LO 48.8: Explain best practices in implementing an approach that uses RAROC to

LO 48.8: Explain best practices in implementing an approach that uses RAROC to allocate economic capital.
Recommendations for implementing a RAROC approach are as follows:
Senior Management
The management team (including the CEO) needs to be actively involved with the implementation of a RAROC approach within the firm and promote it as a means of measuring shareholder value creation. The emphasis should be on the level of profits earned by the firm in relation to the level of risks taken as opposed to merely earning as much profit as possible.
Communication and Education
The RAROC process needs to be clearly explained to all levels of management of the firm in order to have sufficient buy in from management. Specifically, the process of allocating economic capital to the various business units needs to be fair and transparent in order to minimize the common concerns of excessive economic capital attribution to a given business unit. An open dialogue and debate with the various business unit leaders of issues concerning how economic capital is computed would also be helpful.
Ongoing Consultation
There are key metrics that impact the computation of economic capital. A committee consisting of members from the various business units as well as the risk management group should review these metrics periodically in order to promote fairness in the capital allocation process.
Metrics involving credit risk include: probability of default, credit migration frequencies, loss given default, and credit line usage given default. The metrics will change with time and will need to be updated accordingly. The historical period over which the metrics are adjusted is debatablea shorter period may result in fluctuating economic capital amounts and a longer period may result in more stable amounts.
Metrics involving market risk focus on volatility and correlation, and should be updated at least monthly. Metrics involving operational risk are not as defined as they are for credit and
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Topic 48 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 17
market risk, so therefore, involve a significant amount of subjectivity and debate. Other key metrics, like core risk level and time to reduce, should be updated annually.
Data Quality Control
Information systems collect data (e.g., risk exposures and positions) required to perform the RAROC calculations. The data collection process should be centralized with built-in edit and reasonability checks to increase the accuracy of the data. In subdividing the general duties surrounding data, the RAROC team should be responsible for the data collection process, the computations, and the reporting. The business units and the accounting department should be responsible for putting controls in place to ensure the accuracy of the data being used for the RAROC calculations.
Complement RAROC with Qualitative Factors
A qualitative assessment of each business unit could be performed using a four-quadrant analysis. The horizontal axis would represent the expected RAROC return and the vertical axis would represent the quality of the earnings based on the importance of the business units activities to the overall firm, growth opportunities, long-run stability and volatility of earnings, and any synergies with other business units. There are four resulting possibilities: Low quality of earnings, low quantity of earnings: the firm should try to correct, reduce,
or shut down the activities of any of its business units in this category.
Low quality of earnings, high quantity of earnings (managed growth): the firm should maintain any business units that currently produce high returns but have low strategic importance to the firm.
High quality of earnings, low quantity of earnings (investment): the firm should
maintain any business units that currently produce low returns but have high strategic value and high growth potential.
High quality of earnings, high quantity of earnings: the firm should allocate the most
resources to business units in this category.
Active Capital Management
Business units should submit their limit requests (e.g., economic capital, leverage, liquidity, risk-weigh ted assets) quarterly to the RAROC team. The RAROC team performs the relevant analysis and sets the limits in a collaborative manner that allows business units to express any objections. Senior management will then make a final decision. The treasury group will ensure the limits make sense in the context of funding limits. The restriction placed on a firms growth due to leverage limitations helps promote the optimal use of the limited amount of capital available.
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Topic 48 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 17
Ke y C o n c e pt s
LO 48.1 Risk capital is a buffer to shield a firm from the economic impacts of the risks that it takes (i.e., protect against unexpected losses). In short, it provides assurance to the firms stakeholders that their invested funds are safe.
In most cases, risk capital and economic capital are identical; however, strategic risk capital may be added to economic capital as follows:
economic capital = risk capital + strategic risk capital
Regulatory capital is relevant only for regulated industries such as banking and insurance. It is computed using general benchmarks that apply to the industry. Assuming that risk capital and regulatory capital are the same for the overall firm, the amounts may be different within the various divisions of the firm.
For financial institutions, there are four major reasons for using economic capital to allocate risk capital: Capital is used extensively to cushion risk. Financial institutions must be creditworthy. Difficulty in providing an external assessment of a financial institutions creditworthiness. Profitability is greatly impacted by the cost of capital.
LO 48.2 Benefits of using the risk-adjusted return on capital (RAROC) approach include: 1. Performance measurement using economic profits instead of accounting profits.
2. Use in computing increases in shareholder value as part of incentive compensation (e.g.,
scorecards) within the firm and its divisions.
3. Use in portfolio management for buy and sell decisions and use in capital management in estimating the incremental value-added through a new investment or discontinuing an existing investment.
