A Raroc Valuation Scheme for Loans and Its Application in Loan Origination

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ID: 113073
2020
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Abstract
In this article, a risk-adjusted return on capital (RAROC) valuation scheme for loans is derived. The critical assumption throughout the article is that no market information on a borrower’s credit quality like bond or CDS (Credit Default Swap) spreads is available. Therefore, market-based approaches are not applicable, and an alternative combining market and statistical information is needed. The valuation scheme aims to derive the individual cost components of a loan which facilitates the allocation to a bank’s operational units. After its introduction, a theoretical analysis of the scheme linking the level of interest rates and borrower default probabilities shows that a bank should only originate a loan, when the interest rate a borrower is willing to accept is inside the profitability range for this client. This range depends on a bank’s internal profitability target and is always a finite interval only or could even be empty if a borrower’s credit quality is too low. Aside from analyzing the theoretical properties of the scheme, we show how it can be directly applied in the daily loan origination process of a bank.
Reference Key
engelmann2020risksa Use this key to autocite in the manuscript while using SciMatic Manuscript Manager or Thesis Manager
Authors Bernd Engelmann;Ha Pham;Engelmann, Bernd;Pham, Ha;
Journal risks
Year 2020
DOI
10.3390/risks8020063
URL
https://www.mdpi.com/2227-9091/8/2/63/htm
Keywords
loan pricing raroc loan origination

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