RAROC control
The RAROC control ( Risk Adjusted Return on Capital ) characterizes a value-added-oriented target system which is used in credit institutions . It can be used to derive added value (from a purely economic point of view) at various levels (from the overall bank to the individual transaction).
Weaknesses of traditional measures of success
The success measures traditionally used in many credit institutions are characterized by a purely accounting perspective. Key figures such as return on investment (ROI) and return on equity (ROE) relate the profit for the period to a specific accounting or regulatory variable. The development of the aforementioned success factors is primarily based on the fact that in the 1970s and 1980s the focus of banking business was on increasing market share. Since this strategy was primarily aimed at generating new business and there was sufficient free equity available, there was no need to include the risks involved in appropriate pricing.
Although the risks initially i. d. Usually, however, the increased competition - after the onset of market saturation - and the increasing scarcity of equity led to the margins being pushed down so far that further lending was no longer economically viable. The business expansion was nevertheless driven forward in the riskier segments (and ultimately led to the first transfer risk crisis in the 1980s), as the success of the banks was only measured by the volumes achieved.
In the nineties, due to increasing competitive pressure and stricter regulatory requirements, the scientific knowledge (cf.Hans -Dieter Deppe , Bankbetriebliches Growth, Stuttgart 1968) that pure growth in assets is no guarantee for financial strength of a credit institution, but rather is limited by the availability of adequate equity resources. Therefore, the targeted control of risks and the associated effective and efficient allocation of equity became the focus of interest.
Traditional key figures based on commercial accounting are generally insufficient for precise risk control, because they treat all cash flows (with a payment-oriented approach) or balance sheet items (with an asset-oriented approach), regardless of the respective risk. Risks can only be taken into account insofar as they have already become losses or losses are only included in the calculation as rough estimates in the form of provisions. However, neither of these two approaches is nearly as precise as would be desirable for effective risk control. In addition, the general estimates of provisions are also unusable because they do not differentiate between the individual types of risk and their influence on the overall risk.
From an economic point of view, when taking risks, management should see the ratio of net income to the equity base required for this (risk / income ratio). The greater the share of risk and thus the consumption of equity in the overall risk of a bank, the more precisely these risks need to be controlled.
Consideration of risks in bank management
Every transaction and decision within a bank, the outcome of which cannot be predicted with certainty, is subject to risk. Since almost every transaction involves a degree of uncertainty, it also adds to the bank's overall risk. Uncertainties lead to possible fluctuations in the bank's earnings and thus represent a risk for the institution. In order to ensure the solvency of the bank, banks must therefore hold a certain amount of equity from an economic and regulatory point of view that is directly proportional to the risks they are taking is. If a bank were completely risk-free, i. H. If all cash flows or assets were secure, there would be no need to hold equity. However, if a bank is exposed to strong fluctuations in its gross income, operating costs and / or losses or depreciation, there is a need to hold a large amount of capital, even if the bank is (currently or on average) profitable.
The amount of this capital depends on how safe a bank wants to be and thus the probability of default the bank wants to be afflicted with. The targeted solvency level is limited by the minimum rating. Ultimately, this is reflected in the ideas of depositors and supervisory authorities of a safe bank. The new supervisory regulations ( Basel II ) in particular represent a more refined and more economically oriented parameter for the required capital backing than was previously possible through general regulatory provisions.
Basel III can be understood as an update of Basel II and in the so-called Pillar II places a clear focus on economic capital (while Pillar I of Basel III defines regulatory capital).
Regulatory Capital, Book Capital and Economic Capital
- Regulatory capital :
Due to general regulations, the supervisory authorities require banks to provide an adequate amount of capital for the risks they hold in order to ensure that they can meet their obligations “at all times”. Accordingly, the equity base specified there is a minimum.
- Book capital :
The amount of equity that a bank actually has at its disposal is calculated as the residual amount from the total amount of assets minus all liabilities (= book capital). If this size falls below the level prescribed by supervisory law (regulatory capital), the regulators (e.g. BaFin ) typically intervene.
- Economic capital or risk capital :
Although the regulatory capital tries to be a good measure of the determination of the (from an economic point of view) necessary equity capital, it can only be based on general regulations that can only partially reflect the risks actually held by a bank. In order to be able to determine the value contribution of a business area or a bank transaction, it is necessary to develop an exact measure of the required equity. The risk capital (economic or economic equity) is defined as the amount of capital that a transaction or a department needs in order to be able to cover the economic risks it creates with a certain level of security. With the help of economic capital, all risks of a bank can be made comparable. The economic capital is compared with the so-called financial resources, which represent the sum of all liquid and available funds.
