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

Capital Budgeting in Banks 265
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It is not necessary that a bank aligns its actual equity capital with
economic capital, because shareholders only bear one tranche of the
default risk among others.
Economic capital is, in general, independent from the choice of the
actual capital structure. 106 However, the actual capital structure does
not determine the cost of total risk.
Required Hurdle Rate Return of RAROC Setting the hurdle rate in the RAROC
approach is eventually a normative management action. However, it should
be based on proper financial theory foundations 107 in order to indicate
whether value is created or not.
Per our RAROC definition above, the hurdle rate is chosen to be consistent
with the CAPM required return—either at the bank level or at the
transaction level. This creates two serious problems, which are demonstrated
in the following example.
We know from the discussion in the previous chapter that economic
capital is a total risk measure that includes both systematic and unsystematic
risks. 108 We assume for our example the following split of economic
capital between the three types of risk (see Table 6.2). 109
We know from our previous discussion that, typically, operational risk
is mostly idiosyncratic or firm-specific risk. The same is true for parts of
the credit portfolio since we assume that the bank does not hold a fully
diversified portfolio, because it contains regional and customer-specific concentration
risk. Because the market risk portfolio is rather diversified, we
assume the following split between systematic and specific risk, in a CAPM
sense, for our example (see Table 6.3).
Table 6.2
Risk Type
Split of Economic Capital among Types of Risk
Economic Capital
(in Dollars)
Credit Risk 50
Market Risk 20
Operational Risk 30
Total 100
106 As we showed in the beginning of Chapter 5, the optimal capital structure is set
as a trade-off between various marginal costs and benefits.
107 See Schmittmann et al. (1996), p. 649.
108 See Wilson (1992), p. 116.
109 As we have seen above, this split is not atypical for commercial banks.