One of the biggest drawbacks in the subprime crisis was a wrong fit of risk measurements and tools to the firm’s portfolio allocation strategies.1 Crouhy (2009) and Stulz (2009) among others point out what went wrong in the risk management practices during the current and other recent financial crisis: (a) Inadequate use of risk metrics. Daily VaR (Value at Risk) is widely used in financial institutions to assess the trading activities risk. However, VaR measures the minimum worst loss expected (at 99% or 95% confidence level, depending on the distribution used) and not the expected worst loss (Stulz, 2009). Furthermore, VaR does not tell us anything about distribution of the losses BEYOND the minimum worst loss and even worse, it is not sure whether VaR can capture low probability catastrophic events.

1. 1
Market Risk Management
Helios Padilla-Mayer, PhD
1.1 Major market risk management failures during the subprime crisis
One of the biggest drawbacks in the subprime crisis was a wrong fit of risk measurements and tools to the firm’s
portfolio allocation strategies.1
Crouhy (2009) and Stulz (2009) among others point out what went wrong in the risk
management practices during the current and other recent financial crisis:
(a) Inadequate use of risk metrics. Daily VaR (Value at Risk) is widely used in financial institutions to assess the trading activities
risk. However, VaR measures the minimum worst loss expected (at 99% or 95% confidence level, depending on the distribution
used) and not the expected worst loss (Stulz, 2009). Furthermore, VaR does not tell us anything about distribution of the losses
BEYOND the minimum worst loss and even worse, it is not sure whether VaR can capture low probability catastrophic events.
Top management cannot rely on daily VaR results but must concentrate on longer-­‐run risk indicators.
(b) Misjudgement and failure to account for known risks. Even if risks are defined correctly, it could happen that the size of
the loss or probability of a large loss occurring cannot be estimated. Or, if a bank is having several positions, risk manager can
miscalculate the correlation between these positions. During the crisis, correlations tend to increase and evolve randomly – if
a risk manager cannot anticipate that, the bank may perform poorly in the crisis event.2
Known risks can be ignored because
they may be difficult to incorporate in the existing risk model or they are only partially followed. In the existing bonus system,
traders receive their part if they create profits for the institution, but they do not get penalized (that is, there are no negative
bonuses) if they create losses. Such rewarding system creates risk-­‐incentive trading, especially if there are risks if traders can
profit (or lose) from risks that are not completely monitored. Furthermore, introduction of new financial instruments brings
along also incorporation of different risks within a single instrument (market, credit, operational risks) – if one of those risks is
recognized but ignored on purpose, trading can result in large losses. In addition, Basel II definition of operational risk may be
different of regular business risks, which occur in financial institutions.
(c) Failure to incorporate unknown risks. If the risk is unknown, it is difficult to blame risk managers for not accounting it.
However, unknown risks are usually the ones that result in large losses and they are unexpected as event probability is
extremely low. But what is important is the fact that if these risks were accounted for, the executive management would
probably reacted differently. Therefore, managers should find a way to anticipate unknown risks and provide different scenarios
should they occur – stress testing should become a regular activity in active risk management.
(d) Failure to communicate risks to top management. As risk managers do not take decisions on the firm’s strategy and the
level or risk the firm can take on, they cannot be blamed for wrong strategy decisions. However, risk managers’ job is to identify
risk in the company and make sure that this information is clearly communicated to the top management. Only if top
1 This mismatch can be detected in the following quotation from New York Times. An unknown former Citigroup executive said the following
about Charles Prince (Chuck), a former Citigroup CEO, when the bank started engaging heavily in the issuance of CDOs (credit default
obligations): “Chuck was totally new to the job. He didn’t know a CDO from a grocery list, so he looked for someone for advice and support.
That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You
have to take more risk if you want to earn more.’ ” (New York Times, November 22, 2008).
2 Furthermore, risk metrics work well under the assumption that there is enough historical data to estimate distribution of known events and
expect that future events will evolve in the same way. However, historical data had no value in the subprime crisis, as there was no previous
experience in a collapse of a real estate market with outstanding MBS-­‐ and CDO instruments.

2. 2
management understands the risks and consequences of firm’s operations, it can take a position on taking more risk or
dismissing certain operations.
