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RAROC Based Capital Budgeting and Performance Evaluation: A Case Study of Bank Capital Allocation

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  • Christopher James
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    Abstract

    This paper describes the RAROC system developed at Bank of America (B of A) in order to examine how risk-based capital allocation models work. I begin by discussing the economic rational for allocating capital in a diversified organization like the B of A. Drawing on recent work by Froot and Stein (1995) and Stein (1996), I argue that the capital budgeting process used by the B of A resembles the operation of an internal capital market in which businesses are allocated capital with the objective of mitigating the costs of external financing. Viewing the capital budgeting process in this way is useful because it suggests that a businesses contribution to the overall variability of the cash flows of the bank will be an important factor in evaluating the risk of (and the capital allocated to) a specific business unit. In addition, since RAROC systems are used both for capital budgeting and management compensation, the measures of risk are designed to limit rent seeking and influence activities by division managers, Next, given the theoretical background, I provide a detailed look at how the RAROC capital allocation and performance evaluation system works at B of A. The primary objective of B of A's system is to assign equity capital to business units (and ultimately to individual credits) so each business unit has the same cost of equity capital. This process implies that investments in riskier projects or business units (measured by the projects contribution to the overall volatility of the market value of the bank) will be required to use less leverage than investments in less risky business units. This paper was presented at the Financial Institutions Center's October 1996 conference on "

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    Bibliographic Info

    Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-40.

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    Date of creation: Sep 1996
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    Handle: RePEc:wop:pennin:96-40

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    1. Owen Lamont, 1996. "Cash Flow and Investment: Evidence from Internal Capital Markets," NBER Working Papers 5499, National Bureau of Economic Research, Inc.
    2. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
    3. Stein, Jeremy C, 1997. " Internal Capital Markets and the Competition for Corporate Resources," Journal of Finance, American Finance Association, vol. 52(1), pages 111-33, March.
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    Cited by:
    1. Flavio Bazzana, 2001. "I modelli interni per la valutazione del rischio di mercato secondo l'approccio del Value at Risk," Alea Tech Reports 011, Department of Computer and Management Sciences, University of Trento, Italy, revised 14 Jun 2008.
    2. Acharya, Viral V., 2009. "A Theory of Systemic Risk and Design of Prudential Bank Regulation," CEPR Discussion Papers 7164, C.E.P.R. Discussion Papers.
    3. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," NBER Working Papers 5403, National Bureau of Economic Research, Inc.
    4. Stoughton, Neal M. & Zechner, Josef, 2007. "Optimal capital allocation using RAROC(TM) and EVA(R)," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 312-342, July.
    5. Fauziah Hanim Tafri & Rashidah Abdul Rahman & Normah Omar, 2011. "Empirical evidence on the risk management tools practised in Islamic and conventional banks," Qualitative Research in Financial Markets, Emerald Group Publishing, vol. 3(2), pages 86-104, June.
    6. Yoram Landskroner & David Ruthenberg & David Zaken, 2005. "Diversification and Performance in Banking: The Israeli Case," Journal of Financial Services Research, Springer, vol. 27(1), pages 27-49, February.
    7. Beeck, Helmut & Johanning, Lutz & Rudolph, Bernd, 1997. "Value-at-Risk-Limitstrukturen zur Steuerung und Begrenzung von Marktrisiken im Aktienbereich," CFS Working Paper Series 1997/02, Center for Financial Studies (CFS).
    8. Victoria Geyfman, 2005. "Risk-adjusted performance measures at bank holding companies with section 20 subsidiaries," Working Papers 05-26, Federal Reserve Bank of Philadelphia.
    9. Patrick de Fontnouvelle & Virginia DeJesus-Rueff & John Jordan & Eric Rosengren, 2003. "Capital and risk: new evidence on implications of large operational losses," Working Papers 03-5, Federal Reserve Bank of Boston.
    10. Stoughton, Neal & Zechner, Josef, 1999. "Optimal Capital Allocation Using RAROC And EVA," CEPR Discussion Papers 2344, C.E.P.R. Discussion Papers.

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