Risk-Adjusted Return on Capital (RAROC)
Risk-adjusted return on capital (RAROC) is a modified return on investment (ROI) figure that takes elements of risk into account. The formula used to calculate RAROC is:
Where:
Income from capital = (capital charges) x (risk-free rate)
Expected loss = average loss expected over a specified period of time
In financial analysis, projects and investments with greater risk levels must be evaluated differently; RAROC accounts for changes in an investment’s profile by discounting risky cash flows against less-risky cash flows.[1]
Evolution of RAROC
How did RAROC Evolve?[2]
Since most banks measure their efficiency through a RAROC model, it is important to understand its evolution. Arising out of economic theories from the 1970s, the formula optimizes the allocation of bank capital by determining an appropriate measure of risk-adjusted return. Banks, like any other business, seek to generate a superior risk adjusted return to their WACC (weighted average cost of capital). Generally, the cost of capital is around 10% and profit targets between 10% and 15%. To achieve this goal, the banks have the ability to adapt their selling prices, lower costs or change the allocation of capital, ie their commitments to a single prime contractor.
Risk-Adjusted Return on Capital (RAROC) Drivers
The Fundamental Drivers of RAROC[3]
There are two fundamental drivers of RAROC areas as follows:
- Risk Management
Commercial lending institutes such as banks acting as financial intermediaries that accept deposits from public and lend it out to borrowers. The borrowers, in turn, repay the amount borrowed along with an additional sum known as the interest. This interest is fixed by the bank in a way that it covers the cost of operations, the cost of sourcing funds, and the yield for the shareholders of the bank's equity. But the whole operation of borrowing and lending may not be running as smoothly as expected.
A bank may face external or internal fluctuations or disruptions in its daily operations which are known as risks. These risks could be related to macro (industry related) or micro (firm specific) factors in which the firm operates. A financial institution is exposed to operational, credit and market risks in its daily course of business.
- Operational risk is the risk which is not inherent in the business. It relates to human error, fraud, or breakdown of systems and processes.
- Credit risks primarily arise from the risk of default of borrowers when the borrower fails to make required payments back to the financial institution.
- Market risk is appears in forms of fluctuation in prices in the financial markets and the possibility for an investor to experience losses
- Performance Evaluation
Banks reward executive performances with bonuses and incentives, but evaluating performances becomes challenging. RAROC plays an important role by measuring performances against the amount of risk undertaken via the business unit under the particular executive. Even though this is practiced by some banks measuring the performance of a business unit through profit may not truly indicate positive changes in the value of the overall business of the institution.
One of the ways in which RAROC directly simplifies the performance evaluation process is by incorporating risks and pricing the products of the business units. Thus RAROC can profile risk based business units which in turn help to ascertain the risk exposure of the business as a whole.
See Also
Assessment of Risk
Framework for Risk Assessment
Risk Based Testing
Risk IT Framework
Risk Management
Risk Management Framework (RMF)
Risk Matrix
Risk Maturity
Risk Maturity Model (RMM)
Compliance
Corporate Governance of Information Technology (IT Governance)
Key Risk Indicator (KRI)
Business Continuity
Business Continuity Planning (BCP)
Disaster Recovery Planning
Enterprise Risk Management (ERM)
Crisis Management
Risk Analysis
Risk Mitigation
Risk-Adjusted Return
Own Risk and Solvency Assessment (ORSA)
References