Credit Risk and RAROC
CALCULATING LOSSES FOR A LOAN PORTFOLIO
An example for measuring profitability for a commercial bank portfolio of credit assets
The model proposed here takes on the Basel Committee on Banking Supervision (Basel II) approach called the “internal ratings-based” (IRB) approach. By this method, “institutions will be allowed to use their own internal measures for key drivers of credit risk as primary inputs to the capital calculation, subject to meeting certain conditions and to explicit supervisory approval. All institutions using the IRB approach are allowed to determine the borrowers’ probabilities of default while those using the advanced IRB approach are permitted to rely on own estimates of loss given default and exposure at default on an exposure-by-exposure basis.”
In the credit business, losses of interest and principal occur all the time – there are always some borrowers that default on their obligations. The losses that are actually experienced in a particular year vary from year to year, depending on the number and severity of default events.
While it is impossible to know in advance the losses a bank will suffer in any given year, an institution can forecast the average level of credit losses it can reasonably expect to experience. These losses are referred to as Expected Losses (EL).
Beyond loss calculation, this same methodology can be used to calculate a profitability measure called RAROC (Risk Adjusted Return on Capital).
The idea of this example is to show how to calculate profitability using RAROC for each one of the components of this portfolio. According to Wikipedia, “Risk-adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analyzing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust .