Pricing Mechanism for Inventory Finance Business under the RAROC Criterion

Abstract

Risk Adjusted Return On Capital (RAROC) is a loan-pricing criterion that has become increasingly prevalent in the banking industry since the 1990s. Under RAROC, a bank sets the loan term such that a certain rate of return is achieved on the regulatory capital required by the Basel capital regulation. The amount of regulatory capital for each loan is calculated either under the standardized approach (standardized banks, the regulatory capital equals to a fixed proportion of the loan amount) or the internal rating-based (IRB) approach (IRB banks, the regulatory capital is related to the Value-at-Risk (VaR) of the loan). Using a model in which the bank first sets the loan terms and the newsvendor-type retailer then decides the order quantity and the borrowing amount, this paper quantifies the impact of the adoption of the RAROC criterion and the specific approach used to calculate regulatory capital on the bank's loan-pricing decision and the retailer's inventory decision. We find that among the loan terms that satisfy the bank's RAROC criterion, the one that benefits the retailer the most requires the bank to specify an inventory advance rate in addition to the interest rate. Under this Pareto dominant loan term, the retailer's inventory level decreases with the bank's cost of capital and regulatory capital adequacy ratio. Further, the order quantity is more sensitive to his asset level when facing an IRB bank compared to a standardized bank. For the retailer with high (low) initial asset, the retailer's profit and inventory level are higher under the IRB (standardized) loan. For the retailer with medium initial asset, an IRB loan leads to a higher retailer profit but a lower consumer welfare due to a lower inventory level. When the interest rate that the bank can charge is capped by regulation, retailers borrowing from a standardized bank are more likely to be influenced by the interest rate cap than those borrowing from an IRB bank. Under strong empire-building incentives, e.g., the bank will offer loan terms to maximize the size of the loan instead of the retailer's profit, while low-risk retailers still prefer IRB loans, retailers with medium initial asset level shift their preference from IRB banks to standardized banks.