FINAL REPORT OF PROJECT WORK-II

Title of the Project: Calculating RAROC for Corporate

Accounts in Bank of Baroda

By
Jagjeet kumar

Guide
Mr.Alok BANERJEE
(Chief Manager)

Project Work Undertaken at: Bank Of Baroda

Report submitted in partial fulfillment of the requirements for

the award of
Post-Graduate Diploma in Banking and Finance
By
National Institute of Bank Management, Pune, 2007-08
 CONTENTS

Acknowledgement:

Objective

Chapter-I…………………………Introduction

Chapter-II………………………..Review of literature

Chapter-III………………………Data & Methodology

Chapter-IV………………………Results, Analysis & Interpretations

Chapter-V………………………..Conclusions & Recommendations

Chapter-VI………………………Executive Summary

Chapter-
 ACKNOWLEDGEMENT

I sincerely acknowledge my indebt ness to Mr.Asit Pal (General

Manager, Risk Management Department, Bank of Baroda) for giving
me opportunity to conduct my project on calculating the RAROC (Risk
Adjusted Return on Capital) for the Corporate accounts. He has been
constant source of inspiration and guide throughout the project. I am
also deeply thankful to Mr. A D M Chawli (Deputy General Manager,
Risk Management Department) for giving me necessary guidance and
access to resources to conduct my project. I would also thank my
guide and mentor Mr. Alok Banerjee for constant guidance. I am
also especially thankful to Dr.Ashish Saha(Director,NIBM)
,Prof.Kalyan Swaroop(Dean NIBM) and Mr Arindam
Bandhopadhaya (NIBM Faculty ) and other faculties of the institute
for constant guidance and teaching us the subject so that I could do
this Project. I am also grateful to Mr. R.K.Rana (AGM) Mr. H S Patil,
Mr. D Mahabal and Mr. Ratnesh Mishra from the Risk Management
dept for their continued support.
For collection of the data I
have to approach different departments. So I also thank Mr. Awasthi
(DGM recovery) Mr. Upreti, Mr. Upadhe, Mr. Man Mohan Jha from
the ASCROM cell and Mr. Batra, Mr. Bhatia, Mr Prasant and Mr.
Rajesh from wholesale banking department MR Govil from the
planning dept.

Last but not the least I am thankful to all my fellow colleagues and
friends for giving me friendly environment and support. In this final
round I also thank my family who took a lot of pain and perseverance
so that I can do this Project and complete the course.
 Objective
The main objective of the project is to calculate RAROC for the
corporate accounts based on the data provided by the Bank. The
RAROC has emerged as the powerful tool to measure profitability of
the Bank. It incorporates the cardinal principle of finance i.e. Risk and
Return and combines them the Economical Capital requirement of the
Bank based upon the quantum of risk taken in the business. This kind
of the study has become important as traditional methods of
profitability measure like ROA, ROC, etc don’t take into account the
quantum of risk undertaken by the Bank in its day-to-day business.
After BASEL-II implementation the requirement of Capital is linked
with the Risk undertaken. So we may say that RAROC is basically
BASEL-II compliant performance measure for the Banks. This
integration of Capital along with the business expansion and risk
undertaken becomes more relevant for Banks as they are not going to
Capital market so frequently particularly for PSBs where any further
Capital infusion requires Govt's commitment also.
Though RAROC concept is generally
applied at firm level and it incorporates all kinds of the Risks, i.e.
Credit, Market and Operational risks and Banks economic capital based
on the Credit, Market and Op Var. But my study is limited in scope to
calculating RAROC for the selected corporate accounts. This limitation
is obvious due to the fact there is constraint of resources like data,
time and manpower and software.
One of the aims of the project is to compare
RAROC with that of cost of capital determining performance of
Corporate accounts at both bank level & business unit levels. In
decision making RAROC may be applied as a thumb rule as
•If RAROC > Cost of capital, there is a value addition
•If RAROC < Cost of capital, value is destroyed
•If RAROC = Cost of capital, value is maintained
 INTRODUCTION
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. However, more and more (RAROC) is used as a measure,
whereby the risk adjustment of Capital is based on the capital
adequacy guidelines as outlined by the Basel Committee (currently
Basel II).

Broadly speaking, in business enterprises, risk is traded off against

benefit. RAROC is defined as the ratio of risk adjusted return to
economic capital. Economic capital is a function of market risk, credit
risk, and operational risk. This use of capital based on risk improves
the capital allocation across different functional areas of banks,
insurance companies, or any business in which capital is placed at risk
for an expected return above risk-free.