(e) Inappropriate monitoring and managing of risks. Once risk is identified in a certain operation or product, the risk manager
cannot revert from it. On the contrary, a constant monitoring of risk is required because in financial firms, risks are changing
continuously, even if the bank does not extend or change its trading portfolio. This is even more delicate with complex financial
products, such as subprime derivatives – when the value of the underlying asset is changing, so does the value of the derivative
and with it the risk characteristics of the instrument. This is particularly important in a situation when the firms want to reduce
its risk over the short period of time. If the market is not liquid enough (the case of the subprime crisis, when all financial banks
tried to offload risky assets as once), then institutions are left over with risky instruments and they cannot access markets for
additional funding.
1.2 Basel III and Dodd-­‐Frank Act
Basel III3
and Dodd-­‐Frank Act4
aim were introduced in order to strengthen the ability of supervisors and regulators to
anticipate risk management actions. Namely, faulty risk management decisions are blamed to be a main cause of the financial
crisis. Basel III tries to incorporate both micro-­‐ and macro-­‐prudential elements. From the micro-­‐prudential side, there is a need
for higher and better quality capital, and the introduction of leverage and liquidity ratios.5
From the macro-­‐prudential point of
view, Basel III introduces the counter-­‐cyclical capital buffer6
and conservation buffer. These rules will not prevent further crisis
in the future, but the idea behind is that the financial system will be better equipped to withstand the crisis consequences.
However, does the introduction of these ratios really tackle the risk management failure as addressed in 1.1? First of all,
Basel III is based on a one-­‐size-­‐fits-­‐all, meaning that it favours large banks and thus pushes for consolidation of smaller and
medium-­‐sized banks. Secondly, higher capital and liquidity requirements will lead to a reduced credit availability and thus add
further pressure to a much-­‐needed economic recovery. The need to regulate will not bring financial stability by itself and should
not be take away management failures due to loose risk management standards and supervisory practices. A recent US$ 2billion
UBS rouge trade episode confirmed that most of the poor risk managers, supervisors and investors are still actively involved in
the international financial community. There is no discussion about correct risk metric techniques, capturing risks correctly and
providing necessary information to executives in the bank. Furthermore, Basel III says nothing about eliminating the moral
hazard problem of taxpayer support for creditors. There is no discussion on restraining excessive risk-­‐taking practices by
promoting high-­‐quality risk management and governance practices.
One of the main features of the Dodd-­‐Frank Act, especially section 165, is dealing effectively with systemic risk.7
Unlike
Basel III, it seems that it addresses more efficiently existing risk management failures cited in 1.1.8
With respect to risk
3 Bank for International Settlements: “International Regulatory Framework for Banks (Basel III)”, web site: www.bis.org/bcbs/basel3.htm.
4 Information on Dodd-­‐Frank Act has been extracted from the following web site: http://dodd-­‐frank.com/.
5 Banks need to have sufficient liquid assets to meet the liquidity problems they may face without public support. Only in extreme
circumstances should the central bank contemplate acting as a lender of last resort. The liquidity coverage ratio (LCR) therefore fulfils a useful
task. Also, banks need to limit the maturity mismatch in their balance sheets. Funding very long-­‐term assets with very short-­‐term liabilities
creates risks not only to the bank itself but also to the wider economy. Here, the net stable funding ratio (NSFR) is useful. The crisis also
emphasised the need to monitor banks’ liquidity in different currencies.
6 A capital will be piled up in good time and could be drawn down in the stress period.
7 The Act concentrates on prudential standards, and refers to bank holding companies that hold more than US$ 50 billion in consolidated
assets and non-­‐bank financials and are systemically important according to the Financial Stability Oversight Council criteria.
8
However, there are still remaining flaws.

