Speaker A
Now we are seeing what is the risk-adjusted return on capital used for this particular portfolio of secured term loans.
Explains risk-adjusted return on capital (RAROC) for secured term loans and mortgage loans, highlighting its use in banking performance evaluation.
Key Takeaways
- RAROC provides a more accurate profitability measure by incorporating risk and capital consumption.
- Transfer charges represent internal cost of funds between deposit-generating and loan-originating branches.
- Provisioning for NPAs can be done via accounting standards or expected loss models involving PD, LGD, and exposure at default.
- Risk-weighted assets and capital requirements vary based on credit ratings and regulatory frameworks.
- RAROC enables banks to compare portfolios and make informed strategic decisions on resource allocation.
What the video covers
- The video explains the concept of risk-adjusted return on capital (RAROC) for a portfolio of secured term loans.
- It discusses total income, other income, expenditures, and transfer charges related to branch networks and cost of funds.
- The calculation of provisions for non-performing assets (NPAs) using accounting and expected loss approaches is covered.
- Risk-weighted assets and capital requirements are explained using Basel norms and internal/external rating approaches.
- The video compares accounting measures like net interest margin with risk-based measures such as RAROC.
- RAROC helps evaluate profitability by considering capital consumption and risk, especially for different credit ratings within a portfolio.
- It is useful for internal performance evaluation of portfolios, branches, products, and setting strategic goals.
- An example comparing mortgage loans and secured term loans illustrates differences in risk-adjusted returns.
- Mortgage loans show higher risk-adjusted returns (~9%) compared to secured term loans (~0.7%).
- RAROC is widely used internationally by banks for product and branch evaluation and strategic decision-making.
Chapters
- 00:00Introduction to risk-adjusted return on capital for secured term loans
- 00:51Explanation of transfer charges and cost of funds
- 03:36Provisioning for NPAs: accounting vs expected loss approach
- 04:23Capital requirements and risk-weighted assets
- 05:10Comparison of accounting vs risk-based profitability measures
- 05:56Impact of credit ratings on capital allocation and returns
- 07:20Using RAROC for internal performance evaluation and strategy
- 08:18Example: Mortgage loans vs secured term loans risk-adjusted returns
- 09:15Advantages and international use of RAROC framework
- 11:24Pricing differences and portfolio size considerations
Full Transcript — Download SRT & Markdown
Speaker A
So here we are looking at total interest income, total other income being generated. Other income is maybe processing charges and commitment charges, maybe any type of penalties being levied. So all this is the other income coming out of that particular asset.
Speaker A
And we know the total income, and we also know the total expenditure. The expenditure is other than the interest expenditure.
Speaker A
Then we have taken here transfer charge. What is this transfer charge? Exactly, it is something like cost of funds or it is cost of funds only.
Speaker A
In a branch network system, one or a couple of branches may be very good in generating or originating the advances or loans.
Speaker A
And a larger number of the branches are comfortable to generate the deposits. That means all branches do not have the advantage of both generating deposits as well as giving the loans.
Speaker A
So the deposit-generating branches are focusing on raising the funds, mobilizing the deposits.
Speaker A
Whereas the branches which are focusing on the advances will lend those deposits. That means the bank will transfer the deposits from the deposit-generating branch or centralized treasury branch to the branch which is providing the advances or originating the loans.
Speaker A
So, there is a transfer price between these two. That means the branch which is giving the advances is borrowing internally from the treasury branch.
Speaker A
So, they have to pay money for that. So, that is a cost of funds. So, we have the transfer charge.
Speaker A
And we know what is the operating profit, and we know the net NPA provision required for this one.
Speaker A
In calculating the NPA provision also for secured term loans, one can calculate based upon the accounting measures like how many assets have become substandard assets, and how many assets are doubtful assets, and accounting provision created for the secured term loan.
Speaker A
Or one can do it on the basis of the estimated or expected losses approach also.
Speaker A
Expected losses approach is for each type of loan, probability of default (PD), loss given default (LGD), and loan amount exposure at default is to be considered.
Speaker A
So, expected loss is a combination of these three things: PD, LGD, and exposure at default.
Speaker A
So, a provision can be calculated by using either the expected loss approach or standardized approach, and the bank knows how much provision is required for that particular secured term loan portfolio.
Speaker A
Then, what is the credit risk of the risk-weighted assets? Credit risk-weighted assets. Credit risk-weighted assets means each loan in that secured loan portfolio is carrying some risk weight. We have discussed the Basel approach of estimating that capital adequacy. Risk-weighted assets. Either it can be a standardized approach or currently many banks are following the internal ratings approach or external ratings approach, a combination of these two things. So the risk weights are assigned on the basis of the credit ratings or it can be on the basis of any other model also.
Speaker A
So we will be knowing what the risk-weighted assets are, and we also know how much capital is required for those risk-weighted assets. So the capital required for those assets is some 11,000 and odd capital is required.
Speaker A
So to have a portfolio of a particular value, what is the risk capital required is some 11,000 and above risk capital is required, and what is the rate of return the bank has generated on this portfolio.
Speaker A
That is what risk-adjusted return on capital is, and you will be surprised to see it is just 0.75%.
Speaker A
So this 0.75% is the rate of return generated on the risk-adjusted return on the capital. We call it risk-adjusted return. Although we know that the yield on advances is 7% and yield on net advances is this much, and after looking at the spread, net interest margin, and all that, one we have some net interest margin of some 1% is something there, but negative net interest margin could be there because of that transfer charge also.
