Credit risk and RAROC

This banking example shows how to measure profitability for a commercial bank portfolio of credit assets. In the credit business, losses of interest and principal occur all the time - there are always some borrowers that default on their obligations. The losses that are actually experienced in a particular year vary from year to year, depending on the number and severity of default events.

Using a Basel II-based approach we propose a Loss-Given-Default type of model inserting Monte Carlo simulation in order to incorporate probabilities that allow calculation of unexpected losses.