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

Financial RAROC Based Capital Budgeting
Institutions and Performance Evaluation:

Center A Case Study of Bank Capital
Allocation
by
Christopher James
96-40
For an electronic copy of this paper, please visit: http://ssrn.com/abstract=1000
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RAROC Based Capital Budgeting and Performance Evaluation:
A Case Study of Bank Capital Allocation 1
Draft: September 22, 1996
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.
Christopher James is at the Graduate School of Business, University of Florida.
This paper is based on work done in conjunction with a paper written for the Journal of Applied Corporate Finance
with Ed Zaik, John Walters and Gabriela Kelling from the Bank of America.
This paper was presented at the Wharton Financial Institutions Center's conference on Risk Management in
Banking, October 13-15, 1996.
Since the late 1980s, a number of large U.S. banks have invested heavily in systems
designed to measure the risks associated with their different lines of business. The immediate
purpose of such risk-measurement systems is to provide bank managements with a more reliable
way to determine the amount of capital necessary to support each of their major activities and,
thus, to determine the overall leverage for the bank as a whole.
This recent interest in measuring risk is partly a response to the greater regulatory
emphasis on capital adequacy that has come with both the implementation of the Basel risk-based
capital requirements issued in 1988 and the passage of FDICIA in 1991. Even more important,
however, than such regulatory changes are fundamental changes in the business of banking. As
the progressive deregulation (capital requirements aside) of the industry continues, banks are
choosing to provide an increasingly diverse set of products and services. The real innovation in
these new performance-evaluation methods lies in their ability to allocate banks’ capital among
their expanding array of nontraditional, fee-based activities -- many of which do not involve any
use of capital for finding purposes but create a contingent liability for the bank. The ultimate goal
of these risk-based capital allocation systems, which are often lumped together under the acronym
RAROC (risk-adjusted return on capital), is to provide a uniform measure of performance.
Management can, in turn use this measure to evaluate performance for capital budgeting and as an
input to the compensation system used for senior managers,
1
In this paper I describe the RAROC system developed at Bank of America (B of A) in
order to examine how risk-based capital allocation models work. In 1993, B of A’s Risk and
Capital Analysis Group was charged with the task of developing and instituting a single
corporate-wide system to allocate capital to all the bank’s activities. Since 1994, that system has
been providing quarterly reports of risk-adjusted returns on capital for each of the bank’s 45
business units. By 1995, B of A had also developed the capability to calculate RAROC down to
the level of individual products, transactions and customer relationships. This three-year process
of developing and implementing a system to measure economic returns provides an interesting
case study in the application of financial theory to real business problems.
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.
What Is RAROC?
Development of the RAROC methodology began in the late 1970s, initiated by a group at
Bankers Trust. Their original interest was to measure the risk of the bank’s credit portfolio, as
well as the amount of equity capital necessary to limit the exposure of the bank’s depositors and
other debtholders to a specified probability of loss. Since then, a number of other large banks have
developed RAROC or (RAROC-like systems) with the aim, in most cases, of quantifying the
amount of equity capital necessary to support all of their operating activities -- fee-based and
trading activities, as well as traditional lending.
Bank of America’s policy is to capitalize each of its business units in a manner consistent
with an AA credit rating, based on the unit’s “stand-alone” risk, but also including an adjustment
for any internal diversification benefits provided by the unit. (As I will discuss in more detail later,
the stand-alone risk of a business unit is measured by the expected, or forward-looking volatility
3
of its operating value.) Each of these individual capital allocations are then aggregated to arrive at
the optimal level of equity capital for the entire bank.
RAROC systems allocate capital for two basic reasons: (1) risk management and (2)
performance evaluation. For risk-management purposes, the overriding goal of allocating capital
to individual business units is to determine the bank’s optimal capital structure. This process
involves estimating how much the risk (volatility) of each business unit contributes to the total
risk of the bank and, hence, to the bank’s overall capital requirements.
For performance-evaluation purposes, RAROC systems assign capital to business units as
part of a process of determining the risk-adjusted rate of return and, ultimately, the economic
value added of each business unit. The economic value added of each business unit, defined in
detail below, is simply the unit’s adjusted net income less a capital charge (the amount of equity
capital allocated to the unit times the required return on equity). The objective in this case is to
measure a business unit’s contribution to shareholder value and, thus, to provide a basis for
effective capital budgeting and incentive compensation at the business-unit level.
RAROC and Financial Theory
Allocating equity capital on the basis of the risk of individual business units seems
pointless in the classical theoretical paradigm of “frictionless” capital markets (one with perfect
information and without taxes, bankruptcy costs or conflicts between managers and shareholders).
If markets operated in this manner, the pricing of specific risks would be the same for all banks
and would not depend on the characteristics of an individual bank’s portfolio. Moreover, given
