Banks utilize RAROC (risk-adjusted return on capital), a risk-based profitability measurement, to assess the efficiency of their business relationships with corporations.
Similarly, savvy treasurers use the tool to monitor costs and ensure competitive pricing in their banking relationships.
The range of products and services offered by banks are evolving, and their costs are increasing as treasurers’ needs broaden, regulations become more burdensome, and markets grow more sophisticated. As a result, corporate treasurers face less transparency in their increasingly complex relationships with banks.
The question that banks and corporations face is what is an appropriate level of paid expenses and earned income for a mutually beneficial relationship to exist?
In exchange for providing corporations credit lines, banks seek “side business” to compensate for accepting the credit risk. “Side business” covers a range of products and services, including cash management, market operations, coverage rates, and exchange rates.
The system creates uncertainty surrounding the fair value of the services provided to corporations for two primary reasons:
- In the absence of a benchmark, companies often believe they are obtaining optimal pricing. However, without the guidance of an advisor with a database of best prices for similar companies (i.e., industry, rating, size, etc.), a company is never certain where it stands relative to comparable organizations. Companies frequently pay fees for unnecessary services or, conversely, unwittingly expose themselves to disengagement risk if a bank believes it is not earning a sufficient overall return relative to risk.
- Since “side business” is additional compensation corporations pay to justify the bank’s open credit risk exposure, the calculation to determine sufficient return is complex. Quantifying a mutually beneficial banking relationship requires accurately pricing the individual variables of credit exposure and products and services, among other variables. Each bank utilizes its own internal model with different prices for the variables, adding another level of complexity to the calculation. This means each bank always measures and defines an acceptable rate of risk-adjusted return differently than their peers!
Superior profitability to weighted average cost of capital
Since most banks measure their efficiency through a RAROC model, it is important to understand its basis.
The formula, a byproduct of 1970s economic theories, optimizes the allocation of bank capital by determining an appropriate measure of risk-adjusted return. Banks, like other businesses, seek to generate a superior risk-adjusted return to their weighted average cost of capital (WACC). Generally, the cost of capital is around 10% with profit targets between 10% and 15%. To achieve their goal, banks adapt their selling prices, lower costs, or change the allocation of capital (i.e., their commitments to a single prime contractor).
The image below illustrates the formula used to calculate RAROC.
Treasurers should periodically engage an outside advisor to formally measure the corporation’s RAROC with each bank to ensure accurate benchmarking of services and fees to comparable organizations.
Corporations with existing models should periodically recalibrate their models.
An analysis engagement can be implemented for the life of a banking relationship or for a predetermined period. Results may take up to several months to accurately calculate, dependent upon the scope of the operation.
An accurate RAROC analysis requires knowledge of each bank’s preferred range of parameters for different inputs. This understanding is acquired over years of working with banks across industries, credit ratings, and sizes.
To determine a fair profit margin for banks, a corporation must determine the income it generates to the bank and the bank’s costs of services it provides to the corporation.
Income corresponds to the fees and commissions paid by the corporation, which typically evolve over time and introduce variability in the profitability of the relationship. Costs are mainly comprised of operating expenses, which are possible to model using traditional ratios (e.g., cost income ratio, etc.), but must be calculated to accurately reflect the average cost of each transaction type in the banking industry.
Outside factors such as taxes and liquidity costs accounted for 200 basis points (BPS) of widening during the financial crisis and had a material impact on the profitability of banking transactions. These costs have since fallen back to a historical low range between 10 and 60 bps, partly due to the implementation of Basel III liquidity ratios (LCR and NSFR).
Aside from the operating costs, banks bear the cost of risk inherent to each transaction.
The cost of risk is expressed through the average loss and by providing internal capital. The average loss is defined as the product between the exposure of the bank at default (EAD), the rate of loss given default (LGD), and the probability of default attributed to the borrower (PD) by the lender. These same parameters are used with the residual maturity in order to set the amount of economic capital.
Notably, each bank takes a different approach to establish an internal rating of a company. There are two primary methodologies utilized:
- A bank may opt to use the LGD and other parameters provided by the IRB Foundation.
- A bank may use the Advanced IRB method whereby the bank develops its own internal empirical model to quantify the requisite capital for credit risk.
The probability of default is derived from the rating of the borrower.
The rating scales used by banks and the corresponding default probabilities are typically available in the bank reports. However, a default probability, even for a “risk-free” asset, is never zero and the PD is particularly sensitive along the border between investment grade and high-yield debt. As a result, the latter can lead to large disparities in financing terms offered by different banks to the same borrower. The disparity creates opportunities for astute treasurers to persuade lenders outside the market to meet their internal rating. To utilize this strategy, the treasurer must capitalize upon the differences between the rating criteria used by the banks and those used by rating agencies.
Tools by which to navigate
The relationship between income generating bank services and the risks inherent in providing such services will affect RAROC levels. In other words, unsecured funding is often the least profitable for banks given the level of risk. In contrast, other services such as bond issuances and asset management generate minimal risk and provide high relative rates of return.
By accurately tracking the rates of return generated by each banking relationships, corporations can possess a tool that will enable them to assess, control, and monitor the value of their banking relationships.
Wherever RAROC can uncover sources of savings, such as in unnecessarily high credit lines, superfluous services, excessive fees, or abnormally high rates of return, treasurers will possess the tools and information to equalize the balance of power in future negotiations.
Example of RAROC for a five-year amortizing bank loan
Data derived from use of RAROC