A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 7.55 percent. The one-year loan interest rate is 8.00 percent and the bank must pay 7.40 percent to raise the funds. The cost to service the loan is 0.3 percent. If the loan defaults,92 percent of the money lent will be lost. Based on historical default rates,the extreme worst-case loss scenario is about 5 percent. Should the bank make the loan? Why or why not?

Question

Quizplus · Accepted Answer

The RAROC for the loan can be calculated as follows:
Expected Return = (8.00% - 7.40% - 0.3%) * (1 - 0.92) = 0.14%
Risk-Adjusted Return = Expected Return / 5% = 2.8%
RAROC = Risk-Adjusted Return + Benchmark Rate = 2.8% + 7.55% = 10.35%
Since the RAROC of 10.35% is less than the benchmark rate of 7.55%, the bank should not make the loan. Therefore, the correct choice is D.

A Bank Is Using the RAROC to Evaluate Large Business