4
market prices of risk, whether a bank varied leverage on the basis of risk or varied the cost of
capital with the risk of the project would result in the same capital budgeting decisions and
investment activity for the bank.
Of course, no self-respecting banker would accept the proposition that capital markets
operate without frictions. Indeed, banks and other financial intermediaries add value precisely
through their ability to reduce market frictions -- frictions such as limited public information and
the possibility of costly renegotiations of troubled credits. This role implies that a large portion of
bank assets are likely to be difficult for outside investors to value, which in turn may create
information and agency problems for banks themselves when they have to raise capital externally.
As Froot and Stein ( 1995) point out, faced with an increasing cost of raising external funds banks
will behave in a risk-averse fashion. Specifically, a business unit’s contribution to the overall cash
flow volatility of the bank will be an important factor in the capital budgeting decision. Moreover,
in this environment capital structure, risk management and capital budgeting are inextricably
linked together.
Finance theory suggests that, in designing a capital allocation system, the first step is to
identify the costs and benefits of holding equity capital in the context of these market frictions. In
banking, as in most industries, the tax shield provided by tax-deductible interest payments (as
opposed to non-deductible dividends) creates an incentive to make extensive use of debt
financing. Banks’ access to fixed-rate deposit insurance also makes debt in the form of deposits a
low-cost source of finding. When combined with this federal insurance subsidy, depositors’
5
further reduction of their required interest rates for the liquidity and convenience of demand and
time deposits is an added incentive for banks to use this form of leverage. The advantages of debt
financing for commercial banks suggests that holding a large capital buffer will be costly.
The benefits of increasing financial leverage must, of course, be weighed against the costs.
In the extreme case, high leverage can lead to default and a costly reorganization. But there are
also significant costs to banks that can arise in cases of financial distress that are much less
extreme. For one thing, FDICIA imposes heavy costs (in the form of increased regulatory
oversight) on banks that violate the minimum capital standards. But the most serious deterrent to
high leverage in banking is the possibility for liquidity constraints to cause major disruptions on a
bank’s operating activities. As Merton and Perold (1993) pointed out, banks and other financial
firms can be distinguished from industrial companies by the fact that their customers are often also
their largest liability holders. For example, a banks’ depositors, swap counter parties and letter-of-
credit beneficiaries all have liability claims on the bank. And because these customers place a
premium value on assurances of performance on their contracts, they show a strong preference
for banks with a high credit quality. As a consequence, a high credit rating is generally held to be
essential for a bank to be a major swaps dealer, to underwrite securities or to compete effectively
1
in the corporate banking market.
l
This argument also suggests that if the importance of a high credit rating varies with the
type of business, the capital requirements will vary. Requiring all businesses to be capitalized at a
particular level may create an additional burden for those businesses that require a lower credit
rating.
6
In sum, the benefits of debt financing for banks suggests that there are costs associated
with holding a lot of capital. This implies that risk-management concerns will enter into capital
budgeting decisions. This has two important implication for the design of a capital allocation
system. First, when evaluating the risk of a new project or business unit the project’s contribution
to the overall variability will affect the project’s hurdle rate or cost of capital. In particular, Froot
and Stein show that assuming a simple one factor pricing model (for tradable risk) the hurdle rate
the bank for an investment project will take the following form:
Where:
Intuitively, the hurdle rate reflects the business unit’s priced risk plus the contribution of
the project to the overall volatility of the bank’s cash flows. The price for the bank specific risk
will vary directly with the cost of external financing and the cost of capital short falls. The
7
important insight of this model is that given the market frictions that make risk management and
capital structure matter, bank-specific risk factors are an important element of the capital
budgeting process.
A second implication of these market frictions is that the bank should hedge all tradable
risks-- risk that can be hedged at little cost in the capital market. This implication follows directly
from the fact that the bank’s required price for bearing tradable risk will exceed the market price
for the risk by the contribution of a hedgable risk to the overall variability of the bank’s portfolio.
The only risk the bank should assume are illiquid or nontradable risk in which it has a comparative
advantage in bearing (perhaps as a result of it’s information producing activities in the capital
markets). Currency and interest rate risk would appear to fall into the tradable risk category,
while credit risk (particularly arising from lending to nontraded entities) would fall into the
nontradable category.
Agency and information problems that make external financing costly, also provide
incentives for diversification and the creation of an internal capital market in which capital is
allocated by a centralized headquarters. Specifically, as discussed in Stein ( 1996) an internal
capital market can improve investment efficiency when agency problems between managers and
outside investors create credit constraints. The basic idea is that unlike private lenders,
