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.

Keywords: 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

JEL Classification: G22, G31