Risk-Adjusted Performance: Lessons from
the Financial Crisis

Abstract

The chain of mortgage and structured financing events that led to the financial crisis has left financial service companies grasping for answers as to how a systemic failure of nearly unprecedented magnitude could have occurred given all the technical advances and developments in managing risk that occurred over this period. At the center of these events was a systemic lack of risk-adjusted performance measurement employed by institutions responsible for originating, servicing, and securitizing mortgage loans. It is important for a firm to understand the correlations among products in the course of its portfolio allocation process even if it does not employ a formal optimization exercise. Risk-adjusted return on capital (RAROC) measures have been widely used by financial institutions since the late 1970s to compare both returns and risks among products in their portfolio allocation. Looking forward, banks should abandon simple ROE-based metrics in favor of various risk-adjusted return metrics such as RAROC. From an analytic perspective, this requires firms to invest in data and technologies allowing them to compute reliable estimates of economic capital.

TOPICS: Credit risk management, legal and regulatory issues for structured finance