Account for good practice when rolling out a RAROC-based method for allocating economic capital.
The idea
A RAROC rollout fails more often from organisation than from mathematics, so good practice is practical. Secure visible senior management support and agree the methodology with the business units early. Use one consistent definition of capital, confidence level, horizon and hurdle rates, so unit RAROCs are comparable. Make assumptions transparent, and have the risk function independently validate and back-test the models. Use the output for both decisions (pricing, capital budgeting) and performance evaluation. Phase in links to compensation after a reporting-only pilot, and watch for gaming, such as units shifting into risks the model underestimates. Treat allocated diversification benefits openly, so units understand why their charge changes. Review hurdle rates and models regularly. The exam point is that consistency, transparency, buy-in and incentives matter as much as the formula.
A practice question
Which is good practice when rolling out a RAROC-based capital allocation system?
- Keep the methodology confidential from the business units to prevent them from gaming it.Why not: Opacity undermines acceptance and makes it harder for managers to act on the results.
- Let each business unit choose its own confidence level and horizon for its capital.Why not: Creates RAROCs that are not comparable across units.
- Obtain visible senior-management support and involve the business units in the design. - correct
- Apply the system only to trading, because lending is hard to measure.Why not: Selective application defeats the purpose of firm-wide, comparable capital allocation.
A rollout needs senior management commitment and business-unit buy-in; transparency and consistent, firm-wide application make the numbers usable in decisions.
A harder one
The risk department builds a RAROC model alone and then presents the results to the business units, who reject the capital charges as arbitrary. What would have been better practice?
- Engage the business units early to agree definitions, data and assumptions so the system is accepted. - correct
- Impose the charges and link bonuses to them immediately to force acceptance.Why not: Imposing the system without buy-in and linking pay at once invites resistance and gaming.
- Replace the model with each unit's own estimate of its capital.Why not: Unit-specific models are inconsistent and give managers incentives to understate their risk.
- Drop economic capital and use accounting equity, which the units already understand.Why not: Accounting equity does not measure risk, which defeats the purpose of RAROC.
Acceptance depends on the units understanding and trusting the method. Early consultation on definitions, data and assumptions is standard practice for a successful rollout.
The hardest tier
A bank adopts RAROC and, in the first year, links bonuses to unit RAROC although the data and models are new and untested. Which design is closer to good practice?
- Keep the immediate link, so behaviour changes quickly and errors are exposed.Why not: Errors in untested models would drive pay and decisions, damaging credibility.
- Link bonuses only to the units that volunteer, and use accounting ROE for the rest.Why not: Splits the bank into two incompatible measures and loses comparability.
- Run a reporting-only pilot, then phase in the link to pay once the numbers are trusted. - correct
- Delay all use of RAROC until every unit has its own validated model.Why not: Replaces a firm-wide framework with separate unit models and an open-ended delay.
Good practice is staged introduction: calibrate, test and explain RAROC in a pilot, fix data issues, and only then tie it to decisions and pay.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Risk Capital Attribution and Risk-Adjusted Performance Measurement
- Separate risk capital, economic capital and regulatory capital from one another, and explain why and by which techniques economic capital is used to apportion risk capital.
- Explain how the RAROC (risk-adjusted return on capital) approach works and how capital budgeting draws on it.
- For a project, a loan or a portfolio of loans, compute RAROC and interpret it, then rank business unit results using it.
- Account for the problems of using RAROC to measure performance, among them selecting a time horizon, measuring default probability and picking a confidence level.
- Work out the hurdle rate and use it to reach business decisions through RAROC.
- Work out the adjusted RAROC of a project in order to decide whether it is viable.
- Account for the difficulties of modeling diversification benefits, in particular summing up a firm's risk capital and spreading economic capital among its business lines.