Credit Risk and Risk Adjusted Return on Capital

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Comes with one PDF document (17 pages), one unsolved Excel spreadsheet (Credit Risk Model & RAROC unsolved.xlsx), one solved Excel spreadsheet (Credit Risk Model & RAROC solved.xlsx) and 6 videos with 27′ 35″ of training.


Credit Risk and RAROC


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 .

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Fernando Hernandez


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