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Risk‐Adjusted Measures of Value Creation in Financial Institutions |
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| Authors: | Alistair Milne Mario Onorato |
| Affiliation: | 1. Faculty of Finance, Cass Business School, City University, London, UK and Monetary Policy and Research Department, Bank of Finland, Helsinki, Finland E‐mail: amilne@city.ac.uk;2. Algorithmics Inc & Faculty of Finance, Cass Business School, City University, London, UK E‐mail: monorato@algorithmics.com |
| Abstract: | Abstract Many financial institutions assess portfolio decisions using RAROC, the ratio of expected return to risk (or ‘economic’) capital. We use asset pricing theory to determine the appropriate hurdle rate, finding that this varies with the skewness of asset returns. We quantify this discrepancy under a range of assumptions showing that the RAROC hurdle rate differs substantially, being higher by a factor of five or more for equity which has a right skew compared to debt which has a pronounced left skew, and also between different qualities of debt exposure. We discuss implications for both financial institution risk management and supervision. |
| Keywords: | asset pricing banking capital allocation capital budgeting capital management corporate finance downside risk economic capital economic value added performance measurement RAROC risk management hurdle rate value at risk G22 G31 |