RAROC Based Capital Budgeting and Performance Evaluation: A Case Study of Bank Capital Allocation

This paper describes the RAROC system developed at Bank of America (B of A) in order to examine how risk-based capital allocation models work. I begin by discussing the economic rational for allocating capital in a diversified organization like the B of A. Drawing on recent work by Froot and Stein (1995) and Stein (1996), I argue that the capital budgeting process used by the B of A resembles the operation of an internal capital market in which businesses are allocated capital with the objective of mitigating the costs of external financing. Viewing the capital budgeting process in this way is useful because it suggests that a businesses contribution to the overall variability of the cash flows of the bank will be an important factor in evaluating the risk of (and the capital allocated to) a specific business unit. In addition, since RAROC systems are used both for capital budgeting and management compensation, the measures of risk are designed to limit rent seeking and influence activities by division managers,<p> <p>Next, given the theoretical background, I provide a detailed look at how the RAROC capital allocation and performance evaluation system works at B of A. The primary objective of B of A's system is to assign equity capital to business units (and ultimately to individual credits) so each business unit has the same cost of equity capital. This process implies that investments in riskier projects or business units (measured by the projects contribution to the overall volatility of the market value of the bank) will be required to use less leverage than investments in less risky business units.<p> <p>This paper was presented at the Financial Institutions Center's October 1996 conference on "