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

Bernd Engelmann and Ha Pham

Risks, 2020, vol. 8, issue 2, 1-20

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.

Keywords: loan pricing; RAROC; loan origination (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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