Case 089Capital and regulationCore

A bank's corporate, retail and SME businesses each report income, expected loss and economic capital. With a 12% hurdle, compute RAROC by business and decide which one destroys value.

The situation

Irvalo Bank reports three businesses. Corporate lending earns Rs 300 crore of income net of funding and operating costs, carries an expected loss of Rs 120 crore and uses Rs 1,500 crore of economic capital. Retail earns Rs 450 crore, with Rs 200 crore of expected loss and Rs 1,200 crore of capital. SME lending earns Rs 200 crore, with Rs 110 crore of expected loss and Rs 900 crore of capital.

The board's hurdle rate, the return shareholders require on capital, is 12%. The head of corporate banking argues his business is the most profitable because it keeps the largest share of its income after losses.

Your task

What is each business's RAROC, which destroys value against the hurdle, and is the head of corporate banking right?

Quick check

Which business destroys value at a 12% hurdle?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

RAROC is 12.0% for corporate, 20.8% for retail and 10.0% for SME, so SME destroys about Rs 18 crore of value a year against the 12% hurdle. Corporate only just earns its capital. The head of corporate banking is measuring profit per rupee of income, where corporate leads at 60%; per rupee of capital at risk, retail leads by a wide margin. Capital should follow the second measure.

Step 1What does RAROC measure that profit does not?

It asks how much each business earns for the risk it makes shareholders carry. Two shops can each make Rs 1 lakh a month, but if one needed Rs 10 lakh of stock and the other Rs 50 lakh, they are not equally good businesses. RAROCRisk-adjusted return on capital: income after costs and expected loss, divided by the economic capital held against unexpected loss. divides profit after expected loss by the capital held for unexpected loss, so it compares businesses on the same footing.

The relationship
RAROC=income−expected losseconomic capitalSME=200−110900=10.0%\text{RAROC} = \frac{\text{income} - \text{expected loss}}{\text{economic capital}} \qquad \text{SME} = \frac{200 - 110}{900} = 10.0\%
incomerevenue net of funding and operating costs
expected lossthe average credit loss the business should expect each year
economic capitalcapital held against losses worse than expected
What it says in wordsTake the profit left after normal losses and divide by the capital needed to survive abnormal ones.
Step 2Which business clears the hurdle?

Corporate earns Rs 180 crore on Rs 1,500 crore, exactly 12.0%. Retail earns Rs 250 crore on Rs 1,200 crore, 20.8%. SME earns Rs 90 crore on Rs 900 crore, 10.0%. Turn each into value added by subtracting 12% of its capital: corporate adds nothing, retail adds Rs 106 crore and SME subtracts Rs 18 crore. The bank as a whole earns 14.4%, above the hurdle, which is exactly how a value-destroying business hides inside a profitable bank.

Return on the capital each business uses, against a 12% hurdle0%5%10%15%20%12.0%Corporatevalue +020.8%Retailvalue +10610.0%SMEvalue -1812% hurdleWhole bank14.4%RAROC
Irvalo's retail business earns 20.8% on its capital and adds Rs 106 crore of value, corporate earns exactly the 12% hurdle, and SME earns 10.0%, destroying Rs 18 crore a year even though the bank overall earns 14.4%.
Step 3Is the head of corporate banking right?

On his own measure, yes: corporate keeps 60% of its income after expected loss, against 55.6% for retail and 45% for SME. But that measure ignores how much capital each rupee of income ties up, and corporate ties up the most, Rs 1,500 crore for Rs 300 crore of income. Ranked by RAROC, retail is first and corporate a distant second.

BusinessProfit after EL, % of incomeRAROCValue added at 12%, Rs crore
Corporate60.0%12.0%+0
Retail55.6%20.8%+106
SME45.0%10.0%-18
Ranked by profit per rupee of income corporate leads at 60%, but ranked by return on capital retail leads at 20.8% and SME, at 10.0%, is the only business below the 12% hurdle.

Close with a decision, not an exit. SME needs Rs 18 crore more profit, or 2 points of return, to clear the hurdle: reprice new loans, cut expected loss through tighter underwriting and collections, or reduce capital with collateral and guarantee cover. Exit only if none of those works, and first check what SME brings the rest of the bank, such as deposits and fee income that are booked elsewhere.

Where candidates lose it

The frequent error is ranking businesses by income or by profit margin, which rewards the business that uses the most capital. RAROC exists because capital is the scarce resource, and a business that earns a lot while tying up a lot can still fall short of the hurdle.

The second is recommending an immediate exit from SME. Interviewers want the levers first, price, loss and capital, and the cross-selling question before a business is closed.

What the interviewer asks next

  • How would you allocate economic capital across the three if their losses are not perfectly correlated?
  • SME reprices and income rises to Rs 220 crore. Does it clear the hurdle now?
  • Why might a regulator's capital rules and the bank's economic capital disagree on which business is best?

Company names and figures are illustrative.