headquarters has control rights over projects that provide incentives for “winner picking”-- the
practice of shifting funds from one business unit or project to another. The improvement in
efficiency arises from headquarters’ ability to derive private benefits from several projects
8
simultaneously, but unit managers can only derive benefits from a single business unit. This
implies that headquarters will sometimes be willing to take finds from weaker projects and
allocate these finds to relatively strong projects. Moreover, in allocating capital within an internal
capital market, the relative rankings of projects is important. Thus, an ordinal measure of the
value added associated with the bank’s business unit will be need to allocate capital among
competing business units.
In summary, capital market frictions provide an economic rational for risk management
and the allocation of capital based, in part, on the contribution of an individual project to the
overall volatility of the cash flows of the bank. Moreover, to the extent that these frictions lead to
credit constraints, allocating capital to a diverse set of projects based on an ordinal measure of the
value of the project can increase investment inefficiency. Before discussing the implications of this
analysis for the design of RAROC systems, I briefly discuss recent empirical evidence on effect of
capital market fictions on bank investment and the operation of internal capital markets in
banking.
Empirical Evidence Concerning Capital Constraints
The preceding discussion suggests that rationale for risk management and how capital is
allocated will depend on the importance of external financing constraints that banks face. How
important are these constraints? A recent study by Houston James and Marcus (1996) , provides
empirical evidence on the importance of external financing costs in banking. Specifically they
examine the relationship between loan growth (the equivalent in banking to investment activity)
9
and internally generated finds for a sample of 281 bank holding companies and approximately
2,000 of their subsidiaries over the period 1981 through 1989. Following Frazzari, Petersen, and
Hubbard (1988), capital market imperfections are assumed to create a wedge between the cost of
internal and external financing that is reflected in a sensitivity of loan growth to bank earnings.
Their results are reported in Table 1. Notice that loan growth is significantly related to internally
generated additions to capital after controlling differences in the ratio of the market to book value
of equity (a measure of growth opportunities). Moreover, the sensitivity of loan growth to
internally generated finds is significantly higher for holding companies at or below the regulatory
minimum capital ratio.
Further evidence on the importance of financing constraints is provided by examining the
relationship between loan growth of individual subsidiaries of bank holding companies and the
subsidiaries own cash flows as well as the cash flows of other subsidiaries with in the same
holding company. Specifically, following an approach similar to Lament (1996) we examine
whether loan growth at relatively small (less that 15 percent of the holding company assets)
subsidiaries of bank holding companies depends on the capitalization of the holding company and
the earnings of other subsidiaries within the holding company. If bank holding companies are
capital constrained and allocate capital according to the relative value of projects then one would
expect a negative relationship between loan growth at a subsidiary and loan growth of other
subsidiaries of the holding company.
10
The results of the analysis are presented in Table 2. Notice that loan growth of the
subsidiary is positively related to the both the subsidiaries own cash flows and the cash flows of
the other subsidiaries within the holding company. Moreover, the coefficient estimate on the cash
flows of other subsidiaries is significantly greater that the coefficient on the subsidiaries own cash
flows. More importantly, we find a negative and statistically significant coefficient on the loan
growth of other subsidiaries within the holding company. This is evidence consistent with the
operation of an internal capital market, in which the holding company “picks winners” (and “sticks
loser”),
Implications For the Design of Capital Budgeting Systems
At Bank of America, the capital charge for each business is obtained by multiplying
economic capital by the same, corporate-wide cost of equity capital -- the so-called “hurdle rate.”.
A project or business unit is then evaluated according to its expected “residual income” -- or what
B of A calls the “economic profit .“ Economic profit is calculated as earnings (net of taxes,
interest payments and expected credit losses) less a charge for the cost of equity capital. The
amount of capital allocated varies with the contribution of the project to the overall volatility of
the earnings of B of A (the project’s so called internal beta).
How well does this methodology conform with the capital budgeting framework
discussed above? First note that the capital allocation system is designed so that an equity
investment in each project will have the same risk. This is accomplished by assigning more capital
to riskier projects. Assuming for the moment that the right measure of risk is used to allocate
11
capital, this procedure implies that the same cost of equity capital should be used to evaluate all of
the projects in the bank. In particular, allocating capital in this way ensures that even though risk
on an “unlevered” basis may vary widely across the various activities of the bank, on a levered
basis, the risk of various activities are the same. Second, notice that capital is allocated according
to the project’s internal beta and not the project’s systematic or priced risk. One reason for this is
the difficulty of estimating betas for individual lines of business with few stand-alone competitors.
And given the lack of objective data, the “influence costs” due to disputes among managers
assessed different costs of capital were likely to be significant.