Speaker A
So, all this is the accounting measure, whereas the risk capital measure, the risk-adjusted return on capital of this portfolio is this much.
Speaker A
So, what is the difference between these two things? There are so many accounting as well as risk-based measures. So, let me clarify these things.
Speaker A
What is the difference between these two approaches? In the risk-adjusted return on capital approach or any other risk-adjusted evaluation, we are considering what is the capital being consumed and what is the rate of return being earned on that particular capital amount.
Speaker A
So, within the loan portfolio, if there is a low-rated asset, suppose assume that a low-rated borrower, triple B rated borrower is there within the secured term loan.
Speaker A
So, this triple B rated borrower, the bank has to assign more capital to this borrower compared to a borrower with triple A rated or double A rated.
Speaker A
The loan amount may be the same or the loan amount is naturally different. Interest rate is based upon various types of factors; the interest rate is being fixed.
Speaker A
Normally, interest rate will also consider the credit risk associated with this particular loan. And as the bank is keeping more amount of the capital for this, the return on capital of such particular asset will be different compared to a low-risk asset of the same portfolio.
Speaker A
Or we are looking on the basis of the entire portfolio. So, we are looking at whatever the risk-weighted assets and risk capital given for that entire portfolio. If we want to compare this risk capital consumed by this portfolio versus another portfolio on the basis of the risk-adjusted parameters, which portfolio is contributing a lot to the bank's profitability will be known out of this risk-adjusted return on capital measures.
Speaker A
So, basically this risk-adjusted return on capital measure is useful for evaluating internally the performance of various portfolios or various verticals or various branches or various products.
Speaker A
So, at the granular level, the profitability can be measured by using this risk-adjusted return on capital performance evaluation measure. This will indicate this can be a suitable way for evaluating the branches, evaluating the products, and it would be helpful for the bank to set a strategy for the next couple of years.
Speaker A
So, this is about risk-adjusted return on capital. For the sake of clarity, I would like to give one more example of mortgage loans.
Speaker A
In the mortgage loans here, mortgage loans mean loans given against the property. Normally, these could be retail advances.
Speaker A
Retail advances mean individuals are borrowing. Not necessarily the amount-wise, the amount could be larger also in this.
Speaker A
So, individuals are borrowing. So, we are calculating what is the yield on advances, what is the net interest margin, and what is the status of the loans in terms of the risk, how many NPAs are there, and how much is the rate of return being generated by using the accounting information. Similarly, we can also use risk-based information and can see the profitability of this particular portfolio.
Speaker A
So, the mortgage loans are generating a risk-adjusted rate of return of 9% and above, whereas the secured term loans of the bank are giving a risk-adjusted rate of return of just 0.7%.
Speaker A
So, now the bank knows which portfolio is giving higher profitability on the risk capital being assigned to that particular portfolio.
Speaker A
So, this is the advantage of the risk-adjusted return on capital framework, RAROC or RoRAC. So, normally it depends upon the bank's choice which method they are using, and internationally several banks are also using this type of method and evaluating the products, evaluating the verticals, and if the branch network is there, even the branches can be evaluated. This is something like risk capital is known to each product, risk capital of each product is known well in advance.
Speaker A
And risk based upon the risk c
Speaker A
rate of return being generated by using the uh accounting information. Similarly, we can also use risk-based information and can see the profitability of this particular portfolio.
Speaker A
So, the mortgage loans are generating a risk-adjusted rate of return of 9% and above, whereas the secured term loans of the bank is giving a risk-adjusted rate of return of just 0.7%.
Speaker A
So, now the bank knows which portfolio is giving higher profitability on the risk capital being assigned to that particular portfolio.
Speaker A
So, this is the advantage of risk-adjusted return on capital framework, RAROC or RoRAC. So, normally depends upon the bank's choice which method they are using, and internationally several banks are also using this type of the methods and evaluating the products, evaluating
Speaker A
the verticals, and if the branch network is there, even the branches can be evaluated. This is something like risk capital is uh known to each product, risk capital of the each product is known well in advance.
Speaker A
And risk based upon the risk capital, how much rate of return the bank has generated by consuming the risk capital.
Speaker A
That means just uh two gross level of information is not sufficient enough to evaluate the performance. For example, a uh secured term loans, the size of the portfolio could be more compared to mortgage loans.
Speaker A
Or vice versa. One way of looking is uh how much of the volumes the bank has generated in terms of the mortgage loans versus uh secured term loans.
Speaker A
Second is uh what is the yield on advances generated by mortgage loans versus uh secured term loans.
Speaker A
So, mortgage loans may be priced at uh external benchmark lending rate and uh the rate of return could be different compared to the secured term loans, which may be priced on the basis of the uh marginal cost lending rate.
Speaker A
But when it comes to the capital being consumed by these two portfolios, because capital is uh very, very qualitative thing and a very rare thing, and raising of the capital is a challenging thing, as well as uh if the
Speaker A
huge amount of capital is raised, shareholders' return will be compromised, return on equity will come down. So, the banks are expected to use the capital very efficiently.
Topics:risk-adjusted return on capitalRAROCsecured term loansmortgage loansbanking risk managementrisk-weighted assetscapital adequacynon-performing assetscost of fundsbank portfolio evaluation