RAROC system allocates capital for 2 basic reasons

1. Risk management
2. Performance evaluation

For risk management purposes, the main goal of allocating capital to

individual business units is to determine the bank's optimal capital
structure (i.e., economic capital allocation is closely correlated with
individual business risk).
As a performance evaluation tool, it allows banks to assign capital to
business units based on the economic value added of each unit.
Some of the benefits are listed below
• Segment wise Risk profile generation:
• Incentives based on RAROC
• RAROC based planning
• Pricing strategy of the loans
• It will show how much risk adjusted return different segments of
the business are giving when we compare them with Economic
capital based hurdle rate (RAROC).
• It will provide which segment is creating the shareholder’s
wealth and which segments are destroying them.
• The Economic Capital is also expected to be less when we take
the diversification benefit than the for the standalone case.
• Business decision making
• Restructuring & Revamping.
 • Product performance appraisal

Overview of Typical RAROC Model

Portfolio Capital Model

Obligor Risk
Rating PD
Process & PD Migration Diversification

Structure Corporate
Asset Quality LGD Policy EC
[Loss Given Default] (Economic
Capital)
Target Debt Rating
Structure EA D [for Portfolio]
Term [Expos Given Default]
Loan Type

Loan Amount UL
[Unexpected Loss] RAROC

Term
Total Revenues

Typical NIX
- Overhead Net
(Non-Interest Income
RAROC Expense)
Schematic - Expected Loss
LGD
Amount
PD - Income Tax
& Capital Tax
 REVIEW OF LITERATURE
Commercial Banks are typical financial intermediary who accepts
deposits from the Public and invest in form of the loans, investments in
bonds or equities, etc. For mobilization of the deposit they pay interest
to the depositors and also they have operation cost associated with the
operation. The investments and the loans granted by the Banks yield
interest which typically covers the cost of fund and operations cost
besides yielding sufficient margin to the shareholders of the Bank. But
all things do not go as planned. It has been observed that the Banks
are typically exposed to risks emanating from the Market variables like
interest rate movement, equity price volatility, volatility in forex
markets, derivative spread and losses etc giving rise to Market risk.
On loan front the Banks are basically exposed to the default or no
payment of the interest as well as principle of the loans. This is called
Credit risk. Besides these two types of the primary risk another type
of risk which has become prominent now a day is Operational Risk.
This risk is due more to control and checks system failure i.e. poor
Management. Formally we may define these risk categories as follows:

Credit Risk: Credit Risk arises from default when an individual,

company, or government fails to honor a promise to make a
payment. Ex-Counterparty credit risk, Loan credit risk, Issuer Credit
Risk, Settlement credit risk, etc.

Market Risk: Market Risk arises from the possibility of losses

resulting from unfavorable market movements. So it is Risk to
losses due to changes in the perceived value of an asset, without
any contractual failures. Ex- losses in equity market, forex market,
bond market, etc.

Operational Risk: The most general definition of operational risk is

that it is the risk of losses due to factors other than market risk and
credit risk. Basel committee defines it as “The risk of direct or
indirect losses resulting from inadequate or failed internal
processes, people and systems or from external events”

The typical loss reward distribution of these three types of risks are
shown in following page
BASEL Committee has in recent recommendations (BASEL-II) has
emphasized over the management of these risk Banks face. For the
measurement and management of the different risks BASEL-II has
advised the following approach
o Credit Risk
 Standardized Approach
 Internal Rating Based Approach (IRB-Foundation)
 Internal Rating Based Approach (IRB-Advanced)
o Market Risk
 Standardized Approached (Maturity)
 Standardized Approach (Duration),
 Internal Risk Based Approach (VaR)
o Operational Risk
 Basic Indicator Approach
  Standardized Approach
 Advanced Measurement Approach
RBI has also applied the recommendations of the BASEL-II in phased
manner. So from 31.03.2008 our Bank has to comply with BASEL-II
recommendations as prescribed by RBI. So Banks are required to have
Capital for each of these risk class. This requirement of Capital has
necessitated the performance measure which gives the Shareholder
the commensurate return vis. a vis. risk taken by the Bank. RAROC is
such measure which measures the risk return reward and compares it
with the cost of capital of the Bank.

But before going on lets define few terms which will be useful in
understanding RAROC concept.