3. 3
governance, the Federal Reserve will require publicly traded, systemically important non-­‐bank financial institutions to establish
risk committees responsible for oversight of enterprise-­‐wide risk management practices. Publicly traded bank holding
companies must have a risk committee if they hold $10 billion or more in assets, the Fed may lower this threshold. If any of
financial institutions becomes too big, the Act allows that the Federal Reserve increases its reserve requirement, thus
preventing another example of “too-­‐big-­‐to-­‐fail” rescue schemes (such as AIG). According to the Volcker Rule, the banks cannot
own, invest or sponsor hedge funds for their own profit, but only if such hedge funds serve directly to their clients. Another
positive feature of Dodd-­‐Frank Act is improving risk disclosure, which will reduce asymmetric information and make risk
transparent to all market participants. Furthermore, Act also requires a periodic stress testing to make sure that banks are not
exposed to liquidity risk and that the institutions can account for some unknown risks. However, one thing that the Act does
not address is investors’ complacency, which resulted in irrational investments. Secondly, the Act does not address the
problems of risk metrics – as mentioned in 1.1, VaR techniques did not always results in best investment portfolio choice.
2.1 Risk metrics in practice
Risk management follows two main objectives: diversify investment portfolios and reduce their volatility. If financial
institutions use their expertise correctly, they can generate profit by taking on a manageable amount of risk, repackage it and
transfer to the market. However, if risks are not properly assessed and measured, they are not possible to control. Here is where
the use of risk metrics becomes useful. A true assessment of risk enables management to get a clear view of institution’s
financial position and helps in formulating future business strategy. Financial risk is usually understood as a probability that
actual return will be lower than expected return. This probability is related to unexpected events in the market’s direction. In
order to manage risk, it is important to assess the probability of such event to happen and quantify the size of the potential
loss. Use of risk metrics facilitates quantification and therefore pricing of risk-­‐related events and thus enables management to
decide whether it is profitable to engage in riskier business strategies. The idea behind incorporation of risk metrics in practice
was behind more efficient risk management from different points of view (McNeil, Frey and Embrechts, 2005): (1) societal view:
quantifying risk would allow smooth functioning of the financial system and send early warning signs about the possible
systemic risk problem stemming from an individual financial institutions; (2) the shareholders’ view: quantifying risk will enable
to determine by how much a value of the financial institutions, and hence, the shareholders’ value could increase; and (3)
economic capital of the firm: risk metrics convert a risk distribution to the amount of the capital needed to support risk in line
with the financial institution’s financial strength (characterized by a credit rating, for example).
2.2 Benefits and limitations of risk metrics
Benefits (some benefits are already discussed above):
a) Risk metrics are risk manager’s primary tool to measure the influence of each risk factor on the volatility of portfolio returns
and then manage the composition of the portfolio so that the volatility of the portfolio’s returns is reduced.
b) Risk metrics methods produce a numerical measure of the probability of the loss event, and quantify the level of different
types of risk in the institution’s portfolio.
c) VaR as the most known and used risk metrics is a meaningful method of assessing the overall market risk of short-­‐term trading
positions (1-­‐10 day) under the assumption of normal distribution – thus, in “normal” business conditions, it uses the past
behaviour of risk factors to predict their future behaviour, and it is based on historical distribution of returns.

4. 4
d) Other risk metrics, such as stress testing, scenario analysis, are useful and became acknowledged in extreme events (crisis
situations) because they try to assess impacts of only exceptional (low probability) events.
Limitations:
a) Whilst quantitative measurement systems support effective decision-­‐making, better measurement, they cannot be seen as
a substitute for well-­‐informed, qualitative judgment. This is especially important for risk categories, such as operational risk,
where quantification is difficult and complex.
b) The success and accuracy of quantitative models depends on their underlying assumptions, the robustness of their analytical
methodologies and the data inputs. Risk metrics are used to build up appropriate hedging strategies. However, during extreme
events these hedging instruments may not be appropriate because key assumptions built into the pricing models may not hold
anymore.
d) While VaR is widely used, an overreliance on the results it provides can lead to misinterpretation. VaR does not include
extreme events and does not account for the fact that in such events correlations between asset classes increases significantly
and leads to unexpected concentrations of risk.9
Furthermore, when managers try to unwind these positions in order to reduce
concentration risk, they have difficulties in succeeding due to an abrupt lack of liquidity in financial markets.
e) VaR requires a good estimation of the lower tail of distribution in order to produce sensible results. However, lower tails
have usually only few observations available, therefore estimation errors can be large.
f) VaR usually takes into account a short period and thus not many data observations (1-­‐year daily observations produce about
250 data points). For that reason, VaR estimates can show a substantial downward bias.
h) Cross-­‐border spill over impact of shocks is unprecedented. Even if risk metrics appropriately indicated the risk event in one
financial institution, this event spreads rapidly across the markets, giving the risk managers very little time to react.
