Risk-Adjusted Return on Capital (RAROC) is a powerful risk measurement tool that assists banks and financial institutions both in measuring solvency and evaluating the performance of different business activities. The increased interest in measuring risk is partly a response to the greater regulatory emphasis on capital adequacy that has come with the implementation of the Basel II risk-based capital requirements.

Though the RBI is expecting banks to move towards a standardised approach, a capital-conscious bank would move towards an advanced Internal Rating-Based (IRB) approach. There have been fundamental changes in the business of banking which have awakened interest in risk measurement tools.

The real innovation in these new performance evaluation tools lies in their ability to allocate banks' scarce capital among their expanding array of activities. While regulatory capital focuses on satisfying the objectives of the regulator, economic capital looks at internal management of the business to maximise shareholder return. RAROC and EVA are credible tools and key drivers for conscious decision-making.

As different businesses have different risk profiles, comparing the long-run performance of the banking business using traditional measures like return on assets (ROA) or return on equity (ROE) can be complicated and misleading. RAROC attempts to address the issue of capital allocation from the perspective of improving performance - measured from both the inside as well as outside of the bank.

What we generally call profits are usually not profits at all. Until a business generates a profit figure that is greater than the cost of equity capital (the hurdle rate), it crushes shareholders' value. In order to meaningfully compare RAROC in various businesses, economic profit should be based on 'required economic capital allocations', consistent with the bank's core solvency level target. The allocation of capital as per economic profit would actually enhance shareholders value.

By definition, RAROC is the ratio of risk-adjusted net income to the level of risk the asset or portfolio has. This can also be estimated at region/branch level to assess the profitability of a bank on a granular basis. Similarly, RAROC can also be used to assess the profitability of a loan portfolio (for example, retail assets portfolio, corporate assets portfolio, SME portfolio and so on). Once RAROC is computed, the bank's top management can compare it with a benchmark hurdle rate which is the opportunity cost of taking a risk in the business.

The hurdle rate has to be benchmarked to the market rate which is based on the shareholder's expectation of the bank's stock return on a risk-adjusted basis. Hurdle rates vary from bank to bank depending upon stock volatility vis-�-vis the volatility in the market index (beta). It is worthwhile to mention that the five-year annual average return in the stock market (S&PCNXNIFTY) is 30.73 per cent on a pre-tax basis.

Since equity income is taxable, the post-tax annual average return comes around 20.59 per cent. If the risk-free rate is 7.75 per cent (364 T-bill rate in India in 2007) and the beta of a bank is 1; then using CAPM, the hurdle rate for the bank would be=7.75%+1�(20.59%-7.75%)=20.59%.  A bank should necessarily know whether it is really making a profit from its business/business segments. To evaluate the risk-adjusted profit position, it should compare its post-tax RAROC with its individual cost of capital. This difference (that is, the difference between RAROC and Hurdle Rate) is called the "Economic Profit" (EVA).

At NIBM, we have developed a RAROC and EVA methodology which can compute overall bank performance on a risk-adjusted basis. The analyses can be further extended in evaluating risk-adjusted performances of zones/regions and finally at the branch level. In addition, a bank can also evaluate the performance of its various business segments and ultimately trace the contribution of each portfolio on the RAROC-EVA axis.

The chart illustrates how a relatively medium-sized public sector bank with twelve regional offices can use the RAROC-EVA tools. The analysis reveals that the bank is making economic profits from Mumbai, Ahmedabad and Delhi regions on a risk-adjusted basis. However, Bangalore, Pune, Bhuj, Kolkata, Bhopal, Thane and Meerut regions of the bank are making low returns which are far below its hurdle rate (22.44 per cent) on a post-tax basis. The bank can use this analysis to target the performance of individual regions and bring them above the hurdle.

The calculator also facilitates setting return targets, deposit mix, rates and volumes, advance, mix, rates and volumes, other income, recovery targets and so on.  It also prods the bank to move away from the traditional 'Transfer Pricing Mechanism (TPM)' to 'Fund Transfer Pricing Mechanism (FTP) to generate the desired business profile to augment its performance. The table shows the comparison of the loan portfolio performances of various Indian banks on RAROC and EVA bases. One can clearly see that these banks differ greatly in terms of their RAROC and EVA.

A bank's risk managers should understand that in the emerging realities of the market, if the bank's equities are not on the efficient frontier, rational investors would sell their security interests in the bank and switch over to more risk-efficient securities. Future debt holders would also demand higher yields in order to offset the riskiness in financing the bank. As a result, the bank management will be forced to generate higher returns to compensate investors.

The RAROC and EVA framework is a top-down integrated approach to wealth maximisation and would help the top management formulate growth plans to maximise returns from business through appropriate pricing and return strategies across branches and regions. Here are the benefits of the RAROC and EVA system for banks:

• As banks become 'capital-hungry' to meet their growth expectations and simultaneously meet the regulatory requirements in the Basel-II era, they would have to remain responsive to the expectations of the market on a risk-adjusted basis to ensure the continued supply of financial capital from shareholders and human capital from the ultimate stakeholders.

• One of the fundamental limitations in the existing business growth strategies of Indian banks, especially public sector banks, is their virtual, if not complete, disconnect with riskiness. 'Profit-rich but risk-poor' strategies are doomed for failure in the long run!

•  The finalisation of business targets should no longer remain a mundane 'volume-mix' targeting exercise but should incorporate inherent risk-return dimensions. Business strategies that ensure risk and return by choice and not by chance are key to ensure the continuing success of banks in the emerging market.

•  In order to align the performance of individual zones/regions/branches to the overall corporate expectations in terms of RAROC and EVA, the vocabulary of risk management has to percolate down to the individual unit level.

• New performance benchmarks in the form of RAROC and EVA should form the unifying cord in every bank.

Bandyopadhyay is Assistant Professor, Finance, NIBM and Saha is Director, NIBM. They can be reached at arindam@nibmindia.org and director@nibmindia.org, respectively.