Risk-adjusted return: banking sector analysis through the RAROC model

Bank sector scenario in Brazil nowadays is facing increasingly competitiveness and credit loans expansion. Moreover, the resources are scarce and the decision to allocate capital to a product or another represents an important trade-off for managers, what reinforces using robust decision-making tools that consider risk to maximize returns. The aim of this work was to analyze the risk-adjusted return for the banking sector through the RAROC model based on three perspectives: Regulatory, Economic and Forecasted RAROC. The database was provided by a financial institution and contains data for the two core business products (Payroll-linked and Working Capital loans) as well as macroeconomic variables. This work contributes to the literature by proposing a new approach which enables to measure profitability stratified within the institution's portfolio and furthermore to project its values. Methodologically, a Value at Risk (VaR) model with Monte Carlo Simulations was used for the Economic RAROC, a Vector Autoregressive (VAR) model for Forecasting and a historical approach for the Regulatory RAROC. Through Regulatory RAROC an ex-post analysis, month by month, reveals that the Payroll-linked loans returned 8.13% on average with positive and superior average market values throughout the entire period, while Working Capital presented 4.03%, but a result that varied greatly with several negative returns. Furthermore, the Economic Capital calculated for Payroll-linked was substantially lower than the Regulatory while in Working Capital was the contrary, reinforcing that the first would present a much higher return as optimizing the allocated capital (from 6.87% to 45.75% in 2019M06), highlighting the relevance of an internal model. Finally, the Forecasting RAROC enables an ex-ante prospective decision and the results reveals that in a 12-month future scenario the Payroll-linked would return 9.31% in average while Working Capital would present 1.29%, confirming that the first product will continue to remunerate the invested capital properly while the second has a potential for return, however without measures that change the current projected scenario, the product does not present itself as a good capital investment. To conclude, the overall tests reveal that the models had a good performance and therefore bring innovative results that satisfactory contributes to a strategic management focused on risks.