P2.T7.24.11 Types of Capital Requirements and RAROC

[Nicole Seaman]

Learning Objectives: Define, compare and contrast risk capital, economic capital and regulatory capital, and explain methods and motivations for using economic capital approaches to allocate risk capital. Describe the RAROC (risk-adjusted return on capital) methodology and its use in capital budgeting.

Questions:

24.11.1. Due to foreseen market volatility, the Board has unanimously agreed to raise $15 million in capital to reduce leverage. The Board has tasked the Chief Risk Officer (CRO) with determining criteria for better-allocating resources to manage any liquidation risks while aligning with economic realities and regulatory requirements.

The CRO, in his report, writes the following:

• Statement 1: $10 million of the capital will serve as a cushion to absorb unexpected losses from the firm’s activities, calculated to ensure the firm remains solvent under stress scenarios up to a 99.9% level of confidence.
• Statement 2: $5 million will cover potential losses or any write-offs from investments anticipated to have a high probability of success initially. This amount is proxied by spent capital and goodwill, capturing the notion that the capital may be spent without providing future returns or only very low returns.

Which of the above statement(s) pertain to Strategic Capital and Economic capital?

a. Both pertain to Strategic Capital
b. Statement 1: Strategic Capital, Statement 2: Risk Capital
c. Both pertain to Risk Capital
d. Statement 1: Risk Capital, Statement 2: Strategic Capital


24.11.2. A leveraged fund needs to determine how much capital is required to maintain solvency at a 99.5% confidence level, given the inherent inability to guarantee viability under extreme circumstances. The fund's total portfolio value is $2 billion. Given that average expected losses are $50 million, there is an anticipated increase in the worst-case loss scenario from $500 million to $1 billion.

Which of the following is closest to an increase in the fund's Economic Capital Requirement?

a. $950m
b. $450m
c. $500m
d. $1bn


24.11.3. The bank's Audit and Risk Committee (ARC) is reviewing the performance of $100 million in new loans generated during the year. The Risk-Adjusted Return on Capital (RAROC) projected at initiation was 8.23%. By year-end, the actual RAROC was -1.40%. The Chairman of the Audit and Risk Committee has requested insights from the internal audit and finance departments regarding this variance.

The following information was shared with both departments:

• Economic capital: 40%
• Expected revenue: 7%
• Return on Economic Capital: 1%
• Expected credit loss on loans: 3%
• Operating costs: 2.5%
• Taxation: 30%
• Sector-wide credit spreads had narrowed.

Finance department: The RAROC was miscalculated because the initial estimates did not accurately factor in the expected losses. Additionally, actual operating costs were double the anticipated amount, which contributed to the discrepancies.

Internal Audit: The initial RAROC calculation was accurate; however, the variance was primarily due to macroeconomic and systematic factors across the sector, not due to any errors in budgeting.

Which statement is most likely to be correct?

a. Finance Department
b. Internal Audit Department
c. Both are correct
d. Both are incorrect

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