More importantly, if the bank’s main concern is with providing a relative ranking of
competing projects, (consistent with operating an internal capital market), and the bank lays off
“hedgable” risks, allocating capital based on internal betas will, in general, accomplish this goal.
To see this, suppose that the proper method of allocating capital involves allocations based on a
two factor model similar to the one described in equation (1). In particular, the true cost of capital
(or alternatively the amount of equity capital allocated to a project) is determined by the projects
“market beta” and the projects internal beta. Instead of using this model, the bank allocates capital
according to estimates of each projects internal beta (i.e the covariablity of the project’s returns
with the banks existing portfolio of projects). The resulting estimates of project risk will suffer
from omitted variable bias (since the market return is omitted).
12
While the resulting risk estimates are biased and inconsistent, the bias is likely to be small
2
if the bank lays off the unit’s hedgable risk. A number of banks allocate capital based on either
total project risk (variance) or a project’s systematic risk. But neither of these methods will
preserve relative rankings. However, if equation (1) reflects the cost of capital, these alternative
2
Formally, suppose that the true model is
Where Rm= market return and Rp= Return on the bank’s existing portfolio.
Instead of estimating (2), the bank estimates a single factor model:
The resulting estimate of the internal beta is biased since,
However, to the extent that the bank lays off hedgable risks associated with the projects
13
3
allocation schemes do not preserve relative rankings.
RAROC, Economic Profit and Performance Measurement
In addition to capital structure planning, RAROC systems are used to evaluate the
performance of business units for purposes of compensating line managers. At many banks,
including B of A performance is evaluated according to the “residual income” -- or what B of A
calls the “economic profit” -- of the activity. The objective of this calculation, again, is to provide
an ex-post measure of the value added by a particular activity -- one that allows the economic
profit of “off-balance-sheet” activities to be compared to that of traditional asset-based activities,
The value added associated with each activity can then be used as a basis for determining
incentive based compensation for line managers.
Using capital allocations for both capital budgeting and management performance
evaluations raises the question of what is the appropriate measure for measuring risk. Bank of
America allocates capital according to the nonhedgable risk that originates in a business unit, For
example, in lending activities, the net income of loans is calculated assuming “matched duration”
finding, i.e., the loan is funded in a way that removes the interest-rate risk associated with the
loan. This process also removes from the capital calculation volatility arising from risks that can
3
See Uyemura, Kantor and Pettit (1996) for a description of industry practices. It is
interesting to note that even if only systematic risk affects the cost of capital, using internal betas
still results in the correct relative rankings. This follows from the fact that the return on the bank’s
portfolio can be thought as a the return on the market portfolio measured with error. As a result
estimates of internal betas are biased and inconsistent estimates of market betas. However, the
bias is the same for all new projects and as a result relative rankings are preserved.
14
4
be easily hedged. The Treasury unit is responsibility for hedging interest rate and currency risk .
This process reduces the risk assumed by line managers (through variability in their compensation)
and focuses their attention on risk that they can potentially influence. As a result of this process,
most business units are allocated capital based on credit risk and business risk (volatility arising
from operational errors) and not based on volatility arising from hedgable risk.
A second and more subtle reason for basing compensation (through the capital allocation
process) on nonhedgable risks in the business unit is that these risk are likely to result from rent
seeking behavior of business unit managers. In particular, suppose that division managers derive
private benefits from growth in the size of their division. To the extent that riskier divisions are
allocated more capital and therefore face a higher capital charge, division managers can increase
their size by understatingthe risk of their division. Since division managers are likely to have
better information about the unique (nonhedgable) risk that arise in their department, rent seeking
behavior is likely to take the form of obscuring this risk. By evaluating performance based on the
realized outcomes of a position (net of hedgable risk) relative to management forecasts, this type
of rent-seeking behavior can be mitigated.
Given the discussion concerning why banks allocate capital, I turn next to a discussion of
the system used by Bank of America for allocating capital and evaluating the performance of its
business units.
4
To the extent that the Treasury does not hedge interest rate and currency risk, then it is
allocated capital in proportion to these hedgable risk.
15
II. RAROC at Bank of America
Until late 1993, the primary profitability measure in management reports at B of A was
return on assets -- net income divided by total assets. For several years, the Bank had struggled
with little success to measure performance on a risk-adjusted basis. Like many other banks, B of
A had attempted to apply Risk Based Capital Guidelines to profitability measurement. Using
regulatory requirements to determine the equity levels of each business, the bank had developed
for purposes of capital budgeting and performance evaluation a complicated process for assigning
different risk-based hurdle rates to each business. But, because of the difficulty of reconciling
regulatory equity requirements with a portfolio-based risk framework, this approach met with
considerable internal resistance.