Interest on economic capital
Standard risk costs cover the expected credit risk, which is based on past experience. However, there are always unexpected risks, for example the default of a large borrower who is not covered by normal loan defaults. The bank must also make provisions for these unexpected risks and needs equity in the form of reserves and hidden reserves to cover them. One speaks here of economic capital. Deutsche Bank writes in its risk report: “Economic capital is a measure that can be used to determine the equity capital that is needed to absorb extreme unexpected losses from our exposure. "Extreme" here means that there is a 99.98% probability that the aggregated losses within a year will not exceed our economic capital for the year. We calculate the economic capital for the default risk, the transfer risk and the settlement risk - as components of the credit risk - as well as for the market risk, the operational risk and for general business risks. We use the economic capital to summarize the risk positions of the bank from individual business lines to group level. We also use economic capital (as well as goodwill and other non-depreciable intangible assets) to allocate the book capital to the business lines. This enables us to measure the risk-adjusted performance of the individual business units, which is a central role in managing our financial resources in order to optimize the added value for our shareholders. In addition, we use economic capital - especially for credit risks - to measure the risk-adjusted profitability of our customer relationships. ”(Source: Deutsche Bank: Annual Report 2003) The amount of economic capital to be kept for the lending business is determined according to the value at risk . This is the loss that with a very high probability (at least 99%) will not be exceeded even if all the most unfavorable influencing factors come together. In relation to the lending business, the return on economic capital must cover the risk of unexpected loan defaults.
Example: Bayernbank AG has determined economic capital of EUR 600 million using the value-at-risk method, which must be reserved for unexpected loan defaults. If an interest rate of 10% is also applied for this, then this is a further EUR 60 million that is included in the credit calculation. In this case, this corresponds to twice the amount of the imputed risk. Since unexpected loan defaults are more likely to occur with poorer credit ratings than with better ones, it is advisable to link them to the standard risk costs. The interest on economic capital in the Bayernbank case is therefore twice the standard risk costs. Thus, a total of EUR 100 million of the total profit entitlement of EUR 167 million is covered by the interest on the legal and economic capital. The rest must be generated from businesses that do not require equity capital.
Efficient allocation of the scarce resource economic capital
Different banks focus their business activities on different financial services. The top management of the bank is responsible for ensuring that the bank's capital is optimally deployed in the business areas. There, the (limited) capital must ultimately be used as effectively and efficiently as possible (risk-return tradeoff). In order for the management to be able to fulfill this task, it is necessary that a transparent control / measurement parameter is available that allows a meaningful comparison between activities with different risk characteristics from an economic point of view.
The Risk Adjusted Return On (Economic) Capital , RAROC, is a measure that enables such a comparison and also has significant advantages. The RAROC of an activity can be compared with the necessary return that the shareholders (or the board of directors) of a company demand for the use of the capital ("hurdle rate"). Such a comparison can be carried out at any level within the bank: at the transaction level, the product level, the customer level, the business line and division level and the overall bank.
Definition of RAROC and connection to value creation
Risk management is derived from the bank's target system, which in turn is linked to value creation. The core of this concept is the statement that every transaction made should increase the value of the bank over the long term. If you look at a single transaction or a portfolio of transactions, the question of added value can be answered with the help of the RAROC. The RAROC corresponds to the risk-adjusted return on the tied economic capital and can be transformed directly into a value-added variable:
- ,
in which
- Value creation = risk-adjusted return - cost of economic capital
- Cost of economic capital = economic capital · hurdle rate
In order to be able to calculate the RAROC precisely, both the risk-adjusted return and the necessary economic capital must be precisely determined. The risk-adjusted return is the economic (non-accounting) return that a transaction or division generates over a specified period (usually one year). The average amount of credit or other losses to be expected is deducted from the net income and set in relation to the necessary economic capital, or the costs associated with the economic capital are also deducted to determine the added value. To determine the added value, the RAROC can be compared with a hurdle rate (= cost of capital). If the RAROC is above this hurdle rate, value is created; if the RAROC is below, the corresponding value is destroyed.
literature
- Schierenbeck, Lister, Kirmße: Profit-oriented bank management , Volume 2: Risk controlling and integrated risk / return management . Gabler, 9th edition, Wiesbaden 2008, ISBN 3-834-90447-3
- Wernz: Bank control and risk management . Springer Gabler, Heidelberg / Berlin 2012, ISBN 978-3-642-30555-9