Credit Risk: It is defined as the non fulfillment of the contractual

obligation by the counterparty/obligor. This non-fulfillment may be due
to obligor inability or unwillingness and may be also classified as
exogenous or endogenous factors related to the borrower (systematic
or unsystematic). The credit risk also arises due to concentration of
exposure in certain sector of the economy (CONCENTRATION RISK).
Concentration risk is mitigated through the exposure norms related to
individual and group companies and industry /sector exposure
limit.The credit risk is also dependent on the economic cycle and world
over it is observed that the Defaults increases as the economy slows
down.

Probability of Default (PD):- It is defined as the probability of non –

payment of the loan as well as interest by the counterparty/obligor
fully or partially. The PD is calculated with the help of credit rating
migration matrix. It is usually measured for next 1-year rating process
is done usually once in a year. The factors affecting the PD are internal
to the obligor as well as external. Credit Rating is important tool to
measure the PD.

Loss Given Default (LGD): It is the fraction of the EAD that will not
be recovered if default occurs and is calculated as a percentage of the
exposure at the date of default. LGD is facility specific and depends
upon the collateral quality, seniority, legal framework, economic cycle
etc.
 LGD = 1 – Recovery Rate/EAD
When we discount the recovery to the date of default then it is called
the economic LGD.

Exposure at Default (EAD): It represents the expected level of

usage of the facility when default occurs. This factor also depends
upon the type of facility, borrower’s history and his liquidity conditions.

EAD = Outstanding + (CCF  Free Limit)

Outstandingd – Outstandingd–1
CCF = ——————————————
Limitd–1 – Outstandingd–1

Expected Loss (EL): It is the anticipated average loss over a defined

period of time. It is akin to cost of doing business and has to be
recovered from the borrowers as risk premium. The expected loss is
taken as the mean of credit loss distribution. This is calculated as

EL=EAD*PD*LGD
Unexpected Loss (UL): Unexpected loss is potential to exceed the
expected loss and is a measure of the uncertainty in the loss estimate.
It is measured as follows

UL=EAD*√(PD*σLGD² +LGD² *σPD²)

Where σLGD² is Variance of LGD and σPD² is variance of PD

Also σPD² =PD*(1-PD) due to binomial distribution of PD

Economic Capital (EC): Economic Capital is the measure of risk and

is based on a probabilistic assessment of potential future losses at a
selected confidence level.

So EC =m x Capital required to cover worst-case loss (Minus expected

loss) due to credit risks.

m is often a multiplier determined by the bank based on its desired

credit rating, its required confidence threshold (say at 99% or 99.97
%) and the actual observed distribution of losses.

EC=N‾1(99.97%)*ULP –ELP (For AA rated banks)

Cost of Capital (COC): Cost of Capital also known as Hurdle rate is
the amount of return shareholder demand for taking risk. It can
measured based on the CAPM model

Hurdle Rate, R=Rf+β(Rm-Rf)

Where β is the slope of regression line running between market return
and stocks return. These returns can be estimated based on the
Market index and share price closing value.
Mathematically the RAROC is defined as below

Risk-Adjusted Income
RAROC = Economic Capital at Risk

These terms may be further explained as below-

Risk Adjusted Income=

+ Financial income (Interest revenue + Fees)

- Cost of Funds (FTP costs)
-Non-interest Operating Expenses
- Expected Credit losses
DATA & METHODOLGY

DATA COLLECTION: The data for RAROC Calculation required was

mainly obtained from the ASCROM system of the Bank. The ASCROM
system gives details like Branch, Borrower name, Limit Sanctioned,
Outstanding Balance, Asset Classification, Credit Rating, etc.The other
sources of data were collected from the recovery dept ,wholesale
Banking dept, NSE website, etc.

For calculation of PD base year 2000 was taken and all funded facilities
above Rs 20 Crores accounts were listed. Ideally this cut off limit
should have been say Rs 50 Crores or Rs100 Crores but due to the fact
that number of such acounts was small so for better statistical
accuracy I have stick to Rs 20 crores as funded exposure at the end of
March from year 2002-2007. The variables like asset class, name of
the account, credit rating, Branch, Zone, etc was noted in EXCEL sheet
(Annexture1).
For calculation of LGD 103 accounts the reference cut off was Rs 1
Crore for all recovered/settled accounts during the period 2005, 2006
and 2007(Annexture2).

For EAD calculation the outstanding balance above Rs 20 crores as on

31.03.2007 was taken. Since the RAROC was calculated at outstanding
as on 31.03.2007 it does make sense. However, it is advisable to
collect more comprehensive data for EAD calculation along with CCF
and unutilized commitments.

