2009
25/2009
Risk-adjusted measures of value creation in financial institutions
Author(s): Alistair Milne – Mario Onorato
2009. 37 pages.
Publisher: Bank of Finand
ISBN 978-952-462-538-8 (Printed publication)
ISBN 978-952-462-539-5 (Web publication)
Search words: 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, G22, G31, Alistair Milne, Mario Onorato
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.