RISK ADJUSTED
RAROC
RETURN ON CAPITAL
CONTENT
Economic Capital
Components of Economic Capital
Loss Distributions
Commonly used Loss distribution models
Risk-Adjusted Return on Capital (RAROC)
RAROC Calculation and Interpretation
ECONOMIC CAPITAL
Economic Capital is the amount of capital that a financial institution needs to hold to
cover potential unexpected losses and remain solvent, considering its risk profile.
COMPONENTS OF ECONOMIC CAPITAL
Credit Risk: Capital held to cover losses from counterparty defaults or credit
downgrades. It involves assessing the probability of default and loss given default.
Market Risk: Capital set aside to protect against adverse changes in market factors, such
as interest rates, foreign exchange rates, and stock prices.
Operational Risk: Capital to cover losses arising from failures in processes, systems,
people, or external events.
Liquidity Risk: Capital needed to ensure the institution can meet short-term obligations
without substantial losses.
Other Risks: This may include risks such as business risk or model risk that may require
additional capital.
LOSS DISTRIBUTIONS
Loss distributions are statistical models that represent the range of
potential losses a firm might face.
They are essential for estimating economic capital because they
help define the tail risk (or worst-case scenarios) that economic
capital is designed to cover.
COMMONLY USED LOSS
DISTRIBUTION MODELS
Normal Distribution: Often used for small, frequent losses but not ideal
for large, infrequent losses.
Fat-Tailed Distributions (e.g., Pareto, Cauchy): Capture the higher
likelihood of extreme losses compared to the normal distribution, which
is crucial in risk management.
VaR (Value at Risk) and CVaR (Conditional Value at Risk): These are
metrics based on the loss distribution that provide thresholds for
economic capital by quantifying potential losses over a specific time
period and confidence level.
RISK-ADJUSTED RETURN ON CAPITAL (RAROC)
RAROC is a metric that measures the profitability of an investment or portfolio
adjusted for the risk taken. It is calculated as:
RAROC=(Expected Return−Expected Loss)/ Economic Capital
RAROC=(Revenues - Costs- Expected Losses)/Economic Capital)
Revenues: Interest and transaction-related fees
Expected Losses: The predicted loss of the business based on industry averages
over a period of time
Economic Capital: An institution's own capital estimate of the amount it needs to
remain solvent and maintain its day-to-day operations
RAROC APPLICATION IN
BANKS
RAROC helps financial institutions determine if the return
from an investment or activity justifies the economic capital
allocated to cover its associated risks.
Banks typically target RAROC percentages of 12–15%, but
this can vary across industries and firms.
RAROC can be used for a number of purposes, including:
Measuring solvency, Evaluating the performance of different
business activities, Addressing capital allocation, and
Assessing the profitability of a loan portfolio.
RAROC EXAMPLE
Suppose a bank is evaluating a loan with the following characteristics:
Expected Return: $1,200,000 (This includes interest income and
other fees from the loan)
Expected Loss: $300,000 (This is based on the probability of default
and loss given default)
Economic Capital: $4,000,000 (The amount of capital the bank
allocates to cover potential unexpected losses from this loan)
RAROC CALCULATION
RAROC=Expected Return−Expected Loss/ Economic Capital
1. Adjusted Return:
Adjusted Return=Expected Return−Expected Loss
Adjusted Return=1,200,000−300,000=900,000
2. Calculate RAROC:
RAROC=900,000/4,000,000 =0.225 or 22.5%
INTERPRETATION
• The RAROC for this loan is 22.5%. This figure can then be compared to the
bank's target return threshold (often called the hurdle rate) to determine if
the loan is profitable enough, given the risk.
• If the bank’s hurdle rate is, for example, 15%, a RAROC of 22.5% would
indicate that this loan exceeds the required return on a risk-adjusted basis,
making it a worthwhile investment.
RAROC USES
RAROC can be used to compare investments and loans with
different risk profiles. It can also be used to evaluate the
performance of individual branches and regions, and to set return
targets.
RAROC vs EVA
EVA (Economic Value Addition) is the difference between RAROC
and the hurdle rate, which is the opportunity cost of taking risk in a
business.
Difference between RAROC and RORAC
The main difference between RAROC and RORAC is the component that is
adjusted for risk: RAROC adjusts the return, while RORAC adjusts the capital.
RAROC
Stands for Risk-Adjusted Return on Capital.
It's a metric that measures profitability while taking risk into account.
RAROC adjusts both the return and the allocated capital for the risks involved.
It's used to compare the risk-based profitability of different investment
alternatives.
RORAC
Stands for Return on Risk-Adjusted Capital. It's a metric that calculates a rate of
return while taking risk into account.
RORAC adjusts the capital for risk, but doesn't adjust the return. It's commonly
used to evaluate projects or investments with a high risk element relative to the
capital required.
RORAC (RETURN ON RISK
ADJUSTED CAPITAL)
Determines the rate of return that the bank earns on the risk-adjusted
capital investments in its different products & offerings.
It’s the net income calculated as a percentage of the risk-weighted assets.
The risk weights are the percentage factors that adjust the credit risks of
different loan types and other assets of a bank to reflect the level of
risk/loss to the bank. Basel committee ‘Standardized approach’ prescribed
the risk weightage assigned to different assets. Generally, secured assets
(like mortgage loans secured by residential properties) have low-risk
weights than unsecured assets (like credit cards).
Formula:
RORAC = Net Income/Risk-weighted assets
(where Net Income = Total revenue – Total expenses)
