Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/258016 
Year of Publication: 
2020
Citation: 
[Journal:] Risks [ISSN:] 2227-9091 [Volume:] 8 [Issue:] 2 [Article No.:] 63 [Publisher:] MDPI [Place:] Basel [Year:] 2020 [Pages:] 1-20
Publisher: 
MDPI, Basel
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.
Subjects: 
loan pricing
RAROC
loan origination
JEL: 
C69
C19
Persistent Identifier of the first edition: 
Creative Commons License: 
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Document Type: 
Article
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