2.3 Type and frequency of risk reports
CEO is responsible for strategic component of risk management.10
Immediate reporting to CEO is requested when
current risk exceeds what the board agreed to. Otherwise, CEO should receive regular reports on all risks identified by
organization (Chorafas, 2007): credit, market, liquidity, operational and business risks (compliance risk,11
reputational risk, all
risks concerned with the company’s earnings power). Other important types of risk to be followed are also legal12
, tax13
and
security14
risks. All risks should be assessed under the worst-­‐case stress tests targeting losses that could arise from extreme, but
plausible major events. In case of credit, market, liquidity and legal risks, stress tests should be weighed against institution’s
capacity to bear maximum losses without going under or seeking a bailout solution. Below is a short synthesis of main
categories that should be reported within selected risk aspects:
9 This is true also for other risk metrics.
10 Along with the senior management and Board of Directors, CEO is responsible for definition of risks, ascertaining institutions risk appetite,
formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within
acceptable level and the reward compensate for the risk taken in both on-­‐going business activity and longer term strategic management of
institution’s capital.
11 Compliance risk leads to financial loss due to regulatory fines or penalties, restriction or suspension of business.
12 Financial loss due to legal risk may arise from the unenforceability of rights under the financial contract or due to inappropriate contractual
arrangements.
13 This is the risk that tax authorities oppose institution’s position on tax views.
14 This is the risk of loss of confidentiality, integrity or availability of assets and information through fraud or theft.

5. 5
CREDIT RISK (reporting on a monthly basis) (a) reports on compliance with risk parameters and prudential limits approved by
the Board, (b) reports on prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan
review mechanism, risk concentrations, risk monitoring and evaluation, early warnings, pricing of loans, provisioning,
regulatory/legal compliance, etc. (c) recommendations on clear policies on standards for presentation of credit proposals,
financial covenants, rating standards and benchmarks.
MARKET RISK (reporting on at least monthly basis): (a) summaries of bank’s aggregate market risk exposure, (b) reports
demonstrating bank’s compliance with policies and limits, (c) summaries of finding of risk reviews of market risk policies,
procedures and the adequacy of risk measurement system including any findings of internal/external auditors or consultants.
LIQUIDITY RISK (reporting at least quarterly but in a crisis situation on a daily basis, accompanied with liquidity stress tests): (a)
standard reports such as "Funds Flow Analysis," and "Contingency Funding Plan Summary", (a) asset quality and its trends, (c)
earnings projections, (d) the bank's general reputation in the market and the condition of the market itself, (e) the type and
composition of the overall balance sheet structure, (f) the type of new deposits being obtained, as well as its source, maturity,
and price.
OPERATING RISK (reporting on a quarterly basis): (a) assessment of the exposure to all types of operational risk faced by the
institution, (b) assessment of the quality and appropriateness of mitigating actions, including the extent to which identifiable
risks can be transferred outside the institution, (c) report on controls and systems in place to identify and address problems
before they become major concerns.
AUDIT REPORTS (reporting on an annual basis): Regular reviews of all risks should be carried out by internal audit and
independent external reviewer and reports delivered to CEO.
3.1 Liquidity Risk
Liquidity risk can be defined as a difficulty in liquidating (selling or buying) an investment without accepting a
considerable discount from current market value. It can also be defined as a risk encountered by a bank when it tries to refinance
sizeable amounts of its investment positions at the same time (Crouhy, Galai, Mark, 2006). Basel Committee on Banking
Supervision (2008) distinguishes between liquidity risk related to “market liquidity” and “funding liquidity”. Market liquidity
risk is “the asset risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market
depth or market disruption.” Thus, this is the risk arising from high and unexpected deviations in transaction costs. Funding
liquidity risk, on the other hand, is “the risk that the firm will not be able to meet efficiently both expected and unexpected
current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the
firm.” (Basel committee on Banking Supervision, “Principles for Sound Liquidity Risk Management and Supervision”, September
2008). The funding liquidity risk refers to an ease (or difficulty) of obtaining internal or external funding sources for cash
shortfalls in the company (bank).
