The merit of the journey: a counterpoint to RAROC critics

RMA Journal, The, Nov, 2003 by Brian J. Ranson

This article presents an extract of a larger chapter on RAROC contained in Credit Risk Management, a new book by Brian Ransom Ranson says he wanted to write a book on credit risk for today's managers but "without the math that so often takes a simple idea and makes it incomprehensible."

A basic premise of finance is that capital should only be invested if the probable future return on that capital will exceed its cost. Any potential investment that entails using existing capital or generating incremental capital, then, should be required to fulfill this principle.

Risk-adjusted return on capital (RAROC) is a relatively new tool for applying this premise in the lending and credit risk management context. Also known as return on risk-adjusted capital (RORAC) or risk-adjusted return on risk-adjusted capital (RARORAC), the concept boils down to the opening sentence of this article--nothing more, nothing less.

Bankers Trust pioneered the use of RAROC models in its lending process more than 20 years ago. Today, many banks have built such models, and some use them as decision-making tools at the heart of their lending processes.

Of course, RAROC critics are vocal about its limitations. And there are quite a few. It is not a solution in itself, nor is it more than a measure at a point in time (albeit a critical point in time). But, on balance, most banks that have introduced a RAROC model have retained the concept and built on the model, indicating that the perceived advantages outweigh the disadvantages. Few banks would return to the pre-model processes even if their model were no longer a traditional RAROC structure.

Ultimately, the journey toward developing a model offers tremendous value to those willing to see beyond its limitations.

Criticisms of RAROC

The fact that RAROC is a temporary measurement is just one criticism of its use. So, yes, it is flawed; however, many of the criticisms seem designed to assail rather than contrast with an alternative. Four of the most common criticisms, cited in a recent work on credit risk by Algorithmics, are as follows:

1. RAROC is a no-arbitrage technique. It does not reconcile the prices of loans with those of similar securities available in the market (e.g., bonds, other loans, and credit derivatives). Hence, it cannot assess comparative business opportunities and arbitrage-like situations arising from relative price mismatches. (1)

This statement makes the assumption that a RAROC model should but does not provide a market-relative price to the user but does not do so. It is an accurate statement in that a RAROC model is derived from an inward focus because it uses an individual lender's overhead and tax levels, correlations from an individual balance sheet, and judgmental assessments of risk. That internally acceptable price may not relate to the external market but certainly must be compared.

It also assumes that the operation of a RAROC model implies that the contemplated deal may be at an inappropriate price relative to market alternatives. This is increasingly unlikely in the U.S. syndicated loan market, which has become dominated by relatively few very large banks that originate and syndicate. These banks are well aware of the capital markets price for the credit risk of their clients, and they assume that their other clients (the buyers of the loan) also have that information. Thus, the idea that there remains a wondrous undiscovered arbitrage between corporate loans and bonds is simply not true. Loans have different structures, recovery rates, terms, documentation, and more, and the price should (and most probably does) reflect all those factors.

Credit derivatives are a somewhat different issue, but statistics on credit-derivative pricing remain unreliable because of the problems of data, documentation, and liquidity that had significant impact in the early years of that market.

2. RAROC neglects the "stated consistency of many loan cash flows." (2) Two issues are raised here: 1) Loans have an indefinite maturity date because of prepayment options; and 2) the exposure at default is very difficult to estimate. These are necessary assumptions in a calculation.

The problem of loan prepayment options remains a major thorn that is often ignored in the RAROC calculation because it is a "conservative" assumption. Early prepayment, if known, would have the effect of reducing term risk and improving RAROC. The problem of estimating exposure amounts is insoluble. There is some new data on revolving loan usage levels, but, for the moment, RAROC and other estimation models will require judgmental input on these issues.

3. RAROC takes a static view of credit risk. (3)

For banks that have used these models for some time, this is not the case. Most RAROC users perform the calculation to decide whether to proceed with the transaction. From that point, there is little doubt that the RAROC will change because the risk will change. But as time passes, the bank's calculation of RAROC should also change. It may be because risk changes; it may be from a drawdown on a revolving line or from prepayment. Good loan systems and reviews will then automatically recalculate the RAROC. RAROC should not be a static view. It should be a continuous view, albeit one structured around the model rather than the market.