Risk-adjusted return on capital

The RAROC control ( Risk Adjusted Return on Capital ) indicates a value-added oriented target system, which comes in credit institutions to apply. It can be used to derive the value ( from a purely economic point of view) at different levels ( from the bank as a whole up to the individual transaction ).

Weaknesses of traditional measures of success

The success criteria traditionally used in many banks are characterized by a purely accounting point of view. Ratios such as return on investment ( ROI) and Return on Equity ( ROE) put the net profit each in relation to a particular accounting or regulatory size. The development of the aforementioned performance measures is mainly due to the fact that the focus of banking on the increasing market share in the 70s and 80s. Since this strategy primarily aimed at the generation of new business and sufficient free capital was available, there was no need in this case the risks undertaken in an appropriate pricing involve.

Although the risks initially typically were small, but led to increased competition - after the onset of saturation of the market - and the increasing scarcity degree of equity to the fact that the margins have been squeezed down so far that further lending no longer economically useful had. Business expansion has been driven yet in the riskier segments ( and ultimately led to the first transfer risk crisis during the 80s ), since the success of banks was measured only on the basis of the volumes achieved.

In the 90s, sat in bank management by increasing competition and stricter regulatory requirements in the science very early been demonstrated knowledge ( cf. Hans -Dieter Deppe, Bank Operational growth, Stuttgart 1968) by that a pure growth of assets not guarantee the financial strength of a bank, but rather is limited by the availability of appropriate capital resources. Therefore, the specific control of the risks and the associated effective and efficient allocation of equity in the focus of interest shifted.

The traditional indicators, based on the commercial accounts are insufficient for a precise risk management in general, because with them, the treatment of all cash flows ( in cash oriented approach ) or balance sheet items ( in asset -oriented approach ), regardless of the risk of the same. Risks can be taken into account only in so far as they have already become losses or losses are only rough estimates in the form of provisions in the calculus one. Neither of these two approaches, however, is nearly as accurate as would be desirable for an effective risk management. In addition, the general estimates of provisions are therefore useless because they do not distinguish between the different types of risks and their impact on the overall risk.

From an economic perspective the management in the assumption of risk, the ratio of net income to the equity base needed for this look ( risk-return relation). The greater the risk, and thus the erosion of equity share in the overall risk of the bank, the more accurate these risks require the controller.

Consideration of risks in the bank management

Each transaction and decision within a bank whose output can not be predicted with certainty is risky. As virtually every transaction involves a degree of uncertainty, it also contributes to the overall risk of the bank. Uncertainties lead to potential fluctuations in the income of the bank and thus pose a risk to the institution dar. order to ensure the solvency of the bank, banks therefore need to keep from the economic and regulatory point of view a certain amount of equity that is directly proportional to the risks they is. Would a bank completely risk- free, that is, would all cash flows and assets safe, then there would be no reason to hold capital. When a bank is, however, subject to strong fluctuations in their gross income, operating costs and / or losses or depreciation, there is a need to hold up a large amount of capital, even if the bank operates ( currently or in the average ) profitable.

The amount of such principal amount depends on how safe will be a bank and thus with what probability of failure would be vitiated the bank itself. The target solvency level is limited by the minimum rating. This is found ultimately in the minds of depositors and regulators a secure bank again. Especially the new regulatory requirements (Basel II ) represent a more refined and more oriented to the economic view size for the required capital charge than through general, regulatory requirements was previously possible.

Basel III can be understood as an update of Basel II and placed in the so-called Pillar II a clear focus on economic capital (while the Pillar I of Basel III regulatory capital defined).

Regulatory capital, book capital and economic capital

• Regulatory capital:

The supervisory authorities shall require due to general regulations of banks that they provide an adequate amount of capital for the risks held by them, make sure you can " at any time " to meet their obligations that they. Accordingly, the fixed capital base there a minimum size dar.

• Book equity:

The amount of equity that a bank is actually available, calculated as the difference in total assets, less all liabilities (book capital). If this drops below the size of regulatory required level ( Regulatory Capital ), then typically exceed the regulators (eg BaFin).

