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BFM MODULE - D
Chapter 31: RAROC AND PROFIT PLANNING
(PART-I)

What we will study ?

*What is Profit Planning?

PROFIT PLANNING:
Profit planning in a bank essentially involves
Maximisation of earnings and minimisation of
expenditure.
Bank's Income:

Banks' income arises from three sources, viz.

1-Interest income,
2-Feebased income and
3-Treasury income.
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1- Interest Income (First Source of Income):

Interest income is derived from lending as well as
investments in securities, bonds etc.
In most of the countries, there are norms that a
certain percentage of deposits is mandatorily required
to be kept in government securities.
In our country, statutory liquidity ratio (SLR) takescare of
this aspect.
Though, the investments in government securities are
practically risk-free, the yield on such investments is
lower when compared to the depositrates.
Similarly, the interest income on highly rated
corporate debt is much lower as compared to the
income on lower rated corporate debt.
Banks are required to have a proper blending of
investment in government securities and credit
portfolios to maximise the profits for a given levelof
risk appetite.
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Let us take one example of various combinations.

Suppose a bank has Rs. 1,000 to invest or lend. We
look at four different scenarios as follows:
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Thus, you would observe that risk would increase for

lending to lower rated customers resulting in an
increased need for capital and also improved yield on
the assets.
Effect of NPA on Interest based income:
Banks have to take into account the effect of NPAon
the interest income and thereby on the profitability.
NPAs do not generate income and therefore bringdown
the yield on advances.
Also, under Basel-II/III regime, the risk weightage ofsuch
assets is higher, thereby forcing a bank to maintain
higher capital.
Thus, NPAs have a two-fold effect,

1- reduction in income and

2- need for additional capital.

Hence, return on capital or profitability gets further
deteriorated.
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2- Fee based Income (Second Source of Income):

The second major source of income is derived from
fee-based activities.
The traditional activities such as
demand drafts,
remittances,
safe custody,
guarantees,
letters of credits,
bills, etc.,

continue to be prevalent.
However, with technological changes, some of the
services such as demand drafts, remittances, bills
handling may reduce drastically.
Some new services like
depository services,
internet banking,
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e-commerce
have appeared on the scene.
These services have given a boost to the fee
income.
Banks have also ventured into cross selling of other
financial products such as insurance policies, mutual
funds, etc., and with their established network and
position of trusted entity for their customers, banks can
make logical and natural entry in the selling of such
third party products.
Banks thus tend to become financial super markets
and such measures help increase the fee-based income.
Banks are required to keep in mind the operationalrisks
associated with these new services.
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3- Treasury Income (Third Source of Income):

The last and most important component of incomeis
treasury income, which is derived by trading in
securities, foreign exchange, equities, bullion,
commodities (not permitted in our country) and
derivatives.
This is largely a speculative activity, which banks
undertake with stringent internal controls and checks
in place.
Trading activities may provide large incomes to banks.
These activities may result in large amountsof losses
as well.
If a bank is not adequately capitalised, such lossescan
cause serious problems for it.
In the 90s, Barings Bank, a very old British Bank,
collapsed due to very large losses due to speculative
trading of Nikkei Futures on Tokyo Exchange.
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Bank's Expenditure:
On the expenses side, there are two major
expenses, viz.,
1- interest expenses and

2- operating expenses.
2- Interest expenses:(First factor of expenditure)
There are three major parts of the deposit portfolio.
Current Deposits which are interest free, and Savings
Deposits and Term (short & long) Deposits
– for which interest rates are deregulated in India.
The Savings Deposits interest rates were deregulated
with effect from 25th October, 2011 and interest is
paid on these deposits on daily product basis, but the
comfort for the banks is thatthese rates continue to
be low.
Thus, a bank has to find ways and means to improve
the share of low cost deposits such as Current and
Savings Bank. This helps them to lowerinterest costs.
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Interest rates of term deposits are largely decidedby

market forces.
A bank keeps such interest rates at a level, at whichit
can garner requisite deposits in competition with other
banks.
These interest rates are also influenced by other
instruments such as debentures, postal deposits,
Government securities, provident fund, etc.
2-operating expenses:(second factor of expenditure)
The second factor of expenditure is operating costs,
which consists of staff costs and other costs.
Banks try to improve productivity and also link up some
of the staff costs to productivity by providingincentive
based packages.
Thus, every effort is made to maintain and reducethe
percentage of staff costs to the income level.
Other cost comprises depreciation, rent, utilities,legal
expenses, travelling expenses, postage,
telecommunication charges, stationery, etc.
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Banks like any other commercial organisationswould

ensure that wasteful expenditures are avoided.
Cost benefit aspects are looked into and alternatives
are explored. Thus, every effort to rationalise this
segment of expenditure is made.
In nutshell, profitability is a function of six variables:

1. Interest income
2. Fee-based income
3. Trading income
4. Interest expenses
5. Staff expenses
6. Other operating expenses
Maximisation of the first three variables and minimisation
of the last three variables are therequisites to maximise
profitability.
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BFM MODULE - D
Chapter 31: RAROC AND PROFIT PLANNING
(PART-II)

What we will study ?

*What is RAROC?
RISK AGGREGATION AND CAPITAL ALLOCATION:
Banks, across the world, use different ways toestimate
the aggregate risk exposures.
Mostly 2 ways , one is RAROC and another one isbased
on cash flow and variability in earning.
RAROC:
The most commonly used approach is the RiskAdjusted
Return on Capital (RAROC).
Each type of risk is measured to determine both the
expected and unexpected losses using VaR or worst-
case type analytical model.
The key to RAROC is the matching of revenues, costs
and risks on transaction or portfolio basis
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over a defined time period.

