AA/Aaa = 2 to 3 bps
AA/Aa = 3 to 10 bps
A = 10 to 24 bps
BBB/Baa = 24 to 58 bps
BB/Ba = 58 to 119 bps
Source: Moody’s KMV
How RAROC Works
A RAROC model is simply a return on equity (ROE) model in which the numerator (net income) and denominator (in this case, capital) have been adjusted for risk — a simplified example of which follows:
Bradley A. Hardy, senior vice president of corporate banking at Wells Fargo Bank N.A., explains that banks risk-adjust net income by deducting expected loss, calculated as loss given default (LGD) multiplied by default probability and by exposure amount. It’s the last of these that’s tough for corporate borrowers to determine: a simple term loan exposes the bank to a 100 percent loss, but what is a bank’s exposure to an undrawn line of credit? “Since each bank may calculate this differently, it’s worth trying to get a sense of how ‘friendly’ each bank’s model is to unfunded commitments,” Hardy suggests.
Likewise, while banks may be unlikely to share overhead costs with their clients, asking about them may give a company some sense of the profitability of a particular service.
The most complicated part of the RAROC equation, however, is the denominator. While the amount outstanding is usually obvious, and capital multipliers are easily understood (for example, a AA credit has a capital multiplier of about 7X), the unexpected loss percentage represents the real “black box” calculation that determines the amount of economic capital required. Measured as the standard deviation of expected losses, it is calculated as follows:
Several of these variables are impossible for corporate clients to figure out. For a term loan, for example, the variance in exposure amount equals one, but for just about any other financial product, it can be a tricky number for banks — let alone their clients — to calculate. Likewise, companies are unlikely to be able to deduce the variance of default probability — banks use a figure based on historical experience.
A company’s default probability, by contrast, is easier to determine, and can be a useful number to know. However, it can vary widely by bank, depending on whether the banks use credit ratings, Moody’s KMV ratings (see “Adjusting Credit Ratings,” above), internal models, or some combination of all three. “People are often surprised to see the difference between their public debt rating and their KMV score, and there are often very wide discrepancies,” observes Hardy. “Understanding how the banker views your credit can give some insight into the profitability decision the lender has to make.” —T.R.