A RAROC Valuation Scheme for Loans and its Application in Loan Origination

Abstract

In this article, a RAROC (risk-adjusted return on capital) valuation scheme for loans is derived. The critical assumption throughout the article is that no market information on a borrower’s credit quality like bond or credit default swap spreads is available. Therefore, market-based approaches are not applicable, and an alternative combining market and statistical information is needed. The valuation scheme aims to derive the individual cost components of a loan which facilitates the allocation to bank?s operational units. After its introduction, a theoretical analysis of the scheme linking the level of interest rates and borrower default probabilities shows that a bank should only originate a loan when the interest rate the borrower is willing to accept is inside the profitability range for this client. This range depends on a bank’s internal profitability target and is always a finite interval only or could even be empty if a borrower’s credit quality is too low. Aside from analyzing the theoretical properties of the scheme, we show how it can be directly applied in the daily loan origination process of a bank.

Keywords: RAROC, Loan Pricing, Hurdle Rate, Loan Origination

JEL Classification: G12