3.2 Liquidity risk as the cause of major trading losses
Prior to the recent and other financial crisis, asset markets were normally buoyant and funding was readily available
at low cost. During this time, many banks (financial institutions) were not really cautious about liquidity risk management and
therefore did not have in place an appropriate framework that would take into account liquidity risk arising from individual
business lines. Thus, there was a misalignment between incentives at individual business lines and overall bank’s liquidity risk

6. 6
absorption capacity. Financial institutions usually seek short-­‐term financing, especially in the period of abundant liquidity and
use funds for long-­‐term investments that are less liquid – or, in terms of the financial crisis, assets become illiquid. In the
subprime crisis, financial institutions held sub-­‐prime mortgages, which were packaged in residential mortgage-­‐backed securities
(RMBS).15
However, the crash of the US mortgage markets raised concerns about the valuation of such securities and loss of
investor’s confidence, which was translated initially to a fall in asset market liquidity and then in the increased funding risk.
When the short-­‐term money resources were exhausted (due to international tightening of interbanking money markets and
‘flight to quality’ deposits to commercial banks), banks could not sell their long-­‐term illiquid assets in order to meet their
contingent claims or they had to sell them at a huge discount. Reluctance of banks to provide liquidity called for central banks’
involvement to provide access to unlimited funding so banks could meet their obligations.
As Acharya and Schaefer (2008) point out, when asset and liquidity shocks appear together, the overall impact on
funding liquidity is exacerbated due to three reasons. First, institutions, which are hurt by asset shocks, are forced to liquidate
their positions in illiquid markets. Second, an increased funding liquidity risk will have a negative impact on a market value of
certain collaterals. Third, an increase in funding liquidity will increase hair-­‐cuts (or illiquidity discount) on collaterals.
3.3 Limitations of modelling and measuring liquidity risk
Modelling and measuring liquidity risk is not difficult in the standard cash management, when liquidity risk is
considered as a need for continuous funding. In a ‘normal’ market conditions it is not difficult to predict how much liquidity is
needed to finance future growth or comply with outstanding credit lines. The problem appears in case of an unexpected market
shock, such as the recent crisis. In this case we cannot really rely on standard reports of banking liquid assets or open lines of
credit. What is needed are stress tests (scenario analysis) which analyse the extent to which bank can be self-­‐sufficient in the
event of shock and estimate the reaction time needed for the shock to translate in a funding crisis. Measuring liquidity risk is
associated with the measuring of liquidity and integration of this measure in the risk framework. The measurement is normally
related to the data available and more information is needed the more sophisticated the trading asset is.16
Secondly, it is
difficult to determine which integration technique the optimal one is given the targeted risk position of the financial institution.
One needs to make a trade-­‐off between applying simple and suitable, non-­‐distorting assumptions. Thirdly, the point of
modelling liquidity risk is the ability to manage it. And order to do so, we must define the price of illiquidity and build it into
illiquid positions. This is still not a commonly accepted.
3.4 Basel III and liquidity risk
Basel III suggests two minimum standards for funding liquidity:17
1. Liquidity Coverage Ratio (LCR) assures that the bank has enough high-­‐quality liquid assets to survive a significant stress
scenario for 1 month. The formula applied is
15 To make things worse, a substantial share of RMBS was bought by CDO-­‐managers of asset-­‐backed securities.
16 Stange and Kaserer (2009) distinguish three components of liquidity costs: direct trading costs, the price of asset in relation to its mid-­‐price
(which is set at the middle of the bid-­‐ask-­‐spread) and delay costs if position cannot be traded immediately. This information is not easily
available when the complexity of trading assets increases.
17 Basel Committee on Banking Supervision, “Basel III: International framework for liquidity risk measurement, standards and monitoring,”
BIS, Basel December 2010.

7. 7
,
Where total net cash outflows are defined as total expected cash outflows minus total expected cash inflows in the specified
stress scenario for the subsequent 30 calendar days.
Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high-­‐quality liquid assets as a
defence against the potential onset of severe liquidity stress.
2. Net Stable Funding Ratio (NSFR) exhibits a sustainable maturity structure of assets and liabilities over the one-­‐year time
horizon.