4. Using risk-based pricing, which will allow proper pricing that takes into account the
economic risks undertaken by a firm in a given transaction.
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LO 48.3 The basic RAROC equation is as follows:
RAROC =
after-tax expected risk-adjusted net income
economic capital
A more detailed RAROC equation for capital budgeting decisions is as follows:
RAROC = taxes + return on economic capital transfers exp ected revenues cos ts exp ected losses
taxes + return on economic capital transfers
economic capital
LO 48.4 In computing RAROC, the focus is often on a one-year time horizon. However, it is possible to look at multi-period RAROC to obtain a more accurate RAROC measure for longer-term transactions and loans. One issue that arises is how much economic capital to allocate if the risk of a transaction changes dramatically in subsequent periods. There is a lot of subjectivity in selecting the time horizon for RAROC calculation purposes. A longer time horizon could be selected to account for the full business cycle, for example. A key consideration with the selection of a time horizon is the fact that risk and return data for periods over one year is likely to be of questionable reliability.
A point-in-time (PIT) probability of default could be used for short-term expected losses and to price financial instruments with credit risk exposure. A thro ugh-the-cycle (TTC) probability of default is more commonly used for computations involving economic capital, profitability, and strategic decisions.
In computing economic capital, the confidence level chosen must correspond with the firms desired credit rating. Choosing a lower confidence level will reduce the amount of risk capital required/allocated and it will impact risk-adjusted performance measures.
LO 48.3 The hurdle rate is computed as follows:
(CE x R c e ) + (PE x R pe )
(CE + PE)
Once the hurdle rate and the RAROC are calculated, the following rules apply:
If RAROC > hurdle rate, there is value creation from the project and it should be accepted. If RAROC < hurdle rate, there is value destruction from the project and it should be rejected/ discontinued. 2018 Kaplan, Inc. Page 141 Topic 48 Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 17 LO 48.6 RAROC should be adjusted to take into account systematic risk and a consistent hurdle rate as follows: Adjusted RAROC = RAROC (Bg (R y Rp) LO 48.7 The overall risk capital for a firm should be less than the total of the individual risk capitals of the underlying business units. This is because the correlation of returns between business units is likely to be less than +1. A business unit with earnings or cash flows that are highly correlated to the overall firm should be allocated more risk capital than a business unit with earnings or cash flows that are negatively correlated (assuming similar volatility). Having business lines that are countercyclical in nature allows the overall firm to have stable earnings and to attain a given desired credit rating using less risk capital. LO 48.8 The management team needs to be actively involved with the implementation of a RAROC approach within the firm and promote it as a means of measuring shareholder value creation. The RAROC process needs to be clearly explained to all levels of management of the firm in order to have sufficient buy in from management. A committee consisting of members from the various business units as well as the risk management group should periodically review the metrics that impact economic capital calculations in order to promote fairness in the capital allocation process. The RAROC team should be responsible for the data collection process, the computations, and the reporting. The business units and the accounting department should be responsible for putting controls in place to ensure the accuracy of the data being used for the RAROC calculations. A qualitative assessment of each business unit could be performed using a four-quadrant analysis. The horizontal axis would represent the expected RAROC return and the vertical axis would represent the quality of the earnings based on the importance of the business units activities to the overall firm, growth opportunities, long-run stability and volatility of earnings, and any synergies with other business units. Business units should submit their limit requests (e.g., economic capital, leverage, liquidity, risk-weighted assets) quarterly to the RAROC team. The RAROC team performs the relevant analysis and sets the limits in a collaborative manner that allows business units to express any objections. Page 142 2018 Kaplan, Inc. Topic 48 Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 17 C o n c e pt C h e c k e r s 1. 2. 3. Which of the following statements regarding the risk-adjusted return on capital (RAROC) methodology is correct? A. In the context of performance measurement, RAROC uses accounting profits. B. In the numerator of the RAROC equation, expected loss is added to the return. C. If a business units cost of equity is greater than its RAROC, then the business unit is not adding value to shareholders. D. RAROC is useful for determining incentive compensation but it lacks the flexibility to consider deferred or contingent compensation. $1.2 billion principal amount 6% pre-tax expected return on loan portfolio Assume the following information for a commercial loan portfolio: Direct annual operating costs of $8 million Loan portfolio funded by $1.2 billion of retail deposits; interest rate = 4% Expected loss on the portfolio is 0.4% of principal per annum Unexpected loss of 7% of the principal amount Risk-free rate on government securities is 1 % Assume no