For calculation of Yield data was collected from the sanctioned files of
the Corporate Loan over the period from 2002-2007.Altogather 117
cases were studied and noted down (Annexture3).

For the Cost of Capital calculation the closing share price of the BOB
on NSE was collected for the period from 01.04.2006 to
31.03.2008.For beta calculation the S&P500 Index closing was
selected for the same period (Annexture4).

For Cost of fund and Operating expenses Banks Audited BS of 2007

was taken as reference source and cost was determined based on the
published data.

The primary assumption behind the sanction of the loans is that funds
are profitably deployed and these loans yield enough return not only to
satisfy the depositors and meet the Operating expenses but also
generate enough income for the shareholder. Many a times the big
corporates get the Sub-BPLR loans and in absence of proper risk
reward mechanism it becomes difficult to determine the profitability of
decision taken, though our gut feeling says that the sanction process is
profitable. RAROC helps in concretizing this gut feeling.

Tools adopted in this study are simple EXCEL based technique which
can be comprehended easily and also there are no advanced software
to do such study at present.
 Analysis, Results, & Interpretations

PD Calculation: For PD calculation the no of accounts at the

beginning was segregated among the different rating categories and it
was determined how many got slipped into default categories (Default
category is as NPA as per regulatory definition). This data was
collected for the years 2003,2004,2005,2006 and 2007(Annexture-5).
As can be seen from the sheet the no of accounts defaulting is highest
in year 2004. In total there were 6 defaults over the period and out of
these 4 were in B and C categories. This result is in conformity with
our assumption that the good rated accounts have less PD. The PDs for
the relevant years are 0, 2.78%, 0.88%, 0.65% and 0.44%
respectively. One interpretation of reduction in PD in later 3 years is
that Economy has been very buoyant after 2004 and it also reinforces
our hypothesis that in expansion phase the no of defaults are less. The
yearly PD is then multiplied with the weights of the No of accounts in
the pool (709) and then the mean weighted PD is arrived at. In our
study this comes to 0.85%.The variance of PD comes to 0.84%
The Rating Migration was also studied on 102 corporate accounts as on
31.03.2002 as base and their behavior during the next five years i.e.
upto 2007.These accounts were classified as per rating categories and
year to year rating migration juxtaposed(Annexture-6). This
methodology is commonly followed for the study of the bonds default
characteristics. So the accounts were sorted as per the rating
categories of the first year and the subsequent ratings were also
noted. So the accounts remained in the same rating category or
upgraded, downgraded or even defaulted. In few cases the accounts
were withdrawn without default. For such Rating withdrawal the study
has considered them as rating retained in their original grade as
suggested by the Edward Altman in his book Managing Credit
Risk(page218-220). The yearly PD has been calculated as shown in
Transition Matrix for different years (Annexture-7). Here the
methodology used is similar to calculation of pooled PD. As can be
seen the retention rate in rating category is highest for good accounts
and is low for the lowly rated accounts. Also the rating migration is
along the diagonal axis implying the rating retention characteristics.

The same data pool is analyzed for cumulative 1-year, 2-year, 3year, 4-
year and 5-year rating migration and default (Annexture-8). Here in
the 5 –year migration matrix we observe that the rating withdrawal
has mostly occurred in AAA and AA accounts (good quality customers
have left the Bank more than the bad quality customers ), which is the
matter of concern as the no of relatively low quality accounts have
increased and in the process the credit quality has deteriorated. Here
also overall diagonal concentration of rating category is observed but
in last migration matrix (5 year cum PD) as we can see there is
considerably divergence towards the mid-rating segment. This finding
is in consonance with rating Transition Matrix for 5 years as given on
page 222 of the above mentioned book.

LGD Calculation: For the LGD calculation the study has taken 103
accounts as sample and the date on default, date of compromise,
years in default, recovery amount, recovery cost, etc were determined.
These amounts were discounted to the date of default taking 10%
average discount rate (Bank uses 10% as discount rate). Then the
economic LGD is calculated for the individual accounts. The pooled
LGD can be taken from aggregate figures as shown in Annexture-2.

