Research Discussion Papers, Bank of Finland
No 25/2009:
Risk-adjusted measures of value creation in financial institutions
Alistair Milne ()
and Mario Onorato ()
Abstract: 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.
Keywords: 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; (follow links to similar papers)
JEL-Codes: G22; G31; (follow links to similar papers)
37 pages, November 2, 2009
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