RAROC

Risk Adjusted Return On Capital

By:-
Inderjit Singh
&
Pardeep Kumar
RAROC (Risk Adjusted Return On Capital) is a
measure of profitability and performance
RAROC = Risk Adjusted return / Risk Adjusted
Capital
RAROC is a method for measuring risk-based
profitability that also enables a consistent
comparison of the risky financial returns of
projects or investments. It is usually defined as
the ratio of risk-adjusted return to the
economic capital.
Ratios helps in decisions on the value of
investments or projects and to create long-
term strategies that bear risk in mind.
Risk Adjusted Return = Revenues –Expenses –
Expected Losses + Revenue on ECAP +/-
Transfer Values/Prices
Risk Adjusted Capital = Capital to cover worst-
case loss (minus expected losses) to a required
confidence threshold for credit, market, and
operational risks
 Advantages

These ratios allow for the incorporation of

market risk, credit risk, and operational risk
within a simple comprehensive framework
that shows the interrelationships between
different sorts of risk and scenarios where
there might be a too-high concentration of
risks.
 Disadvantages

These ratios cannot cover systemic risks,

which still need to be calculated separately.
 Question
A bank that has a corporate loan portfolio of $1 billion that
has a return of 9%. The bank has an operating direct cost of
$9 million per annum, and an effective tax rate of 30%.
The portfolio is funded by $1 billion of retail deposits with an
interest charge of 6%.
Unexpected losses associated with the portfolio is such that
economic capital is set at $75 million (i.e., 7.5% of the loan
amount) against the portfolio (invested in risk-free securities)
and the risk-free interest rate on government securities is 7%.
The expected loss on this portfolio is assumed to be 1% per
annum (i.e., $10 million).