate return
via the CAPM). RAROC assumes that one single hurdle rate can be used
bankwide for all transactions, because the amount of required economic
capital correctly adjusts for risk by changing the leverage of the transaction
accordingly. This assumes that a correct risk measure is used to allocate
capital. 46 However, in a RAROC world, capital is allocated according to the
project’s internal beta 47 and not the project’s systematic or priced risk in the
broad market. 48 We will examine potential problems arising from this approach
in the subsequent sections in more detail.
When this approach does not work correctly, a fixed hurdle rate across
all businesses and transactions has two problems. It leads to the following
behavior: 49
43 See, for example, Wilson (1992), p. 112.
44 This is exactly the purpose for which RAROC was first developed at Bankers Trust;
see, for example, Zaik et al. (1996), p. 84.
45 See James (1996), p. 14, who describes this as “matched duration” funding at
Bank of America.
46 Even though the risk on an “unlevered” basis varies widely across transactions,
such a measure would adjust it on a levered basis, so that the risk is the same for all
activities.
47 We have stated above that only the existing portfolio matters in that context.
48 See James (1996), p. 12.
49 See Brealey and Myers (1991), Chapter 5. Also see Kimball (1998), p. 38.