In November 1993, efforts to redefine performance measurement were given high priority.
A Risk & Capital Analysis Department was formed at the Bank and given the responsibility of
developing the overall framework for risk-adjusted profitability measurement, Senior management
pressed for quick implementation. The overall development process was allotted just four months.
The initial staffing of the department included a manager and four financial analysts.
The short-term objective of the RAROC project was to develop a comprehensive and
consistent methodology for attributing capital to the bank’s “first-tier” business units. Following a
pilot test in the Bank’s U.S. Corporate Group, an initial set of RAROC calculations were
performed for 45 different lines of business. Since successful completion of this first pass in
16
March of 1994, the Bank has been progressively integrating RAROC concepts into existing
management and reporting systems.
The Framework
Risk is defined by Bank of America as any phenomenon that creates potential volatility in
the economic cash flows of the bank. The purpose of risk capital is to provide comprehensive
coverage of losses for the organization as a whole. By “comprehensive,” they mean coverage of
all sources of risk with a very high degree of confidence.
Bank of America has identified four major categories of risk associated with its various activities:
● Credit risk is the risk of loss due to borrower default. In addition to default risk on loans,
credit risk also includes a trading counterpart’s failure to pay on a contractual obligation.
● Country risk is defined as the risk of loss on cross-border and sovereign exposures due to
governmental actions. Suspension of hard currency payments, radical devaluation of the
currency and nationalization of assets held as investments are some examples of such
government actions.
● Market risk is the risk of loss due to changes I the market price of the Bank’s assets and
obligations. Examples of market risk are foreign exchange risk, interest-rate risk and
options risk on mortgages and deposits.
● Business risk is the uncertainty of the revenues and expenses associated with non-portfolio
activities, such as origination, servicing and data processing. Business risk is a function of
17
general industry factors, company-specific factors and external factor, such as
technological advances and regulatory changes.
Risk can be measured along two dimensions -- expected loss and unexpected loss.
Expected loss is the average rate of loss expected from a portfolio. In the case of credit risk,
expected losses are reflected in loan rates and fees. Because such losses are intended to be
covered by operating earnings, they are reported in required loan-loss provisions on a bank’s
P&L. It is unexpected loss that creates the need for economic capital. And, for each of the four
sources of risk associated with a given business unit, it is unexpected loss that determines
economic capital.
Capitalization and Confidence

