Risk-adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing

a consistent view of profitability across businesses. The concept was developed by Bankers Trust and principal designer Dan Borge in the late 1970s.
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Note, however, that more and more return on risk adjusted capital (RORAC) is used as a
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measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel III.
Contents
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1 Basic formula 2 See also 3 References 4 External links

[edit]Basic

formula
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RAROC = (Expected Return)/(Economic Capital) RAROC = (Expected Return)/(Value at risk)

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or

Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, it is a buffer against expected shocks in market values. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. 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 the risk-free rate. RAROC system allocates capital for two 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 structurethat is 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.

BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11. The third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision, credit rating agencies. Ratings of creditworthiness and of bonds, financial bundles and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings onmortgagebacked securities, credit default swaps, and other instruments that proved in practice to be extremely bad credit risks. In Basel III, a more formal scenario analysis is applied (three official scenariosv from regulators, with ratings agencies and firms urged to apply more extreme ones). The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.050.15%.
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Outside the banking industry itself, criticism was muted. Bank directors would be required to

know market liquidity conditions for major asset holdings to strengthen accountability for any major losses.
Contents
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1 Overview 2 Summary of proposed changes

2.1 US implementation

3 Macroeconomic Impact of Basel III 4 Key dates

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4.1 Capital Requirements 4.2 Leverage Ratio 4.3 Liquidity Requirements

5 Studies on Basel III 6 See also 7 References 8 External links

[edit]Overview

Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress. [edit]Summary
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of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised. Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings Tier 2 capital instruments will be harmonised Tier 3 capital will be eliminated.
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Second, the risk coverage of the capital framework will be strengthened. Promote more integrated management of market and counterparty credit risk Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transactions Raise the capital buffers backing these exposures Reduce procyclicality and Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses) Provide incentives to strengthen the risk management of counterparty credit exposures Raise counterparty credit risk management standards by including wrong-way risk

Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II riskbased framework. The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.

Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). The Committee is introducing a series of measures to address procyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios. Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).
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Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress. )
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The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% for tier 1 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)' [edit]US

implementation
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The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules. It summarized them as follows, and made clear they would apply not only to banks but to

all institutions with more than US$50 billion in assets:

"Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions" - see scenario analysis on this. A risk-based capital surcharge

Market liquidity, first based on the US's own "interagency liquidity risk-management guidanceissued in March 2010" that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime - see below.

The Federal Reserve Board itself would conduct tests annually "using three economic and financial market scenarios." Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information, would be made public" but one or more internal company-run stress tests must be run each year with summaries published.

Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit."

"Early remediation requirements" to ensure that "financial weaknesses are addressed at an early stage". One or more "triggers for remediation--such as capital levels, stress test results, and riskmanagement weaknesses--in some cases calibrated to be forward-looking" would be proposed by the Board in 2012. "Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales."
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It was unclear as of December 2011 how these rules would apply to insurance, hedge funds and other large financial players. The announced intent was "to limit the dangers of big financial firms being heavily intertwined."
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[edit]Macroeconomic
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Impact of Basel III

An OECD study released on 17 February 2011, estimates that the medium-term impact of Basel III implementation on GDP growth is in the range of 0.05% to 0.15% per year. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To

the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.
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Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector, and it can ensure that past excesses are avoided. Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business.
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