transfer pricing issues 30% effective tax rate Based on the information provided, which of the following amounts is closest to the RAROC? A. 9.33% B. 10.03%. C. 12.33%. D. 14.66%. Which of the following statements regarding the computation of economic capital is correct? I. Selecting a longer time horizon for RAROC calculations is preferable because risk and return data is more reliable with more time. II. Choosing a lower confidence level will not likely reduce the amount of risk capital required if the firm has little exposure to operational, credit, and settlement risks. A. I only. B. II only. C. Both I and II. D. Neither I nor II. 2018 Kaplan, Inc. Page 143 Topic 48 Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 17 4 5. Which of the following statements regarding the choice of default probability approaches in computing economic capital is correct? A. A through-the-cycle (TTC) approach should be used to price financial instruments with credit risk exposure. B. A point-in-time (PIT) approach is more commonly used for computations involving profitability and strategic decisions. C. A TTC approach is more likely to result in a lower volatility of capital compared D. A firms rating will not change when analyzed under the PIT approach versus the to the PIT approach. TTC approach. Which of the following statements regarding best practices in implementing a RAROC approach is correct? A. A successful RAROC approach is focused on maximizing profits earned by the B. A restriction on the firms growth due to leverage limitations may result in firm. higher profits. C. The data collection process throughout the firm should be decentralized to allow the various business units to ensure the utmost accuracy of data. D. Metrics involving credit risk, market risk, and operational risk to compute economic capital are generally clearly defined and may be computed objectively. Page 144 2018 Kaplan, Inc. Topic 48 Cross Reference to GARP Assigned Reading - Crouhy, Galai, and Mark, Chapter 17 C o n c e pt C h e c k e r An s w e r s 1. C The cost of equity represents the minimum rate of return on equity required by shareholders. Therefore, if RAROC is below the cost of equity, then there is no value being added. Response A is not correct because RAROC uses economic profits, not accounting profits. Response B is not correct because in the numerator of the RAROC equation, expected loss is deducted from the return. Response D is not correct because RAROC has the flexibility to consider deferred or contingent compensation. 2. B Unexpected loss ($1.2 billion x 7% = $84 million) is equal to the amount of economic capital required. The return on economic capital is then $84 million x 1% = $0.84 million. Also, expected revenues = 0.06 x $1.2 billion = $72 million; interest expense = 0.04 x $1.2 billion = $48 million; expected losses = 0.004 x $1.2 billion = $4.8 million. RAROC = taxes + return on economic capital transfers exp ected revenues cos ts exp ected losses taxes + return on economic capital transfers economic capital RARQC = (72 8 48 4.8 + 0.84 + 0) x (1 0.3) = 84 3. B Choosing a lower confidence level will not likely reduce the amount of risk capital required if the firm has little exposure to operational, credit, and settlement risks. The reduction would be much more dramatic only if the firm has significant exposure to such risks because large losses would be rare. In selecting a time horizon for RAROC calculations, risk and return data for periods over one year is likely to be of questionable reliability. 4. C A firms rating is more likely to change when analyzed under the point-in-time (PIT) approach compared to the through-the-cycle (TTC) approach. As a result, the TTC approach results in a lower volatility of economic capital compared to the PIT approach. A PIT approach should be used to price financial instruments with credit risk exposure and to compute short-term expected losses. A TTC approach is more commonly used for computations involving profitability, strategic decisions, and economic capital. 5. B A restriction on the firms growth due to leverage limitations may result in higher profits because it requires the firm to be creative and to optimize a scarce resource (the limited amount of capital available). Response A is not correct. A successful RAROC approach is focused on the level of profits earned by the firm in relation to the level of risks taken. Response C is not correct. The data collection process should be the responsibility of the RAROC team; the process should be centralized with built-in edit and reasonability checks to increase the accuracy of the data. Response D is not correct. Metrics involving operational risk are not as defined as credit and market risk, therefore, there is often a significant amount of subjectivity involved in the computations. 2018 Kaplan, Inc. Page 145 The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in: Ra n g e o f Pr a c t i c e s a n d Is s u e s in Ec o n o mi c Ca pi t a l Fr a m e w o r k s Topic 49 E x a m F o c u s This topic requires an understanding of many risk management concepts that you have already covered at FRM Part I, as well as in earlier readings in the FRM Part II curriculum. Specifically, this topic expands on the concept of economic capital, which is the capital required to absorb unexpected losses for a given time horizon and confidence interval. For the exam, pay attention to the terminology and attempt to integrate this material to the sections pertaining to market risk and credit risk so as to reinforce your understanding. E c o n o m i c C a p i t a l I m p l e m e n t a t i o n F r a m e w o r k

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