The ratio is structured in a way to guarantee that long-­‐term assets are funded with stable liabilities with respect to their liquidity
risk profiles. This ratio tries to limit the excess reliance on short-­‐term wholesale funding during the booming market liquidity
and ensure better assessment of liquidity risk across all on-­‐ and off-­‐balance sheet categories.
4.1 Pricing a new loan
One of the most critical decisions in the bank is loan pricing as it directly influences earning, credit risk and capital
adequacy. There are “traditional” elements to be considered in loan pricing. However, in addition to that, is very important to
price risk premium, based on expected losses. Furthermore, loan agreement is usually conditioned on collateral with can be
either a tangible asset or a financial institution issuing a guarantee. If the latter is the case, a loan pricing, especially when
calculating expected losses, should consider guarantor’s characteristics as well. The traditional elements that must be
considered in the loan pricing are the following:
(1) Cost of funds. This information should usually come from the treasury department. (2) Capital Adequacy and Earnings
Requirements. In order to determine earning needs, the bank must comply with capital requirements. Loan pricing will be
impacted by the need of raising additional fund or excess level of capital. (3) Cost of operations. These are costs related to
operating expenses (such as salaries and benefits, travel, insurance fee, financial assistance fee, etc.) As operating costs alter
during the year, they need to be closely monitored to that they are correctly reflected in interest rate spreads. (4) Credit risk
requirements. It is important to make correct loan loss provisioning according to the previous client default history. (5) Interest
Payment and Amortization. It is important to determine the interest payment (how is interest paid credited to repayment of
interest and principal, are there compounding accrued interest on a specific time interval, is there a grace period for principal
repayment, etc.) and amortization scheme as this impacts bank’s profitability. (6) Loan contract options/clauses. Options such
as early prepayment rights, interest cap, etc. must be included in loan pricing to guarantee a proper compensation for bank if
any of these options are actually exercised (7) Loan portfolio/Assets share. This indicator is important as loan pricing depends
on efficient use of capital. If the loan book of the bank is large, it can generate sufficient earnings to keep loan rates low.
However, too high loan book can result in a less then optimal ROE in relation to ROA.
In order to correctly price risk based on expected losses, the following elements must be considered: (1) the credit
quality of the borrower and guarantor, as indicated by their Internal Ratings (or credit ratings available from rating agencies)
and the related estimates of expected default frequencies. (2) The default correlation between the borrower and its guarantors
aims to capture the joint probability of default of the various participants to a loan due to the specific relationships among them
100%
days calendar 30 next the over outflows cash net Total
assets liquid quality highof Stock
LCR ³=
100%
funding stableof amount Required
funding stableof amount Available
NSFR ñ=

8. 8
(e.g. parent-­‐subsidiary; client-­‐supplier) or to their dependence from common “background factors” of a systemic nature (e.g.
fluctuations in aggregate demand). As there are few empirical estimates of correlation, its introduction into the expected loss
calculation has to rely on subjective credit judgements. (3) The contractual structure, represented by loan clauses and financial
covenants (e.g. reserve accounts, guarantee release tests, limits on distributions, gearing ratios) agreed with the borrower. The
expected loss calculation relies on certain assumptions to model the influence of contractual stipulations via recovery rates
and/or default probabilities (e.g. a financial covenant, by setting a cap on leverage, may reduce the probabilities of default). (4)
The recovery rate. The part of the defaulted loan that is expected to be salvaged in case of default depends on the loan’s
seniority and security structure. In case of limited-­‐recourse operations, it usually requires considerable preliminary analyses
since a project’s salvage value is a complex function of its degree of completion and usage level over time. (5) The loan’s
duration, as defined by final maturity, grace periods, or frequency of interest payments. The effect of duration on the risk
premium is somewhat complex, as the generally higher expected loss resulting from a longer loan life has to be weighed against
the increased length of time over which it can be recovered via the risk premium.
Thus, if a loan is priced only under incorporating “traditional” elements, its pricing will not reflect unexpected losses
and the loan could be under-­‐priced given the level of risk it bears. Adding expected loss pricing (as suggested by RAROC
approach) is extremely important as it mirrors correctly the level of risk lender is taking when engaging in the finance contract.
