Many credit unions have been asking us questions about RAROC (Risk Adjusted Return on Capital), a useful tool that helps you consistently analyze profitability across your different business lines. We know some credit unions are already using this tool to help them make good business decisions.
Using RAROC, your front office can check if a potential transaction meets or exceeds the profitability targets—or hurdle rate—set by your credit union (we set ours during the budgeting process). To measure RAROC, divide the expected return of a transaction by the capital allocated to that transaction.
As an example, let’s say a commercial loan of $10MM has a calculated RAROC of 15 per cent. If your credit union’s hurdle rate is 20 per cent, you will either have to price the loan higher to meet your profitability expectations on the transaction. If higher pricing is not achievable, the transaction could be declined altogether so you can allocate the capital required for that loan to a product or business that can earn a higher risk adjusted return on the same or lesser amount of capital.
RAROC is not designed to take decision making out of the hands of management, instead it is to serve as a tool they can use to make better decisions. Management can still approve transactions below the hurdle rate but there will be negative financial consequences for doing so, which can be tied into accountability/performance targets.
By applying the same calculation methodology to each product, RAROC gives you a consistent view of profitability across your business, using a consistent tool adjusted for capital consumption, cost of liquidity and expected default rates. Every product takes on different capital allocation, expected credit losses, and other input profiles, but the calculation itself is consistent across all lines of business, which allows you to compare them. Also, RAROC captures the risk/return of a transaction through the expected credit loss of the loan, throughout its life. This recognizes that certain transactions, such as an unsecured commercial loan, would have higher default risk than an insured residential mortgage; therefore, it must be priced higher to earn an equivalent RAROC. Other measures may not consider the risk of a transaction, and therefore miss a key aspect of appropriately pricing the loan.
Due to the pandemic, Concentra has needed to stay agile in reviewing and approving transactions that have not met our hurdle rate. By maintaining an agile RAROC framework, we can still manage profitability within the RAROC tool during times of crisis. This challenging environment in 2020 has resulted in the adjustment of corporate financial targets, which has created the need for refinements within the RAROC tool. The tool requires a certain degree of flexibility.