The Risk-Reward Tradeoff

The relationship between risk and reward is complex and forms the basis of investment and risk management decisions. The relationship between risk and reward is often summarized in the principle of the risk-reward tradeoff. This principle states that higher potential rewards are typically associated with higher levels of risk.

Striking the right balance between potential gains and potential losses is at the heart of investment decisions. Also, acknowledging and mitigating conflicts of interest is crucial to ensure unbiased and sound risk assessments.

Risk Adjusted Return On Capital (RAROC)

A bank can incorporate both expected and unexpected costs using the Risk-Adjusted Return on Capital (RAROC) metric. The formula for RAROC is given below:

$$ \text{RAROC} = \frac{\text{Reward}}{\text{Risk}} $$

Here, “Reward” is defined as the After-Tax Risk-Adjusted Expected Return, and “Risk” is the economic capital. Accordingly,

$$ \text{RAROC} = \frac{\text{After-Tax Risk-Adjusted Expected Return}}{\text{Economic Capital}} $$

If the RAROC exceeds the cost of equity capital, the portfolio is considered as valuable to investors. The cost of equity capital is the minimum return required by shareholders to compensate for the risk. The concept of RAROC is widely used beyond the banking industry.

Impact of Conflicts of Interest

Conflicts of interest can introduce biases and distortions in risk management decisions. When individuals or entities have competing interests that may compromise objectivity, the integrity of risk assessments can be undermined. Conflicts of interest can lead to misaligned incentives and cloud the evaluation of risks and potential rewards.

For example, conflicts of interest can arise in the lending industry when employees are incentivized to approve risky loans due to personal gain, even when the loans may not meet adequate risk standards. This can result in an increased exposure to credit risk.