Credit Risk Management and RAROC

Knowledge Center

What is Credit Risk?

To define what credit risk management is, we must first understand the concept of credit risk. Credit risk is the risk arising due to the borrowers failure to strictly comply with the terms of the credit contract. This might happen when the customer is late in debt repayment, not fully pays the debt amount or fails to pay debt when principal and interest amounts are due, causing financial losses and difficulties in the business activities of commercial banks.

What is Credit Risk Management?

Credit Risk Managament is the process of identifying and analyzing risk factors, measuring the level of risk, thereby selecting measures to manage credit activities to limit and eliminate risks in the credit process.

What is RAROC?

RAROC is a risk-adjusted framework for profitability measurement and profitability management. It is a tool for measuring risk-adjusted financial performance. And it provides a uniform view of profitability across businesses (Strategic Business Units / divisions). RAROC and related concepts such as RORAC and RARORAC are mainly used within (business lines of) banks and insurance companies. RAROC is defined as the ratio of risk-adjusted return to economic capital.
 

History of RAROC

Development of the RAROC methodology began in the late 1970s, initiated by a group at Bankers Trust. Their original idea was to measure the risk of the bank's credit portfolio, as well as the amount of equity capital necessary to limit the exposure of the bank's depositors and other debt holders to a specified probability of loss. Since then, a number of other large banks have developed RAROC (or RAROC look-alike systems). Their aim is in most cases to quantify the amount of equity capital, necessary to support all of their operating activities. Fee-based and trading activities, as well as traditional lending.

RAROC systems allocate capital for two basic reasons: (1) risk management and (2) performance evaluation. For risk-management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure. This process involves estimating how much the risk (volatility) of each business unit contributes to the total risk of the bank and, hence, to the bank's overall capital requirements.
For performance-evaluation purposes, RAROC systems assign capital to business units. As part of a process of determining the risk-adjusted rate of return and, ultimately, the economic value added of each business unit. The economic value added of each business unit, defined in detail below, is simply the unit's adjusted net income less a capital charge (the amount of equity capital allocated to the unit times the required return on equity). The objective in this case is to measure a business unit's contribution to shareholder value. And, thus, to provide a basis for effective Capital budgeting and incentive compensation at the Business Unit level.

Economic Capital and three types of Risk

Economic capital is attributed on the basis of three risk factors:

• Market risk,
• Credit risk and
• Operational risk.

Economic capital methodologies can be applied across products, clients, lines of business and other segmentations. As required to measure certain types of performance. The resulting capital attributed to each business line provides the financial framework to understand and evaluate sustainable performance and to actively manage the composition of the business portfolio. This enables a financial company to increase shareholder value, by reallocating capital to those businesses that provide high strategic value and sustainable returns, or with long-term growth and profitability potential.
 

Economic Profit

Economic profit elaborates on RAROC by incorporating the cost of equity capital. This is based on the market required rate of return from holding a company's equity instruments, to assess whether shareholder wealth is being created. Economic profit measures the return which is generated by each business line in excess of the cost of equity capital. Shareholder wealth is increased if capital can be employed at a return in excess of the bank's cost of equity capital. Similarly, when returns do not exceed the cost of equity capital, then shareholder wealth is diminished and a more effective deployment of that capital should be sought.

The Value of Risk Management

Efficient Risk Management can constitute value in the following dimensions (more or less in order of significance):

1. Compliance and Prevention

   • Avoid crises in own organization.
   • Avoid crises in other organizations.
   • Comply with corporate governance standards.
   • Avoid personal liability of managers.

2. Operating Performance

   • Understand full range of risk facing the organization.
   • Evaluate business strategy risks.
   • Achieve best practices.

3. Corporate Reputation

   • Protection of Corporate Reputation.

4. Shareholder Value Enhancement

   • Enhance capital allocation.
   • Improve returns through Value Based Management.

Proactive Risk Management

Proactive Risk Management evaluates:

• The probability of risk occurring,
• Risk event drivers,
• Risk events,
• The probability of impact,
• Impact drivers, prior to the risk actually taking place (figure: Proactive Risk Management - Smith and Merritt).

Book: John B. Caouette, Edward I. Altman - Managing Credit Risk

Book: Carol Alexander - Operational Risk: Regulation, Analysis and Management

Book: Michael K. Ong - The Basel Handbook: A Guide for Financial Practitioners

Book: Donald R. van Deventer, Kenji Imai - Credit Risk Models and the Basel Accords (Wiley Finance)

Forum Forum discussions about Credit Risk Management and RAROC. Meaning of Risk and Risk Events One could define RISK as: the uncertainity in desired outcomes. A RISK EVENT is generally the manifestation of a risk. Its critical factors are: 1. Probability (the probability of the risk event h... 6   1 comments The Role of Letters of Credit in Risk Management and International Trade What is in current financial risk management the role of the Letter of Credit (LOC)? How can the LOC reduce risks in international trade? The current economical crisis affects international trade an... 5   1 comments Enterprise Risk Management In the modern day risk has become an integral part of every corporate. Enterprise risk is managing all risk, irrespective of the type. Enterprise risk management take appreciation of any different ris... 4   1 comments Banks have managed the wrong risks Over the last couple of years, financial institutions have been spending an awful lot of money and effort on understanding and managing their market risks, credit risks and operational risks in tremen... 4   6 comments Risk Management in the Electrical Energy Sector Can anyone tell me the ideal risk management system that can be used in an electrical energy supply industry.... 3   1 comments Introducing a Loss Event Database Hi everyone! My problem is that I would like to introduce a loss database or loss event database at our company. I would like to soon run the first workshops, where I will explain and describe what is... 2   🔥 Laboratory Biorisk Management I need some information or references about the AMP model of laboratory biorisk management. Things like facility design and controls. Thank you very much.... 1   Environmental Risk Factors by Saunders Anybody knows about the model of environmental factors by Malcolm Saunders? Please enter a short explanation, anything is welcome, thanks.... 1   1 comments What are the Main Procedures of Operational Risk Management? What are the main procedures involved in operational risk management?... 1   4 comments Global Financial Pandemonium The global financial pandemonium goes beyond the issue of common sense. I think it's high time people started looking inward and listening deeply to the inner voice that serves as the connector and wi... 0   1 comments Start a new topic about Credit Risk Management and RAROC Sign up for free