4.2 RAROC/EVA approach
The bank management needs to know how to allocate capital to different bank risk-­‐taking units. RAROC is a risk-­‐
adjusted performance measurement and framework to determine which units are creating value for shareholders and which
ones are absorbing resources that could be allocated more efficiently. In this concept, RAROC is calculated for individual units
or business lines. When RAROC is used for capital allocation on ex-­‐ante basis, expected revenues and losses are used for its
calculation. That is, RAROC is calculated as the RATIO between risk-­‐adjusted net income18
and economic capital.19
As such, it
shows bank’s units’ economic profitability by calculating return on economic capital. RAROC can also be rewritten as economic
profit or residual earnings, which is EVA (economic value added) concept, by subtracting a cost of economic capital20
from risk-­‐
adjusted net income. Furthermore, risk-­‐adjusted net income can be taken as a proxy for free cash flow to the shareholders
(Frenkel, Hommel, Rudolf, 2005) and the economic capital is the equity investment in transaction. Economic profit then tells us
what is the contribution of a marginal (business unit) transaction to the bank value given the opportunity cost of capital needed
to finance this transaction. Thus, as long as economic profit if positive, the transaction creates value, otherwise not. Given the
definition of RAROC and EVA, transaction is going to create value for the bank as long as RAROC is greater than the minimum
return required for equity investments, which is hurdle rate. Capital should be allocated to such units by deploying it from units
which transactions result in hurdle rate exceeding RAROC.
For performance-­‐evaluation purposes, ex-­‐ante calculation of RAROC is not the best one as it accounts for expected
losses and not realized losses. When we measure actual manager’s performance and his ability to create profit or cause losses,
18 Risk adjusted net income is calculated as expected revenues decreased by costs, expected losses and taxes, augmented by return on risk
capital and decreased or augmented by transfer
19 Economic capital is defined as a (risk) capital needed for additional transaction.
20 Cost of economic capital is calculated as economic capital * hurdle rate, where hurdle rate is an “appropriate” rate of return for investment
as required by the equity investors.

9. 9
actual losses should be deducted in the numerator of RAROC to provide correct incentives, that is, rewarding a manager if he
actually reduced losses. If a manager’s bonus depends on the difference between revenues created minus actual losses, he will
have an incentive to take up more risk as he knows exactly what his losses are (downside limit) but he may see an unexplored
potential in revenue creation (higher risk should result in a higher revenue – unlimited upside). Usually, riskier desks should be
allocated less capital. However, if capital allocation is based on ex-­‐ante RAROC calculation, unexpected losses are taken into
account and they may be higher or lower than actual losses incurred by the manager. Capital allocation (based on ex-­‐ante
RAROC) to the manager’s business unit may not reflect the real risk-­‐taking incentive of the manager. Thus, the bank must be
careful about using ex-­‐ante or ex-­‐post RAROC measures.

10. 10
Reference:
1. Acharya, V. Viral and Stephen Schaefer, “Liquidity Risk and Correlation Risk: Implications for Risk Management”,
International Financial Risk Institute (IFRI), Draft Paper September 8, 2006.
2. Bank for International Settlements, “International Regulatory Framework for Banks (Basel III)”, Bank for
International Settlements, Basel related web -­‐site: http://www.bis.org/bcbs/basel3.htm.
3. Basel Committee on Banking Supervision, “Basel III: International framework for liquidity risk measurement,
standards and monitoring,” BIS, Basel December 2010.
4. Basel committee on Banking Supervision, “Principles for Sound Liquidity Risk Management and Supervision”, BIS,
September 2008.
5. Chorafas, Dimitris S., “Risk management technology in financial services: Risk Control, Stress Testing, Models and
IT Systems and Structures”, Elsevier Ltd., Oxford, 2007.
6. Crouhy, Michel, “Risk Management Failures during The Subprime Crisis”, 2nd International Financial Research
Forum, Risk Management and Financial Crisis, Paris, March 19-­‐20, 2009 (Power Point presentation.
7. Crouhy, Michel, Dan Galai, Robert Mark, “The Essentials of Risk Management”, McGraw Hill, New York, 2006.
8. Frenkel, Michael, Ulrich Hommel, Markus Rudolf, “Risk Management: Challenge and Opportunity”, 2nd
edition,
Springer, Berlin, 2005.
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