Processing Risk-Weighted Capital

With increased competition, financial managers are recognizing the limitations of the traditional focus on asset growth, market share, or interest earnings per share—all of which ignore the inherent business risks and can be misleading performance indicators. The emphasis is shifting to risk adjusted return on capital (RAROC), which recognizes the importance of capital adequacy—too little capital could lead to a liquidity crisis (in the event of unexpected losses), and too much capital lowers the return on shareholders' equity.

To illustrate, let us assume that a mortgage has been on the books all month, the accrual factor is 30/360, and the loan amount is 100,000 USD. Use Risk-Weighted Capital to calculate normalized loss and allocate capital for the credit risk inherent in the loan:

Assume that the net interest margin on the loan is 158 USD and the funds transfer charge for allocated capital is 6 percent: