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Pitfalls in the application of RAROC in loan management

Author: Dermine, Jean INSEAD Area: FinanceIn: Arbitrageur, vol. 1, no. 1, 1998 Language: EnglishDescription: p. 21-27.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: This article discusses five pitfalls commonly encountered in the application of risk-adjusted return on capital techniques (RAROC) to loan management: the use of a single hurdle rate, the timing of loan provisions, the duration of funding, the time horizon for equity allocation, and the under-identified fenefits of portfolio diversification. Without explicit recognition of these issues by senior bank management, the application of RAROC to risk-adjusted performance measurement can produce misleading information
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This article discusses five pitfalls commonly encountered in the application of risk-adjusted return on capital techniques (RAROC) to loan management: the use of a single hurdle rate, the timing of loan provisions, the duration of funding, the time horizon for equity allocation, and the under-identified fenefits of portfolio diversification. Without explicit recognition of these issues by senior bank management, the application of RAROC to risk-adjusted performance measurement can produce misleading information

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