Through RAROC and EVA tools, Banks can establish a good risk management culture that can create competitive advantage and improve shareholder valueRAROC; EVA; Integrated Risk Management, Banking

Bandyopadhyay, Arindam

Saha, Asish

English

Research Papers in Economics

RAROC & EVA :The New Drivers of Business Growth in Indian Banks
-Dr. Arindam Bandyopadhyay (Assistant Professor, Finance, NIBM)
Dr. Asish Saha (Director, NIBM)
“Through RAROC and EVA tools, Banks can establish a good risk management 
culture that can create competitive advantage and improve shareholder value”
Risk Adjusted Return on Capital (RAROC) is a powerful risk measurement tool that 
assists banks and financial institutions both in measuring solvency and evaluating 
performance of different business activities. The increased interest in measuring risk is 
partly a response to the greater regulatory emphasis on capital adequacy that has come 
with the implementation of the Basel II risk-based capital requirements. Though RBI is 
expecting banks to move towards standardized approach, a capital conscious bank would 
move towards advanced Internal Rating Based approach (IRB). There have been 
fundamental changes in the business of banking which has awaken the interest in risk 
measurement tools. The real innovation in these new performance evaluation tools lies in 
their ability to allocate banks’ scarce capital among their expanding array of activities. 
While regulatory capital focuses on satisfying the objectives of the regulator, economic 
capital looks at internal management of the business to maximize the shareholder return. 
RAROC and EVA are credible tools and key drivers for conscious decision making. 
As different businesses have different risk profile, comparing long run performance of 
banking business using traditional measures like return on assets (ROA) or return on 
equity (ROE) can be complicated and misleading. RAROC attempts to address the issue 
of capital allocation from the perspective of improving performance - measured from 
both inside as well as from the outside the bank. 
What we generally call profits, is usually not profits at all. Until a business generates a 
profit figure that is greater than the cost of equity capital (the hurdle rate), it crushes 
shareholders’ value. In order to meaningfully compare RAROC in various businesses, 
economic profit should be based on ‘required economic capital allocations’ consistent 
with the bank’s core solvency level target. The allocation of capital according to 
economic profit would actually enhance shareholders value. 
By definition, RAROC is the ratio of risk adjusted net income divided by level of risk the 
asset or portfolio has. This can also be estimated at regions/branch level to assess 
profitability of a bank on a granular basis. Similarly, the RAROC tool can also be used to 
assess the profitability of a loan portfolio (for example, Retail Assets Portfolio, Corporate 
Assets Portfolio, SME Portfolio etc.). Once RAROC is computed, the bank’ top 
management then can compare this RAROC with a benchmark hurdle rate which is the 
opportunity cost of taking the risk in the business. The hurdle rate has to be benchmarked 
to market rate which is based on the shareholder’s expectation about the bank’s stock 
1return on a risk adjusted basis. Hurdle rate vary from bank to bank depending upon its 
stock volatility vis-à-vis the volatility in the market index (beta). It is worthwhile to 
mention that the five year annual average return in the stock market (S&PCNXNIFTY) is 
30.73% on a pre-tax basis. Since equity income is taxable, the post tax annual average 
return comes around 20.59%. If risk free rate is 7.75% (364 T bills rate in Indian in 2007) 
and   beta   of   a   bank   is   1;   then   using   CAPM,   hurdle   rate   for   the   bank   would 
be=7.75%+1×(20.59%-7.75%)=20.59%.  Hence, banks should necessarily know whether 
it is really making profit from its business/ business segments. To evaluate the risk 
adjusted profit position, the banks should compare their post tax risk adjusted return of 
risk capital (RAROC) with their individual cost of capital. This difference (i.e., the 
difference between RAROC and Hurdle Rate) is called the “Economic Profit” (EVA). 
At NIBM, we have developed a RAROC and EVA methodology which can compute the 
overall bank performance on risk adjusted basis. The analyses can be further extended in 
evaluating risk adjusted performances of zones/regions and finally at the individual 
branch level. In addition, a bank can also evaluate the performance of its various business 
segments and ultimately can trace the contribution of each portfolio on the RAROC-EVA 
