RAROC and Profit Planning: CAIIB Paper 2 (Module D), Unit 9

RAROC and Profit Planning: CAIIB Paper 2 (Module D), Unit 9

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 9: RAROC and Profit Planning” of “Module D: Balance Sheet Management” from “Paper 2: Bank Financial Management (BFM)”

Profit Planning

Profit planning in a bank essentially involves balance sheet management; covering credit, investment and non-fund based income. Banks’ income arises from three sources, viz. interest income, feebased income and treasury income. Interest income is derived from lending as well as investments in securities, bonds etc.

Thus, you would observe that risk would increase for lending to lower rated customers resulting in an increased need for capital and also improved yield on the assets. Banks need to optimise the investment and lending portfolio to earn the best possible returns for a given capital level.

Banks have to take into account the effect of NPA on the interest income and thereby on the profitability. NPAs do not generate income and therefore bring down the yield on advances. Also, under Basel-II/III regime, the risk weightage of such assets is higher, thereby forcing a bank to maintain higher capital Thus, NPAs have a two-fold effect, reduction in income and need for additional capital. Hence, return on capital or profitability gets further deteriorated.

Thus, every effort to rationalise this segment of expenditure is made. In nutshell, profitability is a function of six variables:

• Interest income
• Fee-based income
• Trading income
• Interest expenses
• Staff expenses
• Other operating expenses

Maximisation of the first three variables and minimisation of the last three variables are the requisites to maximise profitability. All the six factors are dependent on each other and achieving the optimum level is the requirement here.

Economic Capital

The expected loss is a measure of the reserves necessary to guard against future losses. The pricing of products should provide a buffer against expected losses and the unexpected loss is a measure of the amount of economic capital required to support the banks financial risk. This capital is also called risk capital.

Some activities may require large amounts of risk capital, which in turn requires higher returns. This is the essence of risk adjusted return on capital (RAROC) measures. The central objective is to establish benchmarks to evaluate the economic return of business activities. This includes transactions, products, customer trades, and business lines, as well as the entire business.

Risk Capital

RAROC is a part of the family of the risk-adjusted performance measures (RAPM). Consider, for instance, two traders such that each returned a profit of $10 million over the last year. The first is a foreign currency trader, and second a bond trader. The question is, how do we compare their performance? This is important in providing appropriate compensation as well as deciding which line of activity to expand.

Assume the FX and bond traders have notional amount and volatility as described below. The bond trader deals in larger amounts, $200 million, but in a market with lower volatility, at 4% per annum, against $100 million and 12% for the FX trader. The risk capital can be computed as a VAR measure, say at the 99% level over a year, as Bankers Trust did. Assuming normal distributions, this translates into a risk capital of

RC = VAR = $100,000,000 X .12 x 2.33 = $28 million

The risk adjusted performance is then measured as the profit divided by the risk capital,

RAPM = Profit/RC

Thus the bond trader is actually performing better as the FX trader, as the activity requires less risk capital. More generally, risk capital should account for credit risk, operational risk, and any interaction.

RAROC Methodology

Risk Management: Includes the measurement of portfolio exposure, the volatility and correlations of the risks factors.

Capital Allocation: This requires the choice of a confidence level and horizon for the VAR measure, which translates into an economic capital.

Performance Measurement: This requires the adjustment of performance for the risk capital.

Performance measurement can be based on RAPM method. For instance, Economic Value Added (EVA) focuses on the creation of value during a particular period in excess of the required return on capital. EVA measures the residual economic profit as

EVA = Profit – (Capital X k)

Where profits are adjusted for the cost of economic capital, with k defined as the discount rate. Assuming the whole worth is captured by the EVA, the higher the EVA, the better the product or project.

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