Question

Suppose that a business line of a bank has a loan book of USD 100 million. The average interest rate is 10%. The book is funded at a cost of USD 5.5 million. The economic capital against these loans is USD 7.5 million (7.5% of the loan value) and is invested in low risk securities earning 5.5% per annum. Operating costs are USD 1.5 million per annum and the expected loss on this portfolio is assumed to be 1% per annum (i.e., USD 1 million). The firm's cost of capital is 15%. The RAROC for this business is:

A. 26.7%

B. 37.1%

C. 21.2%

D. 32.2%

Answer 1

Expected revenues = Loan Book * Average Interest rate

Expected revenues = $100,000,000 * 10%

Expected revenues = $10,000,000

Interest expense = $5,500,000

Operating cost = $1,500,000

Expected Loss = $1,000,000

Economic capital = $7,500,000

Income from capital = low risk securities rate * Economic capital

Income from capital = 5.5% * $7,500,000

Income from capital = $412,500

RAROC = (Expected revenues - Interest expense - Operating cost - Expected Loss + Income from capital) / Economic capital

RAROC = ($10,000,000 - $5,500,000 - $1,500,000 - $1,000,000 + $412,500) / $7,500,000

RAROC = 32.167% or 32.2%