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Capital Budgeting in Banks 261 all the pitfalls during its implementation, RAROC’s bias is not too large and it is a directionally correct measure to identify value creation in banks (at least) for practical purposes. However, eliminating all the pitfalls—which may only exacerbate the theoretical concerns discussed above 95 —misses the point that there are much more fundamental problems with RAROC, 96 which we will discuss in the next section. Fundamental Problems of RAROC Comparing RAROC to a CAPM-derived hurdle rate to determine the value created by a (risk-management) transaction (as shown in Figure 6.7) results in two fundamental problems: ■ ■ Economic capital has to be treated synonymously with equity capital provided by the shareholders, and it has to be assumed to be able to ultimately fix the actual bank capital structure. CAPM is a market-driven equilibrium model in which only systematic risk with a broad market portfolio counts. It is unclear why a hurdle rate derived in such a world should be compatible with a risk measure that is based on the bank’s concern with the total risk of its (existing) portfolio. RAROC < > Hurdle Rate Economic Capital Total Risk Bank Portfolio Shareholder Capital Systematic Risk Market Portfolio 1 2 Figure 6.7 Fundamental problems with RAROC. 95 Note that these theoretical concerns shown in the simplified model we have used above do not necessarily disappear in a more sophisticated world. 96 Many authors (including myself) spent significant time on trying to fix RAROC and make it multiperiod while ignoring the real key concerns with this measure that lead to fundamental inconsistencies.
262 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS Even though these theoretical concerns have been raised in rudimentary form, for example, by Wilson (1992) and James (1996), they seem to have been ignored by the industry and in the application of the practical solutions economic capital and RAROC. 97 We will address both problem areas in turn below. The Capital Structure Assumption of RAROC In this section, we take a more reality-driven view and investigate what happens if the actual capitalstructure decision of a bank deviates from the strict assumptions behind the above-mentioned RAROC model. This is likely to be the case as we recall that capital has two different functions in banks: 98 ■ ■ A source of funds and, therefore, a part of the working capital of a bank A cushion for economic risks to protect debt holders against losses Therefore, in reality, it is likely that not all transactions are funded purely by debt (in our model above: I is not necessarily equal to V D,0 ), and hence economic capital is not necessarily equal to the capital as provided by the shareholders (i.e., EC ≠ V E,0 ). Moreover, there are many bank transactions that do not require any up-front cash investment at all. For instance, swaps are especially designed to not require such an investment. RAROC is also intended to be applicable to many other nontraditional, fee-based transactions that do not require the investment of cash capital at all. 99 Nonetheless, all of these activities might require a certain amount of economic capital. However, RAROC takes only economic capital into account and ignores the actual capital-structure decision taken by the bank. Only as long as no real equity cash investment is necessary 100 will RAROC lead to unbiased results. 101 In reality, though, we typically find that V A,0 ≠ I (i.e., the bank wants to create value and hence invests in positive NPV projects 102 ) and that the bank is financed by both debt and equity. Hence, when trying to evaluate the economic profitability of any such transaction, not only the risk capital 97 Only Johanning (1998) points out that VaR-based measures should only be used as a restriction and not as an objective function for business decisions. 98 See Kimball (1998), p. 44. 99 See Zaik et al. (1996), p. 83. 100 Another case would be—however coincidental—when economic capital matches the real equity capital. 101 As Wilson (1992), p. 116, rightly observes, therefore RAROC should only be applied to self-financing portfolios with zero value. 102 Some of the bank’s investments might be intentionally negative NPV projects (socalled loss leaders) in order to gain more profitable transactions via cross-selling.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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100 RISK MANAGEMENT AND VALUE CREAT
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Page 316 and 317: eferences Aguais, Scott D., and Ant
Page 318 and 319: References 295 Blanden, Michael (19
Page 320 and 321: References 297 and Abuses,” Journ
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Page 324 and 325: References 301 risiken aus Handelsg
Page 326 and 327: References 303 Investments in Stock
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Page 330 and 331: References 307 Sharpe, William F. (
Page 332: References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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