Magazine article The Journal of Lending & Credit Risk Management

Linking RAROC to Strategic Planning

Magazine article The Journal of Lending & Credit Risk Management

Linking RAROC to Strategic Planning

Article excerpt

During the past 10 years, the science of risk management has been developing and evolving continuously. At first, risk managers focused on monitoring internal controls, measuring risks, and setting limits. Their focus was mostly on preventing unpleasant surprises - the downside of risk. Today's risk managers are still concerned with the downside; increasingly, however, they also help companies to assess various opportunities for growth. Thus, risk managers' goals have expanded to include a focus on helping to improve the company's returns on a risk-adjusted basis.

One of the most important achievements of risk management has been the development of RAROC (risk-adjusted return on capital), a performance measurement tool that has been widely accepted by large banks and investment banks. RAROC is a comprehensive tool that measures return on economic capital(1) and attempts to include all three types of risk that are inherent in business activities - market risk, credit risk, and operational risk.

There are two basic applications of RAROC. Historic RAROC is the traditional application of the tool in performance measurement, which involves calculating the risk-adjusted returns that a business line has generated. Expected RAROC is a prediction of the future returns that will be generated in a particular transaction or line of business. A common example of how expected RAROC is often applied is in creating a loan pricing model. Increasingly, too, expected RAROC is being used in making strategic business decisions such as where to allocate capital or whether to engage in specific mergers and acquisitions. As risk management has come of age, risk managers are taking on a more proactive role in business decisions, and the expected RAROC approach is becoming a more widely used analytical tool.

Meanwhile, during the past few years, the strategic planning function has become increasingly focused on creating shareholder value. Consequently, there is now a need to risk-adjust the strategic planning process. By merging the shareholder value models used in strategic planning with the expected RAROC approach, financial services companies can improve strategic planning decisions.

Combining the Best of Two Disciplines

The task at hand is to develop a comprehensive planning methodology for a financial institution. The best way to do this is to combine the principles of risk management with those of shareholder analysis. Each of these disciplines has its strengths and weaknesses. When combined, however, these two disciplines can offer financial institutions an effective model for strategic planning.

The accepted theory, of managing to create shareholder value (often called value-based management) indicates that share price is determined by a combination of growth, return, and risk. In risk management processes, the common objective is to try to improve risk-adjusted returns and the common language is RAROC, which measures risk and return on a common basis across businesses. However, generally speaking, RAROC incorporates only risk and return, ignoring the growth component of shareholder value [ILLUSTRATION FOR FIGURE 1 OMITTED].

On the other hand, the commonly used models for shareholder analysis and strategic planning typically consider growth and return prospects, but they include a weak, if any, systematic consideration of risk. When stock analysts and budgeters use free cash flow models to simulate shareholder value, the only risk-related component is the cost of capital used to discount future cash flows. Thus, although most people agree that the key drivers of shareholder value are growth, return, and risk, these elements have not been well integrated into most analytic models or management processes.

Using RAROC in Computing Contributions to Shareholder Value

There is a fundamental principle that corporations exist to benefit their shareholders. Consequently, a key measure of senior management's performance is its success in creating shareholder value, defined as the sum of stock price change and dividends distributed. …

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