• Economic capital and risk capital:

Although the Regulatory capital is trying to be a good measure for determining the necessary ( from an economic perspective ) equity, it can only be based on general regulations, which may reflect the fact held by a bank risks only imperfectly. In order to determine the value contribution of a business unit or a bank transaction, it is necessary to develop an accurate measure of the required equity. The risk capital (economic or economic capital ) is defined as the amount of capital to a transaction or department needs to cover the economic risks they generated at a certain level of safety. With the help of economic capital for all risks of a bank can be made comparable. Economic capital is the so-called financial resources, which represent the sum of all cash and available funds, balanced.

Return on economic capital

Standard risk costs cover the expected credit loss, which is based on experience from the past. But there are always unexpected risks, such as the failure of a large borrower, which is not covered by the normal loan losses. Also for these unexpected risks, the bank must make provisions and required to cover their equity in the form of reserves and hidden reserves. This is called the economic capital. For this, the German bank writes in her risk report: " The economic capital is a measure against which equity can be determined, which is needed to absorb very severe unexpected losses arising from our involvement. Extreme ' here means that with a probability of 99.98 % do not exceed the aggregate losses within one year our economic capital for the year. We calculate economic capital for the default risk, transfer risk and settlement risk - as elements of credit risk - as well as for market risk, operational risk and for general business risks. We use economic capital to show an aggregated view of our risk position from individual business lines up to the group level. We also use economic capital ( as well as goodwill and other non- amortizable intangible assets) in order to allocate our book capital among our businesses. This allows us to measure the risk-adjusted performance of individual business units, which is a key metric in managing our financial resources to optimize the value for shareholders. Addition, we consider economic capital - in particular for credit risk - measure the risk- adjusted profitability of our client relationships "(Source: German Bank: Annual Report 2003 ) The amount of kept available for the lending business economic capital is calculated using the Value at Risk. . This is the loss of a very high probability ( at least 99 %) will not be exceeded at meeting of all unfavorable factors. Based on the lending business, the return on economic capital needs to cover the risk of unexpected credit losses.

Example: Bayern AG has determined using the value-at -risk method an economic capital of EUR 600 million, which must be kept for unexpected credit losses. Although this an interest rate of 10 % is applied, then this is a further EUR 60 million, which are included in the credit calculation. This corresponds in this case to twice the imputed ventures. Since unexpected loan losses in poor credit ratings are more likely to occur than better, a coupling offers itself to the standard risk costs. The return on economic capital is so in the case of Bavaria bank twice the standard risk costs. Thus, a total of EUR 100 million of the total profit of EUR 167 million claim by the interest of the legal and economic capital are covered. The remainder must be generated from non- equity transactions requiring.

Efficient allocation of the scarce resource economic capital

Different banks focus their business activities on various financial services. The top management of the Bank is responsible for ensuring the optimal use of the bank's capital in the business fields. There, the (limited) capital must eventually be as effectively and efficiently used ( risk-return trade-off ). Allow management to carry out this task, it is necessary that a transparent Steuerungs-/Messgröße is available that allows a meaningful comparison between activities with different risk characteristics from an economic perspective.

The Risk Adjusted Return On (economic ) capital, RAROC is a measure that allows such a comparison and also includes significant advantages. The RAROC an activity can be compared with the required income, the shareholders (or the Board ) to require an undertaking for the use of capital ( the "Hurdle Rate "). Such a comparison can be performed at any level within the bank: At the transaction level, the product level, the user level, the business lines and space level and the total bank.

Definition of RAROC and related to the value

Risk control is derived from the target system of the bank, which in turn ties in with the value. The core of this concept is the statement that every transaction carried out should increase the value of the bank in the long run. If one considers a single transaction or a portfolio of transactions, the question of the value can be answered with the help of RAROC. The RAROC corresponds to the risk-adjusted return on economic capital and is tied directly transformed into a value Size:

In which

• Value = Risk-adjusted income - cost of Economic Capital

• Cost of Economic Capital = Economic Capital · hurdle rate

In order to calculate the RAROC exactly both the risk -adjusted profitability as well as the necessary economic capital must be determined exactly. The risk -adjusted return is the economic ( not accounting ) earnings, the ( usually one year ) generates a transaction or a business over a specified period. The expected average amount of credit or other losses will be deducted from net income and considered in relation to the necessary economic capital or additionally subtracted associated with the economic cost of capital to determine the value. To determine the value of the RAROC can be compared to a hurdle rate ( = cost of capital ). If the RAROC hurdle rate above this, value is created; is the RAROC below, is destroyed according to value.