A financial institution is considering a loan application for $2 million. It exp

Question

A financial institution is considering a loan application for $2 million. It expects to charge 1/5 % origination fee and 10 basis points as service fee. The institution has estimated a risk premium to be around 0.25%. The market interest rate for similar loans is 11%. The 98th (worst case) loss rate for borrowers has been historically 2%, and the proportion of loans of this type that cannot be recovered on default has been 85%. Using the RAROC, should the financial institution make the loan? Assume cost of funds to be 11.5%.

Explanation / Answer

Answer:

Risk adjusted return on capital is the an adjustment to the return on an investment that accounts for the element of risk. Risk-adjusted return on capital (RAROC) gives decision makers the ability to compare the returns on several different projects with varying risk levels. RAROC was popularized by Bankers Trust in the 1980s as an adjustment to simple return on capital (ROC).

RAROC = (Revenue - expense - expected loss+income from capital )/Capital

revenues = 1/5 of %+.10 basis = .6 million.

Revenue = 11% = 2million *11% = .22 million

Expense = .05 million

expected loss = 2% = .04 million

RAROC = (0.82-.05-.04)/2

36.5%

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