What Is 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. In financial analysis, projects and
investments with greater risk levels must be evaluated differently; RAROC thus
accounts for changes in an investment’s profile by discounting risky cash flows
against less-risky cash flows.

Understanding Risk-Adjusted Return on Capital

Risk-adjusted return on capital is a useful tool in assessing potential acquisitions.
The general underlying assumption of RAROC is investments or projects with higher
levels of risk offer substantially higher returns. Companies that need to compare
two or more different projects or investments must keep this in mind.

RAROC and Bankers Trust

RAROC is also referred to as a profitability-measurement framework, based on risk,
that allows analysts to examine a company’s financial performance and establish a
steady view of profitability across business sectors and industries.

The RAROC metric was developed during the late 1970s by Bankers Trust, more
specifically Dan Borge, its principal designer. The tool grew in popularity through
the 1980s, serving as a newly developed adjustment to simple return on capital
(ROC). A commercial bank at the time, Bankers Trust adopted a business model
similar to that of an investment bank. Bankers Trust had unloaded its retail lending
and deposit businesses and dealt actively in exempt securities, with a derivative
business beginning to take root.

These wholesale activities facilitated the development of the RAROC model.

Nationwide publicity led a number of other banks to develop their own RAROC
systems. The banks gave their systems different names, essentially lingo used to
indicate the same type of metric. Other methods include return on risk-adjusted
capital (RORAC) and risk-adjusted return on risk-adjusted capital (RARORAC). The
most commonly used is still RAROC. Non-banking firms utilize RAROC as a metric for
the effect that operational, market and credit risk have on finances.

Return on Risk-Adjusted Capital

Not to be confused with RAROC, the return on risk-adjusted capital (RORAC) is used
in financial analysis to calculate a rate of return, where projects and investments
with higher levels of risk are evaluated based on the amount of capital at risk. More
and more, companies are using RORAC as a greater amount of emphasis is placed on
risk management throughout a company. The calculation for this metric is similar to
RAROC, with the major difference being capital is adjusted for risk with RAROC
instead of the rate of return.

What Is Return on Risk-Adjusted Capital (RORAC)?

The return on risk-adjusted capital (RORAC) is a rate of return measure commonly
used in financial analysis, where various projects, endeavors, and investments are
evaluated based on capital at risk. Projects with different risk profiles are easier to
compare with each other once their individual RORAC values have been calculated.

The RORAC is similar to return on equity (ROE), except the denominator is adjusted
to account for the risk of a project.
What Does Return on Risk-Adjusted Capital Tell You?
Return on risk-adjusted capital (RORAC) takes into account the capital at risk,
whether it be related to a project or company division. Allocated risk capital is the
firm's capital, adjusted for a maximum potential loss based on estimated future
earnings distributions or the volatility of earnings.

Companies use RORAC to place greater emphasis on firm-wide risk management. For
example, different corporate divisions with unique managers can use RORAC to
quantify and maintain acceptable risk-exposure levels.

This calculation is similar to risk-adjusted return on capital (RAROC). With RORAC,

however, the capital is adjusted for risk, not the rate of return. RORAC is used when
the risk varies depending on the capital asset being analyzed.

Example of How to Use RORAC

Assume a firm is evaluating two projects it has engaged in over the previous year
and needs to decide which one to eliminate. Project A had total revenues of
$100,000 and total expenses of $50,000. The total risk-weighted assets involved in
the project is $400,000.

Project B had total revenues of $200,000 and total expenses of $100,000. The total
risk-weighted assets involved in Project B is $900,000. The RORAC of the two
projects is calculated as:

Even though Project B had twice as much revenue as Project A, once the risk-
weighted capital of each project is taken into account, it is clear that Project A has
a better RORAC.

The Difference Between RORAC and RAROC

RORAC is similar to, and easily confused with, two other statistics. Risk-adjusted
return on capital (RAROC) is usually defined as the ratio of risk-adjusted return to
economic capital. In this calculation, instead of adjusting the risk of the capital
itself, it is the risk of the return that is quantified and measured. Often, the
expected return of a project is divided by value at risk (VaR) to arrive at RAROC.
Another statistic similar to RORAC is the risk-adjusted return on risk-adjusted capital
(RARORAC). This statistic is calculated by taking the risk-adjusted return and
dividing it by economic capital, adjusting for diversification benefits. It uses
guidelines defined by the international risk standards covered in Basel III—which is
a set for reforms that are to be implemented by Jan. 1, 2022, and is meant to
improve the regulation, supervision, and risk management within the banking sector.