This begins with a clear differentiation between

expected and unexpected losses.
Expected losses are covered by specific reservesand
provisions.
and
unexpected losses require capital allocation, which is
determined on the principles of confidence levels,time
horizon, diversification and correlation.
In this approach, risk is measured in terms ofvariability
of income.
Under this framework, the frequency distribution of
return, wherever possible, is estimated and the Standard
Deviation (SD) of this distribution is also estimated.
Capital is thereafter allocated to activities as afunction
of this risk or volatility measure.
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The second approach is similar to the RAROC, but

depends less on capital allocation and more on cash
flows or variability in earnings.
This is referred to as EaR (Earnings at Risk), when
employed to analyse interest rate risk.
Under this analytical framework also, frequency
distribution of returns for any one type of risk canbe
estimated from historical data.
Extreme outcome can be estimated from the tail ofthe
distribution. Either a worst-case scenario couldbe used
or Standard Deviation could also be considered.
Accordingly, each bank can restrict the maximum
potential loss to certain percentage of past/ current
income or market value.
Thereafter, rather than moving from volatility of value
through capital, this approach goes directly tocurrent
earnings implications from a risky position.
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This approach, however, is based on cash flows

and ignores the value changes in assets and liabilities
due to changes in market interest rates.
ECONOMIC CAPITAL AND RAROC:
The expected loss is a measure of the reserves
necessary to guard against future losses.
The pricing of products should provide a buffer
against expected losses.
The unexpected loss is a measure of the amount of
economic capital required to support the banks
financial risk. This capital is also called risk capital.
Some activities may require large amounts of risk
capital, which in turn requires higher returns.
This is the essence of risk adjusted return on
capital (RAROC) measures.
The central objective is to establish benchmarks to
evaluate the economic return of business activities.
This includes transactions, products, customertrades,
and business lines, as well as the entire
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business.
RAROC is also related to concepts such as shareholder
value analysis and economic valueadded.
In the past, performance was measured by
return on assets (ROA), which adjusts profits forthe
associated book value of assets, or
return on equity (ROE), which adjusts profits for the
associated book value of equity.
None of these measures - ROA and ROE - is satisfactory
for evaluating the performance ofbusiness lines as they
ignore risks.
Risk Capital:
RAROC is a part of the family of the risk-adjusted
performance measures (RAPM).
Consider, for instance, two traders such that each
returned a profit of $10 million over the last year.
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The first is a foreign currency trader,and

second a bond trader.

The question is, how do we compare their
performance?
This is important in providing appropriate compensation
as well as deciding which line ofactivity to expand.
Assume the FX and bond traders have notionalamount
and volatility as described below.
The bond trader deals in larger amounts, $200 million,
but in a market with lower volatility, at 4%per
annum.against FX dealer deals in amount of
$ 100 million and 12% of volatility per annum.
The risk capital can be computed as a VAR (Value at
Risk) measure, say at the 99% confidence level over
a year.
Assuming normal distributions, this translates into a
risk capital of
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For Forex dealer:

RC = VAR = $100,000,000 X .12 x 2.33 = $28 million

For Bond dealer:

RC= VAR= $100,000,000 X .04 x 2.33 = $9 million

The risk adjusted performance is then measured asthe

profit divided by the risk capital,
RAPM = Profit/RC RAPM(FX)=
10 million/28 million=0.36
RAPM(BOND)=10 million/9 million=1.11

Thus the bond trader is actually performing betteras

the FX trader, as the activity requires less risk capital.
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RAROC Methodology:

Risk Management:
Includes the measurement of portfolio exposure, the
volatility and correlations of the risks factors.
Capital Allocation:
This requires the choice of a confidence level and
horizon for the VAR measure, which translates intoan
economic capital.
Performance Measurement:
This requires the adjustment of performance forthe
risk capital.
Performance measurement can be based on RAPM
method.

For instance, Economic Value Added (EVA) focuses on

the creation of value during a particular period in excess
of the required return on capital.
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EVA measures the residual economic profit as

EVA = Profit – (Capital * k)

Where profits are adjusted for the cost of economic
capital, with k defined as the discount rate.
Assuming the whole worth is captured by the EVA, the
higher the EVA, the better the product or project.

Banking Industry in India:

The past few decades have been historically

momentous for the banking industry in India.
Starting with the Narasimhan committee report of
1991, the Indian banking has seen a total change inthe
scenario during the last 3 decades.
The process of deregulation which was set in motion
has brought in a sea change in the Indianbanking.
Regulated interest rates and directed investment/
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credit have become things of the past.

The Reserve Bank of India is now more concerned
about prudential norms and disclosure requirements
of the banks.
During the last few decades, several new privatesector
banks have come into existence. They havediverse
ownership patterns.
Similarly, foreign banks have also been givenclearances
for expansion.
Recently, the associate banks of State Bank of Indiaand
Bharatiya Mahila Bank have merged with State Bank of
India.
More mergers may also take place in the near
future.
RBI has also permitted opening of Small FinanceBanks
and Payment Banks which are called as'Differentiated
Banks'.
So in our country the Banking Industry consist of:Public
Sector Banks.
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New Generation Private Sector Banks.

Old Generation Private Sector Banks.Co-
operatiive Banks.
Regional Rural Banks.
Small Finance Banks.
Payment Banks.
Hence, there is a keen competition among thebanks
in the banking sector.
All banks have either upgraded their technology orare
in the process of upgrading it.
New products are being introduced and aggressive
marketing is the order of the day.
Profitability has now become one of the most
important parameters in the banks' functioning.
Indian banks have shown that they are alive to the
changing environment and are geared up to face the
new challenges.