Chapter 8 - Risk-Adjusted Performance Measurement

Abstract

A risk-adjusted performance (RAP) measure is a profitability measure that jointly takes into consideration the margin or profit produced by a business and its capital at risk (CaR). Perhaps the most well-known RAP measure is RAROC (risk-adjusted return on capital), which can generally be defined as the ratio between the profit and CaR for a given business area/unit. Another frequently used performance measure is Economic Value Added, EVA®, which is defined for banks as profit minus the cost of equity capital times capital at risk. Risk-adjusted performance (RAP) measurement is the key area in which VaR measures can provide a fundamental contribution to a bank's decision processes. A risk-adjusted performance measure is a profitability measure combining the profit produced by a business and its capital at risk. RAP measures can be built either to support top-management decisions concerning a business or as a target performance measure for the head of a business unit. This difference is important because while measures designed to support decisions should essentially be precise and theoretically correct, when a RAP measure is used as a performance target for an organizational unit, fairness is more relevant than precision, and the key issue is whether or not the target measure is able to produce desired behaviors. The first decision that one takes while building a RAP measure is whether the measure of capital at risk to be used in the RAP measure should be represented by allocated capital or utilized capital.