# 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.

source: Redbridge DTA

## Components of RAROC

• Revenues – Expenses – Expected Losses + Revenue on ECAP +/- Transfer Values/Prices
• Capital to cover worst-case loss (minus expected losses) to a required confidence threshold (RaboBank’s AAA rating) for credit, market, and operational risks

## Risk-Adjusted Return on Capital (RAROC) Drivers

The Fundamental Drivers of RAROC[3]
There are two fundamental drivers of RAROC areas as follows:

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

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.

## Optimizing RAROC

The Goal is to Optimize RAROC[4]

• RAROC is a ratio that needs to be optimized (the bigger the better), and the way to make a ratio larger it to either make the numerator bigger or the denominator smaller
• With RAROC there are more variables to play with and the interactions are more complex
• Most experienced business managers understand the numerator of the RAROC ratio and know how to make it bigger
• Economic capital, ECAP, is more of a mystery
• Increases in risk adjusted returns (the numerator) may increase the amount of capital (denominator) offsetting the increase in the returns – actually lowering the RAROC

Next Steps

• Optimizing RAROC means not only adding assets (leases) and/or lowering expenses to a portfolio
• It means finding ways to add assets and/or lower expenses in ways that keep the level of capital attracted by those actions level or, even better, lower
• A portfolio of risky assets (leases) is said to be more diverse when the default correlation is low
• A diversified portfolio is a major key to raising RAROC
• Ready to being thinking about Stakeholder Management|Stakeholder Value Management (SVM)]] using RAROC as the tool to measure incremental value under SVM initiatives