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Capital Budgeting in Banks 285
aggregation procedures) and that RAROC still lacks a consistent
industry-wide definition, making the comparability of published results
questionable. But the new Basle Accord and the increased disclosure
requirements under Pillar Three will be helpful in making
banks more transparent in this respect in the near future. The upside
of using data at the bankwide level would be that there would be no
data availability problems at the business unit level as well as no
allocation and transfer-pricing problems vis-à-vis the skew at the
trans-action level. Additionally, one could apply the bankwide hurdle
rate (as can be easily observed in the market), avoiding the determination
problems and potential skews at the business unit or
transaction level. Moreover, rating agencies (such as Standard &
Poor’s) provide sanitized return data on an accounting basis at the
bankwide level that could be easily transformed into risk-adjusted
return proxies. 183
SUMMARY
We started this chapter with a discussion of the various available capitalbudgeting
tools in banks and their ability both to identify the potential for
value creation and to reflect the bank’s concern with total risk. We, thus,
identified RAROC as the most promising candidate, because it uses an
adequate total risk measure (economic capital) and is linked to (traditional)
shareholder value concepts via the comparison to a CAPM-determined
(bankwide) hurdle rate.
Despite its advantages, we found that RAROC is based on rigid assumptions
and is subject to various deficiencies. Moreover, there are fundamental
theoretical concerns with RAROC when it comes to the determination of
value creation:
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The comparison of RAROC to a hurdle rate that is determined in a
neoclassical world is not consistent with a risk measure that is
motivated by the neoinstitutional theory, where total risk counts and
risk management can create value.
The assumption that economic capital is the same as “cash” equity
capital provided by shareholders is not appropriate (it is not necessarily
the case, as covered in the extensive discussion in Chapter 5).
183 For instance, one could take the average of the loan loss provisions of the previous
five years as a proxy for expected (credit) losses, etc.