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

Capital Budgeting in Banks 247
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High-risk projects with negative NPV are accepted
Low-risk projects with positive NPV are rejected
Such behavior, in turn, could lead to corporate-wide underinvestment,
where managers are likely to reject projects with positive NPV, which would
in turn lower the manager’s average RAROC. 50 In order to avoid this problem,
RAROC can easily be transposed into “economic profits” (and hence
dollar numbers), as indicated and defined above, because this is considered
to be a proxy for the NPV rule. However, this conclusion is based on some
implicit assumptions made in the RAROC approach, which we will discuss
in more detail in the next section.
Assumptions of RAROC
As can be easily seen, the comparison of RAROC to a single, bankwide
hurdle rate in order to determine whether a transaction adds value (or not)
is based on several assumptions. In order to be able to identify, discuss, and
evaluate these assumptions, we will use a RAROC model developed by
Crouhy et al. (1999). We will use this model because it is based on the Merton
approach, which has already been employed in the top-down estimation of
economic capital and was found to be one of the most general approaches
because it expresses parameters in market values rather than accounting
values. Another advantage of this model is that it allows for risky debt and
hence default. However, it is based—like the assumption that the comparison
of RAROC and a hurdle rate can be used to determine value creation—
on neoclassical assumptions. The model presented here, therefore, presumes
frictionless markets and no taxes, and hence does not allow for financial
distress costs to be associated with default, implying that capital-structure
decisions are irrelevant.
Again, we assume that there is only one class of (zero-coupon) debt D
maturing at time T with face value F and current market value V D,t
at time
t, being equal to F/(1 + R D
) (T - t) , where R D
is the promised yield to maturity
of the debt. The market value of (the) asset(s) A and equity E at time t are
labeled V A,t
and V E,t
, respectively.
Since RAROC is a single-period measure, we set T equal to a one-year
horizon. As we have seen, the value of equity and debt at the end of the
estimation horizon T equals:
V
ET ,
⎧⎪
VAT
,
−F , if VAT
,
≥ F
= ⎨
⎩⎪ 0 , if VAT
,
< F
and
V
DT ,
⎧⎪
F , if VAT
,
≥ F
= ⎨
⎩⎪ VAT
,
, if VAT
,
< F
(6.3)
50 And hence their compensation if it is linked to their achieved RAROC.