Performance-Based Compensation in Banks: The Use of RAROC and Related Measures

Anja Guthoff and Frank R³ter
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Anja Guthoff: Institut f³r Kreditwesen, Universitõt M³nster, M³nster, Germany
Frank R³ter: LVM-Versicherungen, M³nster, Germany

Homo Oeconomicus, 2001, vol. 17, 489-513

Abstract: RAROC and other risk-adjusted profitability measures are used to measure the risk-adjusted return on banks' investments. The use of these measures in bank management is currently the focus of intensive discussion both in practice - where these measures were developed - and in academia. In this paper we analyze the incentives provided by linear, asymmetric payment functions which are based on risk-adjusted profitability measures. Besides those measures that are already being used in bank management, i.e., RORAC and RAROC, which are based on the value at risk, we also consider measures that are based on the standard deviation and the lower partial moment one. We show that even if appropriate measures of risk are used in the computation of risk-adjusted profitability, agents might be steered toward wrong investment decisions.

Date: 2001
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Persistent link: https://EconPapers.repec.org/RePEc:hom:homoec:v:17:y:2001:p:489-513

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