RAROC Calculation: RAROC calculation is given in Annexture-9 .The

workings are self explanatory. First EAD is taken as Rs1 and then the
calculation is done. The Expected Loss is 0.59% and the unexpected
loss is at 2.3%.Thus we see the unexpected loss is much more than
the expected. At 99.97% confidence interval Economic Capital is
calculated at 6.97% which is less than the 9% CAR as regulator
prescribes. Since, the RAROC calculation typically follows the Advanced
IRB approach for capital calculation. It shows how Banks will be able to
save on the Capital if they have robust system of the risk
management. In our study the RAROC comes to 13.48%.The EL, UL
and EC for the exposure of Rs 304.67 billion (as on 31.03.2007) is also
calculated
When we compare this RAROC with the Cost of Capital we find that our
RAROC was higher than the cost of capital. So we may say that the
corporate accounts are giving profitable returns. However even minor
change in yield in the loan accounts or credit quality deterioration may
result into higher Economic capital, reduced RAROC.
The scenarios are as follows:

Wtd PD=0.85% σpd=0.84%

LGD=69.23% σLGD =24.14%
EAD=1
EL=0.59% UL=2.30%

EC@99.97%(Internal CAR) = 6.97% Yield=8.34%

COF=4.77% OPex =2.05%
RAROC=13.48%
At Yield@8% RAROC=8.60%
COF=5.25% RAROC=6.59 %(< COC)
OPex=2.50% RAROC=6.95 %(< COC)
PD=1.25% RAROC=11.12%
LGD=80% RAROC=13.50%
At EAD (31.03.2007) =Rs 30468.03 cr
EL=Rs 1784.95 Cr UL=Rs 6993.03 Cr
EC=Rs 2122.56 cr
COC (Hurdle Rate) =7.70%

So we can say that the RAROC is highly sensitive to yield on advances,

COF and OP ex.
 Recommendations

Finally we conclude the study with hope that Bank will have to move to
Advanced IRB approach and it will have enough quality data to move
towards RAROC implementation, not only in credit but also for other
areas of risk management. Some important points are as below.
• Bank needs strong MIS system and Costs involved in each
segment. Further it should be the endeavour for the Bank to use
RAROC as signal for taking decisions which involve risk and
Capital.
• Also our Bank is using internal CRISIL model for the risk rating
of the accounts since 2006. In many accounts two or three
ratings are available. So sample validation of the parameters like
PD, LGD, and EAD should be done on these accounts. As these
parameters are highly dynamic and hence needs constant up
gradation.
• For LGD and EAD estimation Bank wide study should be taken
up.
 • The segmental funding pattern of the loans should be identified
and costs incurred should be estimated.
• It is pertinent that organization should become more vertical in
structure so that costs involved can be calculated more
accurately (Activity Based Costing).

Executive Summary

In the end I point down the steps followed by me for the RAROC
calculation:
• Initial step was to determine the methodology to be followed and
quality and quantity of data to be collected.
• Then literature was surveyed to determine the variables to use.
• Then data was collected using ASCROM, recovery history,
sanctioned files, Banks, NSE and other websites.
• The raw data was cleansed and particular outliers were left out.
• Then Excel based calculation was done to calculate the different
elements of the RAROC and then the RAROC was calculated.
• In transition matrix we observe diagonal rating structure which is
in conformity with rating migration marix given by S&P and
Moody’s.
• The calculated RAROC was then compared with the cost of
capital and found that the Corporate Accounts RAROC is higher
 than the cost of capital. This is important because this tells us
that these corporate accounts are adding value to the
shareholders wealth.

Limitations:
 I have not taken sanctioned limits as cut off due to the fact that
that information is not so reliable in ASCROM.
 The choice of Rs 20 crores has been taken on individual
judgment so as to have a sufficient pool of data points.
 Only funded limit is considered, as information regarding the
non-fund limits is not so reliable in ASCROM.
 The data for losses of Rs20 Crores and above are few and hence
proper recovery pattern cannot be drawn easily, so I will use Rs
1 crores and above data for NPA and recovery estimates.

References:
 De servigny and O.Renault, 2004,Measuring and managing
credit risk,S&P ,Mc Grow -Hill.
 A.Bandopadhaya, A note on measurement and
management of credit risk,NIBM
 Anthony Saunders and Cornett,Financial Institution
Management:A Risk Management Approach,chapter
11,12,5 th ed.
 Altman,Narayanan and Cauette,Managing Credit Risk
 Credit Risk + of CFSB
 Phillip Jorian,Value a Risk
 BASELII :International convergence of Capital
measurement and Capital Standards :a Revised
framework(BCBS,June2006 revised)

Websites:
• www.gloriamundi.com
• www.elsevier.com
• www.fic.wharton.uppendu.fic
• www.erisk.com
• www.defaultrisk.com
• www.rbi.org
•