axis. 
Figure 1 illustrates how in reality a relatively medium sized public sector bank with 
twelve regional offices in our country can use the RAROC-EVA tools. The analysis 
reveals that the Bank is making economic profits from Mumbai, Ahmedabad and Delhi 
regions on a risk adjusted basis. However, Bangalore, Pune, Bhuj, Koklata, Bhopal, 
Thane and Meerut regions of the said Bank studied by us are making low returns which 
are far below its hurdle rate (22.44%) on a post tax basis. The bank can use this analysis 
to target the performance of individual regions and bring them above the hurdle. The 
calculator also facilitates setting return targets, deposit mix, rates and volumes, advance, 
mix, rates and volumes, other income, recovery targets etc.  It also prods the bank to 
move away from traditional ‘Transfer Pricing Mechanism (TPM)’ to ‘Fund Transfer 
Pricing   Mechanism   (FTP)   to   generate   desired   business   profile   to   augment   its 
performance.
[Insert Figure 1 Here]
Table 1 shows the comparison of the loan portfolio performances of various Indian banks 
on Risk Adjusted Return on Capital (RAROC) and Economic Value Addition (EVA) 
basis. One can clearly see that these banks differ greatly in terms of their RAROC and 
EVA. 
[Insert Table 1 Here]
The bank’s risk managers should understand that in the emerging realities of the market, 
if the bank’s equities are not on the efficient frontier, rational investors would sell their 
security interests in the bank and switch over to more risk efficient securities. The future 
debt holders would also demand higher yields in order to offset the riskiness in financing 
2the bank. As a result, bank management will be forced to generate higher returns to 
compensate its investors. 
RAROC and EVA framework is a top down integrated approach to wealth maximization, 
would help the top management to formulate growth plans to maximize return from 
business through appropriate pricing and return strategies across branches and regions. 
Benefits of RAROC and EVA System for Banks:
As banks become ‘capital hungry’ to meet their growth expectations and 
simultaneously meeting the regulatory requirements in the Basel-II era, they 
would have to remain responsive to the expectations of the market on a risk 
adjusted   basis   to   ensure   continued   supply   of   financial   capital   from   the 
shareholders and human capital from the ultimate stakeholders.
One of the fundamental limitations in the existing business growth strategies of 
Indian banks, especially public sector banks, is its virtual, if not complete, 
disconnect with riskiness. ‘Profit rich but Risk poor’ strategies are doomed for 
failure in the long-run!
Finalization   of   business   targets   should   no   longer   remain   a   mundane 
‘volume-mix’   targeting   exercise   but   should   built-in   inherent   risk-return 
dimensions. business strategies that ensures ‘Risk & Return by Choice and not 
by Chance’ are key to ensure continuing success of banks in the emerging 
market.
In order to align the performance of individual zones/regions/branches to the 
overall corporate expectations in terms of RAROC & EVA, the vocabulary of 
risk management has to percolate down the hierarchy of banks to the individual 
unit level.
New performance benchmarks in the form of RAROC & EVA should naturally 
form the unifying cord/link in every bank.
Email to Authors: arindam@nibmindia.org, director@nibmindia.org
3Figure1: 
RAROC Vs Hurdel Rate Across the Regions: Year 2007
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4Table 1:
Comparative RAROC & EVA Profile of Indian Banks 
(All Figures in %)
  2004 2005 2006 2007
Large PSB-Bank 1        
RAROC 17.22 14.70 10.87 20.71
EVA -8.60 -10.86 -14.51 -4.46
Tier I CAR 8.47 8.21 10.98 8.74
 ROA 1.14  0.71 0.73 0.72
Large PSB-Bank 2        
RAROC 12.21 6.53 7.58 4.69
EVA -13.03 -18.48 -17.27 -19.96
Tier I CAR 7.81 7.29 7.81 7.17
 ROA  1.1 1.10 1.10 1.00
Smaller PSB-Bank 3        
RAROC -8.37 -11.83 -2.24 10.59
EVA -31.08 -34.42 -24.76 -11.85
Tier I CAR 5.19 6.63 5.96 6.06
 ROA  1.11  0.26  0.29 0.71 
Smaller PSB-Bank 4        
RAROC 26.63 26.97 20.67 22.69
EVA 3.93 4.38 -1.85 0.26
Tier I CAR 8.17 8.03 12.20 9.98
 ROA 1.72  1.59 1.38 1.31
Medium Sized PSB-Bank 5        
RAROC 41.42 36.42 32.80 38.59
EVA 15.81 11.06 7.62 13.61
Tier I CAR 6.75 6.10 7.40 6.24
 ROA 1.67   0.82 0.91  0.91 
Large New Generation Bank-Bank 6        
RAROC 50.15 56.31 77.80 73.30
EVA 33.01 39.00 60.38 55.73
Tier I CAR 8.03 9.60 8.55 8.57
ROA 1.40 1.40 1.40 1.40
5

RAROC & EVA :The New Drivers of Business Growth in Indian Banks

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