Courses about Credit Risk Management and RAROC. Beginners Course Advanced Course Course for Experts

Best Practices The best, top-rated topics about Credit Risk Management and RAROC. Here you will find the most valuable ideas and practical suggestions. 🥇 Risk Versus Uncertainty In the management of risk, what is the distinction between risk and uncertainty? Thanks..... 17   9 comments

Expert Tips Advanced insights about Credit Risk Management and RAROC. Here you will find professional advices by experts. Consultancy Tips Teaching Tips Practical Implementation Tips The Levels of Risk Risk Hierarchy The following hierarchy describes risks types from global down to project level: 1. World system risks: political condi... Critical Success Factors of RM Improve your RM process In E&Y's 2009 Risk Management Survey executives of large organizations highlighted 9 key factors for successful risk man... Strategic versus Financial Risk Management Comparison of Typical Activities STRATEGIC Risk Management in a company usually refers to the following activities: 1. Risk Identification: identificat... Pitfalls of Traditional Risk Analysis Risk Management, Crisis Management In their 2000 book "Managing Crises Before they happens" Mitroff and Anagnos explain their critics on traditional risks... Taking Risk Management from Control and Compliance into a Competitive Advantage Strategic Risk Management Since events tend to be repetitive over time, many management experts support the idea that an effective risk management... Why Society is More Risky than Before Understanding New Risk Categories, Risk Management In his 1992 book "Risk Society: Towards a New Modernity”, Ulrich Beck describes new risk scenarios that companies have t... How to Link Risk Management and Strategy? Strategic Risk Management, Best Practices Firms practicing strategic risk management: 1. Create value by embracing risks, shaping risks, and exploiting flexibili... Moral Intensity: When Will a Decision Be Seen as Unethical? Risk Management, Business Ethics, Ethical Decision-making, Crisis Management, Corporate Responsibility The financial crisis of 2008 has been partly the result of managers and executives taking excessive risks. That's why Fe... Align Your Risk Management Strategy with Investors' View on Risk Strategic Risk Management, Transparant Risk Management Risk is an essential part of any investment. Modern organizations are giving more attention to their risk profile to be... Alternatives to LIBOR - Key Challenges for Transition to Risk Free Rates Inter-bank Offered Rate, LIBOR, SOFR, SONIA, ESTER, SARON, TONAR London Inter-bank Offered Rate (LIBOR) is the rate at which a bank can borrow funds. It is an interest-rate average calc...

Information Sources Various sources of information regarding Credit Risk Management and RAROC. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops. Enterprise Risk Management and Integrated Risk Management Enterprise Risk Management, Risk Management Extensive presentation related to risk management. The presentation includes the following sections: 1. Introduction 2... Open Capital Allocation Using RAROC and EVA RAROC, EVA Equity capital allocation plays a particularly important role for financial institutions such as banks, who issue equity... The Risk Management Process in Steps Risk Management Steps, Strategic Risk Management, Process of Risk Management This presentation elaborates on the risk management process, including some important steps in this process. The present... Enterprise Risk Management: Theory and Practice Enterprise Risk Management In this paper, René M., Stulz and Brian W. Nocco explain how enterprise risk management creates value for shareholders. ... Measuring and Managing Operational Risk in the Financial Sector Financial Sector,Operational Risk This paper by Airane Chapelle a.o. proposes a methodology to analyze the implications of the Advanced Measurement Approa... IT Risks List of Typical Risks of IT Projects Very comprehensive list of no less than 217 risks associated with information technology.... Operational Risk Management Risk Management A comprehensive presentation about Operational Risk Management. The following points are discussed: - ORM terms - ORM ... How to Apply the COSO Enterprise Risk Management Integrated Framework Enterprise Risk Management, COSO ERM Framework This presentation elaborates on the concept of Enterprise Risk Management and the COSO ERM Framework, sections: 1. What... Risk Management in Agricultural Lending Agricultural Risk Management, Micro Finance, Bottom of the Pyramid, Agriculture Risk Management Presentation about Risk Management, especially focused on the Risks in Agricultural Lending. The presentation includes t... The Six Basic Questions of Risk Management Initial Understanding of Risk Management, Risk Management Introduction Managing risk is essentially a process of asking and answering six relatively easy questions no matter what setting (per... Risk Management Diagram Risk Management Download and edit the 12manage PowerPoint model for limited personal, educational and business use. Republishing in int...

Tools Useful tools regarding Credit Risk Management and RAROC. News Videos Presentations   Books Academic More

Compare with: Plausibility Theory  |  Strategic Risk Management  |  Real Options  |  CAPM  |  PRVit  |  Z-Score
 

Return to Management Hub: Decision-making & Valuation  |  Finance & Investing  |  Knowledge & Intangibles  |  Strategy & Innovation

More Management Methods, Models and Theory