Your team is creating a small consulting firm to help small regional banks implement risk-adjusted return on capital (RAROC) initiatives. Your first assignment is coming from a motor financing institution, located in a large emerging market of the ASEAN region. Your job is to develop an automated report on the lender's RAROC and to present it to the Board on a quarterly basis. 

You are being provided the following information by the accounting department:

$2b principal exposure amount

7% pre-tax actual income margin on exposure portfolio gross of interest expenses

Exposure funded by deposits with interest rate paid of 4% and no transfer pricing issues

Operating costs of $30m

Expected loss (EL) of 0.5% on exposure

Unexpected loss (UL) of 6% on principal exposure

Risk-free rate on government securities of 0.4%

35% effective tax rate

(b) Compute the required capital of the firm and explain the type(s) of capital possibly taken into account for RAROC.

(6 marks)

(c) Compute the actual profit of the firm net of tax before expected risk costs.

(4 marks)

(d) Compute the actual RAROC of the firm and discuss whether the firm is value accretive.

(7 marks)

Answer rating: 100% (QA)

b To compute the required capital of the firm for RAROC we need to consider the capital required to cover both expected loss EL and unexpected loss UL ... View the full answer