How much protection is sufficient against unexpected losses? At Bank of America, the
total amount of economic capital attributed to all of the business units is the amount that is
estimated to guarantee the solvency of the bank at a 99. 97°/0 confidence level.
Senior management’s choice of the 99.97% coverage level -- alternatively, a .03 °/0 probability of
default -- was determined by evaluating the implicit risks and default rates of public debt projected
over a one-year horizon. As shown in Table 3 the 99. 97°/0 coverage level was sufficient to
reduce the risk of the bank to the average levels for AA-rated companies.
18
Time Horizon for Measuring Risk
Over what time period should risks be measured? In theory, the choice of time horizon for
measuring risk is arbitrary. One could use volatility measured over five-year or even 10-year
intervals, with the aim of capturing “full cycles” in risk. On the other hand, it is hard to get reliable
data for such long periods, particularly on unfamiliar businesses. And one may be able to get
reasonably precise measurements using volatility over much shorter periods of time.
B of A has chosen to calculate both expected and unexpected loss using a common one-
year time horizon to ensure consistency across the organization. This choice of time horizon is
somewhat of a compromise between a credit-risk and a market-risk perspective. If the time

5
horizon is not consistent, then comparability of return measures is lost.
Another key consideration was to ensure the measures of risk are both as current and as
forward-looking as possible. Both risk measures and capital assignments are updated quarterly.
By assigning levels of capital based on anticipated future risks, rather than on historical volatility,
the system is designed to encourage managers to make changes in the business mix of their unit or
in the composition of the credit portfolio -- changes that will improve the risk-reward profile of
the bank while increasing their own RAROC and economic profit.
5
As noted, the average default rate for AA firms was approximately .03% over that
horizon. Measured over a 10-year-horizon, the default probability for AA loans would be 1.00%
or more. But, in that case, our required confidence level would fall from 99, 97°/0 to 99. 00°/0 or
less, and, thus, the amount of capital required would not necessarily increase as a consequence of
lengthening the horizon.
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Capital and Probability Distributions
To achieve the targeted confidence level for the capitalization of any business, it is
necessary to consider not only the volatility of that business’ results, but also the probability
distribution of potential outcomes. Is the distribution a “normal,” bell-shaped curve, in which high
and low outcomes are roughly symmetrical? Or is the distribution highly “skewed,” with losses
tending to become very large at the extreme end of the distribution? The probability distribution is
important because it will determine the number of standard deviations of unexpected losses to
achieve the 99. 97°/0 confidence interval.
For example, for risks that can be characterized as having normal distributions (such as
interest rate, foreign exchange and other “market risks), capital coverage of 3.4 standard
deviations is consistent with a 99.97% confidence interval. For credit losses, by contrast, the
empirical data suggest that the distribution is not normal, but is highly skewed. And the very small
possibility of very large losses require capital coverage of credit risks of six standard deviations to
achieve the same 99. 97% confidence interval.
Defining Risk: Volatility of Book Capital or Market Value?
But this system raises a theoretical issue that has considerable practical import: In setting a
capital structure target for a bank, how does one measure the volatility of its value or the value of
its individual units? Is the value that of the bank’s stock price or of some proxy for market value,
such as a business unit’s economic cash flows? Or is it the volatility of the bank’s reported
20
earnings and book capital -- the main focus of the regulators -- that is critical in determining
capital adequacy.
Given the rationale for managing the capital position of a bank presented earlier -- the
relevant measure of risk for determining capital adequacy is the volatility of a bank’s cash flows,
not the volatility of its book or regulatory capital.
And just as a bank’s overall capital should depend upon the volatility of its cash flows,
capital allocations to individual business units of the bank should be made on the basis of the
“contribution” of each business unit to the overall volatility of the bank’s cash flows. For many of
the fee-based activities of banks, this arrangement will likely mean assigning considerably more
capital than such operations require in their day-to-day execution. Take the cases of securities
underwriting and the issuance of commitments. Although neither requires much capital for day-to-
day finding of operations (what Merton and Perold (1993) refer to as “cash capital”), both
require the implicit backing of significant amounts of the bank’s capital (“risk capital,”)
Measuring and Capitalizing the Four Sources of Risk
The risk measurement and capital assignments for each of the four sources of risk are
made at the lowest level of the organization that the data will support -- in some cases, down to
the level of the individual facility or transaction. Such a bottom-up, or building-block approach
allows capital to be aggregated or desegregated at various levels and in various ways without
distorting the results. For example, capital can be assigned not only to lines of business, but also,
in many cases, to individual products that cut across the different business units.
21
Credit risk, or the risk of loss due to borrower defaults, is attributed to all units with
borrower counterpart exposure (commercial borrowers, consumer borrowers and trading
counterparties). For commercial portfolios, both credit and country risk capital are calculated at
the individual loan level. This method of calculation allows for the finest possible gradation of
risk. In the case of consumer loans, the sheer volume of such loans makes it cost-effective to
perform credit-risk calculations only down to the “sub-portfolio” level. Sub-portfolios are defined
to be relatively homogeneous groups of loans with the primary stratification based upon the
product and risk classification.
The total amount of credit capital depends on a number of factors. The most important are
the internal credit rating of the borrower and the dollar amount of exposure. Other factors that
some into consideration are the amount of unutilized commitment, the type of collateral
supporting the credit, the instrument type, the size of the exposure relative to the total portfolio
and the industry of the borrower.
Country risk is the risk of loss -- independent of the borrower’s financial condition -- on
foreign exposures arising from government actions. Country risk is attributed to all business units
with cross-border and sovereign exposures. Because country and credit risk are close related, B
of A’s country-risk approach closely parallels its credit risk methodology. The key difference is
that the risk rating of the country is used in place of the customer’s internal risk rating. The
country risk of a cross-border exposure is treated as equivalent to a direct loan to the government
where the loan is domiciled.
22
Market risk is the risk of loss due to changes in the market prices of traded assets and
obligations of the bank. It arises most obviously from an outright position or from an explicit
derivative. At B of A two general processes are used to measure market risk. For most trading
activity, market risk is measured using a “value at risk” or (VAR) framework. For products with
options risk exposure, such as mortgages and home equity loans, the market risk is estimated
using Monte Carlo simulation. Market risk capital is calculated at the trading unit or portfolio
level, with adjustments made to account for diversification associated with the correlation
between trading rooms.
Business risk includes all the risks that the bank is subject to as a result of operating as a
going concern business, but excluding the three portfolio risks listed above. B of A’s current
method for measuring business risk is based on average capitalization rations for non-financial
firms in retail and wholesale industries. Also, now being considered, however, are alternative
approaches, notably, use of performance volatility measures or “pure plays” for possible
implementation by the end of 1996. It is interesting to note that the majority (over 75 percent) of
the capital B of A holds is for credit risk and business risk. This allocation is consistent with a
strategy of hedging most market risk.
23
A Closer Look at Credit Risk
Measurement of credit risk at B of A involves a six step process. The first step is the loan
officer in conjunction with internal credit analysis group to estimate the likelihood of default. This
estimation process for commercial credits is based on a proprietary credit rating model in which a
loan is assigned one of six credit ratings. The default probability associated with each of the credit
ratings is provided in Table 4. The second step in the process is to estimate the bank’s exposure
given default. This involves estimating the outstandings associated with a line of credit given a
default (useage tends to increase immediately prior to a default). Exposure estimates vary with the
type of credit and initial credit rating and are based on historical data. The next step in the process
is to estimate the severity of loss given default. This estimate is based on the collateral type and is
again based on historical data. Given this information the expected loss is simple the default
probability times the exposure and the severity of loss. An estimate of the volatility of loss is based
on a binomial standard deviation formula:
Where: EXP = Exposure LGD = Loss Given Default DP = Default Probability
VOL = Volatility of Severity S = Relative Size Factor C = Correlation
24
Business Unit Calculations
The risk measures described above provide the basis for assigning capital to each of the
bank’s 45 business units. Such capital assignments in turn allow for periodic calculations of
RAROC and economic profit. Every quarter a management briefing book of RAROC and
economic profit performance is distributed to senior management, business managers and senior
finance officers. This book shows results for the current quarter, an eight-quarter trend, and a
projection of the plan for the entire bank and its 45 business groups. Reports and graphics are
presented that allow comparisons of RAROC, economic profit and capital invested across all
business groups.
Calculating RAROC
The calculation of RAROC is relatively simple once all the risk calculations have been
completed. RAROC is computed by dividing risk-adjusted net income by the total amount of
economic capital assigned based on the risk calculation.
The starting point for the numerator is B of A’s management-reporting system. The
existing system allocates income and expense items down to the unit level. This system reports
not only direct revenues and expenses, but also transfer pricing allocations, charges for internal
services and overhead and tax allocations.
Risk-adjusted net income is then determined by taking the financial data allocation to the
businesses and adjusting the income statement for expected loss. A second adjustment is also
25
required to take into consideration the effects on the net interest margin of the change in the
capital accounts as the focus is shifted from book profitability to economic profitability.
Conclusion
This paper describes the capital allocation process used by Bank of America. The way in
which B of A allocates capital is consistent with the existence of market frictions that create a
wedge between the cost of internal and external funds. Moreover, the capital allocation process is
an integral part of not only the capital budgeting process of the bank but also of the performance
evaluation system of senior management. This dual purpose implies that

