Risk-Adjusted Measures of Value Creation in Financial Institutions

40 Pages Posted: 28 Nov 2009

See all articles by Alistair Milne

Alistair Milne

Loughborough University - School of Business and Economics

Mario Onorato

Algorithmics

Multiple version iconThere are 2 versions of this paper

Date Written: November 25, 2009

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

Suggested Citation

Milne, Alistair K. L. and Onorato, Mario, Risk-Adjusted Measures of Value Creation in Financial Institutions (November 25, 2009). Bank of Finland Research Discussion Paper No. 25/2009. Available at SSRN: https://ssrn.com/abstract=1513235 or http://dx.doi.org/10.2139/ssrn.1513235

Alistair K. L. Milne (Contact Author)

Loughborough University - School of Business and Economics ( email )

Epinal Way
Loughborough
Leicestershire, LE11 3TU
United Kingdom

Mario Onorato

Algorithmics ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 207 4813434 (Phone)
+ 44207 481 3130 (Fax)

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