Many companies choose to measure their profitability using concepts such as the Return on Capital Employed (ROCE – which we examined in Treasury Today March 2004) and the Return on Equity (RoE – which we examined in Treasury Today April 2004).
However, neither concept considers the risk that the company takes when investing in a particular project. In other words, they cannot distinguish between the return from a high risk project and that from a low risk one. Investors would expect a higher return, the greater the risk inherent in any project. This is why issuers of high yield bonds have a higher cost of borrowing than investment grade issuers.
This link is also recognised by the banking community, which developed RAROC from the 1970s as a tool to measure the risk inherent in their portfolios, so that an appropriate amount of capital could be set aside to protect against the effects of default. The imminent adoption of the second Basel Capital Accord places a strong emphasis on a bank’s ability to measure this level of capital. Banks also use this analysis to determine whether to provide credit to their corporate customers and, if so, at what cost.
\(RAROC\: = \: \frac{Risk-adjusted \: return}{Risk-adjusted \:capital}\)
The risk-adjusted return = PBIT – expenses – expected losses – taxes where PBIT is profit before interest and taxes.
The risk-adjusted capital = capital set aside to meet the unexpected losses over the measured period with a given level of certainty.
Identifying the risk-adjusted return requires an analysis of the expected losses.
The risk-adjusted capital can be measured either from the top down or from bottom up.
- Top-down.The first decision is to determine the desired level of certainty. Then, by running a Monte Carlo or similar simulation, identify the value of the capital at risk at this level of certainty.
- Bottom-down.The alternative is to identify the level of economic capital to set aside for each one of market, operational and credit risks, again to the desired level of certainty.
These calculations are complex, which is why they remain the preserve of banks. However, it is also important to recognise that banks are increasingly using this analysis to determine how to lend their balance sheets. Projects backed by the banks need to offer a return related to the amount of capital they set aside to manage them. Basel 2 will align the regulatory capital (that which banks have to set aside) with economic capital (which is what banks want to set aside). RAROC is one of the concepts the banks use to assess this.