26
Table 1
Loan Growth and Internally Generated Additions to Capital
Fixed effects regressions relating loan growth to internal additions to capital, capital requirements and firm financial characteristics.
The sample consists of bank holding companies over the period 1981-1989 (t-statistics in parentheses).
a Additions to capital equal net income (before extraordinary items) plus additions to loan loss reserves
b Surplus capital equals actual capital less capital required to meet minimum capital requirements.
c Bind =1 if surplus capital is less than or equal to zero
27
Table 2
Subsidiary Loan Growth, Holding Company Internal Additions to Capital and Loan Growth in Related Subsidiaries
Regressions relating subsidiary loan growth to internal additions to capital, capital requirements and subsidiary and bank holding
companies financial characteristics. The sample consists of 2000 subsidiaries of 178 multiple bank holding companies from 1986-
1990 (t-statistics in parentheses). *
28
Table 3
29
By Rating Class
Estimated Default Probabilities
Table 4
Commercial Credit Capital Allocation by BACRR
First Quarter 1996
(Dollars in Millions)
Summary Results
30
References
Fazzari, S.M., R.G. Hubbard and B.C. Peterson. 1988. “Financing Constraints and Corporate
Investment,” Brookings Paper on Economic Activity, 1:141 -95
Froot, K. and J. Stein. 1995. “Risk Management, Capital Budgeting and Capital Structure Policy
for Financial Institutions: An Integrated Approach,” NBR Working Paper #5403
Houston, J., C. James and D. Marcus 1996. “Adverse Selection Problems and Bank Lending:
Evidence From Internal Capital Markets,” working paper, University of Florida.
Lament, O. 1996. “Cash Flow and Investment: Evidence from Internal Capital Markets,”
forthcoming, Journal of Finance.
Merton, R. and A. Perold. 1993. “Theory of Risk Capital in Financial Firms,” Journal of Applied
Corporate Finance, 6: No.3.
Stein, J. 1996. “Internal Capital Markets and Competition for Corporate Resources,”
forthcoming Journal of Finance.
Uyemura, D.
31

