Risk-adjusted measures of value creation in financial institutions

Abstract

Measuring value creation by comparing the RAROC of an exposure (the return on risk capital) with a single institution-wide hurdle rate is inconsistent with the standard theory of financial valuation. We use asset pricing theory to determine the appropriate hurdle rate for such a RAROC performance measure. We find that this hurdle rate varies with the skewness of asset returns. Thus the RAROC hurdle rate should differ substantially between equity which has a right skew and debt which has a pronounced left skew and also between different qualities of debt exposure. We discuss implications for financial institution risk management and supervision.asset pricing; banking; capital allocation; capital budgeting; capital management; corporate finance; downside risk; economic capital; performance measurement; RAROC; risk management; value creation; hurdle rate; value at risk