RAROC and Profit Planning

Module D: Balance Sheet Management

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CAIIB Super-Notes

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Bank Financial Management: RAROC and Profit Planning

CAIIB SUPER NOTES

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CAIIB Super-Notes

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Contents
Coverage: 1. Profit Planning 2. Risk Aggregation and

Capital Allocation 3. Economic RAROC Capital and

M S Ahluwalia

CAIIB Super-Notes

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1.

PROFIT PLANNING

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CAIIB Super-Notes

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Profit Planning
Essentially involves Balance Sheet Management covering credit, investment and non-fund based income Income arises from three sources (Need to be maximized):
Interest Income
Fee Based Income Treasury Income

Expenses(Need to be minimized):
Interest Expenses Operating Expenses (Staff Costs and other costs)
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2.

RISK AGGREGATION AND CAPITAL ALLOCATION

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Risk Aggregation and Capital Allocation

Most commonly used approach to estimate aggregate risk exposure is RAROC (Risk Adjusted Return On Capital)
Key is matching of revenues, costs and risks on transaction or portfolio basis over a defined period

Expected losses are covered by reserves and unexpected losses require capital
allocation

Second approach is EaR

Similar to RAROC but depends less on capital allocation and more on cash flows or variability in earnings Ignores the value changes in Assets and Liabilities due to changes in market

interest rates

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CAIIB Super-Notes

Sirf Business

3.

ECONOMIC CAPITAL AND RAROC

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Economic Capital and RAROC

Risk Capital: Economic capital required to support the banks financial risk Pricing of products should be a buffer against expected losses

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CAIIB Super-Notes

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Risk Capital
RAROC is part of family of risk adjusted performance measures (RAPM) Risk Capital (RC) = VAR RAPM = Profit/RC

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CAIIB Super-Notes

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RAROC Methodology
Risk Management: Includes measurement of portfolio exposure, the volatility and correlations of risk factors Capital Allocation: Requires choice of a confidence level and horizon for the VAR measure Performance Measurement: Adjustment of performance to Risk Capial
Can be based on RAPM Method EVA = Profit (Capital x k) (Higher the EVA, better the project/product)
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Do you have any questions or queries or some feedback to give? Just mark an email to super.msahluwalia@yahoo.com

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CAIIB Super-Notes

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M S Ahluwalia, amongst other things, is a visual artist, blogger, blog designer and of course an MBA and Banker from New Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

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