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Financial RAROC Based Capital Budgeting

Institutions and Performance Evaluation:

The Wharton Financial Institutions Center provides a multi-disciplinary research approach to

they pursue competitive excellence.

The Working Paper Series is made possible by a generous

Draft: September 22, 1996

Christopher James is at the Graduate School of Business, University of Florida.

thus, to determine the overall leverage for the bank as a whole.

RAROC (risk-adjusted return on capital), is to provide a uniform measure of performance.

input to the compensation system used for senior managers,

of developing and implementing a system to measure economic returns provides an interesting

case study in the application of financial theory to real business problems.

I begin by discussing the economic rational for allocating capital in a diversified

trading activities, as well as traditional lending.

the optimal level of equity capital for the entire bank.

For performance-evaluation purposes, RAROC systems assign capital to business units as

effective capital budgeting and incentive compensation at the business-unit level.

RAROC and Financial Theory

investment activity for the bank.

opposed to non-deductible dividends) creates an incentive to make extensive use of debt

allocated by a centralized headquarters. Specifically, as discussed in Stein ( 1996) an internal

competing business units.

Empirical Evidence Concerning Capital Constraints

of equity (a measure of growth opportunities). Moreover, the sensitivity of loan growth to

minimum capital ratio.

Further evidence on the importance of financing constraints is provided by examining the

holding company. Specifically, following an approach similar to Lament (1996) we examine

subsidiaries of the holding company.

Implications For the Design of Capital Budgeting Systems

the earnings of B of A (the project’s so called internal beta).

assessed different costs of capital were likely to be significant.

from omitted variable bias (since the market return is omitted).

Instead of estimating (2), the bank estimates a single factor model:

The resulting estimate of the internal beta is biased since,

RAROC, Economic Profit and Performance Measurement

including B of A performance is evaluated according to the “residual income” -- or what B of A

profit of “off-balance-sheet” activities to be compared to that of traditional asset-based activities,

incentive based compensation for line managers.

of rent-seeking behavior can be mitigated.

considerable internal resistance.

management and reporting systems.

all sources of risk with a very high degree of confidence.

governmental actions. Suspension of hard currency payments, radical devaluation of the

options risk on mortgages and deposits.

technological advances and regulatory changes.

Capitalization and Confidence

somewhat of a compromise between a credit-risk and a market-risk perspective. If the time

achieve the 99. 97°/0 confidence interval.

achieve the same 99. 97% confidence interval.

Defining Risk: Volatility of Book Capital or Market Value?

not the volatility of its book or regulatory capital.

Measuring and Capitalizing the Four Sources of Risk

borrower counterpart exposure (commercial borrowers, consumer borrowers and trading

product and risk classification.

and the industry of the borrower.

where the loan is domiciled.

between trading rooms.