Risk adjusted return on capital

What Is Risk adjusted return on capital?

Risk adjusted return on capital (RAROC) is a financial performance metric that assesses the profitability of a venture or business unit relative to the risk taken. It is a core concept within financial risk management, particularly used in the banking and financial services industries to evaluate the return on capital while explicitly accounting for risk. By adjusting returns for risk, RAROC provides a standardized measure that allows for a more equitable comparison of diverse activities, projects, or business lines, facilitating informed capital allocation decisions. The underlying principle of Risk adjusted return on capital is that higher risks should necessitate higher returns to justify the economic capital held against those risks.

History and Origin

The concept of Risk adjusted return on capital emerged in the late 1970s at Bankers Trust, an American commercial bank. As financial markets grew increasingly complex, particularly with the rise of derivatives, traditional performance measures proved insufficient for comprehensively analyzing risk and return. Bankers Trust pioneered RAROC as a method to develop a consistent framework for comparing the profitability of transactions, business sections, or entire businesses in relation to the capital at risk. This innovation marked a significant advancement in how financial institutions approached risk management and profit analysis, evolving into an industry standard.⁹ The methodology was designed to measure the anticipated profit from an investment, adjust it for the risk involved, and then compare this risk-adjusted return to the capital invested.⁷, ⁸

Key Takeaways

Risk adjusted return on capital (RAROC) evaluates profitability in relation to the underlying risk taken, providing a risk-adjusted view of performance.
It is widely used in financial institutions for strategic decision-making, including pricing, performance measurement, and capital allocation.
RAROC helps ensure that a business unit or project generates sufficient returns to compensate for the economic capital it consumes due to its risk profile.
A higher RAROC generally indicates a more efficient use of capital for a given level of risk, or a better return for the risk incurred.
Its calculation relies on accurate assessment of risk components, including expected loss and unexpected loss.

Formula and Calculation

The basic formula for Risk adjusted return on capital is:

\text{RAROC} = \frac{\text{Risk-Adjusted Income}}{\text{Economic Capital}}

Where:

Risk-Adjusted Income: Represents the revenue generated by an activity minus all associated costs, including operating expenses, funding costs, and expected loss. It reflects the net profit after accounting for the statistically anticipated losses.
Economic Capital: The amount of capital a firm needs to absorb potential unexpected losses from its activities over a specific time horizon and at a certain confidence level. This is often calculated using methodologies like Value at Risk (VaR) or similar risk models that quantify potential losses from various risks such as credit risk, market risk, and operational risk.

Interpreting the Risk adjusted return on capital

Interpreting the Risk adjusted return on capital involves comparing the calculated ratio against a predetermined hurdle rate or the firm's overall cost of capital. A project or business unit is generally considered viable if its RAROC exceeds this hurdle rate, indicating that the returns generated adequately compensate for the inherent risk. Conversely, a RAROC below the hurdle rate suggests that the activity is not creating sufficient value relative to the risk undertaken, or it may not be meeting the firm's desired profitability thresholds.

For financial institutions, RAROC also provides insight into how well individual business lines align with the firm's overarching risk appetite. A consistent analysis of RAROC across different portfolios helps managers identify areas of strong performance or, conversely, areas where risk-adjusted returns are suboptimal, prompting adjustments in strategy or resource allocation.

Hypothetical Example

Consider a commercial bank evaluating two potential loan portfolios, Portfolio A and Portfolio B.

Portfolio A:

Expected Revenue: $1,000,000
Operating Costs + Funding Costs: $200,000
Expected Loss: $50,000
Economic Capital Required (due to credit risk and other factors): $5,000,000

Risk-Adjusted Income (Portfolio A) = $1,000,000 - $200,000 - $50,000 = $750,000
RAROC (Portfolio A) = $750,000 / $5,000,000 = 0.15 or 15%

Portfolio B:

Expected Revenue: $1,200,000
Operating Costs + Funding Costs: $250,000
Expected Loss: $80,000
Economic Capital Required (due to higher risk): $8,000,000

Risk-Adjusted Income (Portfolio B) = $1,200,000 - $250,000 - $80,000 = $870,000
RAROC (Portfolio B) = $870,000 / $8,000,000 = 0.10875 or 10.875%

In this example, while Portfolio B generates a higher absolute risk-adjusted income ($870,000 vs. $750,000), Portfolio A has a higher Risk adjusted return on capital (15% vs. 10.875%). This suggests that Portfolio A is more efficient at generating returns relative to the capital adequacy it requires to absorb potential losses. If the bank's hurdle rate is, say, 12%, Portfolio A would be considered desirable, while Portfolio B might not meet the minimum risk-adjusted return expectations. This analysis helps the bank make informed capital budgeting decisions.

Practical Applications

Risk adjusted return on capital is a versatile tool with numerous practical applications across the financial industry:

Performance Measurement: Banks and other financial institutions use RAROC to evaluate the performance of individual business units, product lines, or client relationships. This allows management to compare different activities on a consistent, risk-adjusted basis.
Pricing Decisions: RAROC informs the pricing of financial products, especially loans and derivatives. Lenders can adjust interest rates and fees to ensure that the expected return from a loan adequately compensates for the associated credit risk and the economic capital required.
Capital Allocation: By providing a standardized metric for risk-adjusted performance, RAROC guides strategic capital allocation. Firms can prioritize investments in areas that offer the highest RAROC, optimizing the deployment of their limited capital resources across various ventures or departments.
Risk Management: RAROC is integral to robust risk management frameworks, helping institutions align their risk-taking with their strategic objectives and risk appetite. It encourages a focus on efficient risk-taking rather than simply maximizing nominal returns.
Regulatory Capital Alignment: While distinct from regulatory capital requirements like those under Basel III, the principles of RAROC often inform how banks internally manage and allocate capital to meet or exceed supervisory expectations. Regulators, such as the Federal Reserve, emphasize the importance of banks' internal capital adequacy assessments and robust risk management frameworks that consider various risk factors.⁶ The Basel III framework, in particular, has introduced extensive changes to the calculation of risk-weighted assets (RWA), further compelling banks to reconsider their capital allocation strategies in light of regulatory capital costs.⁵

Limitations and Criticisms

Despite its widespread adoption, Risk adjusted return on capital (RAROC) has several limitations and criticisms:

Data Quality and Model Assumptions: Accurate RAROC calculations are highly dependent on the quality and availability of underlying data, particularly for quantifying various types of risk. Inconsistent or incomplete data can lead to skewed results. Furthermore, the models used to estimate economic capital and potential losses, such as Value at Risk (VaR), rely on specific assumptions that might not fully capture extreme market events or "tail risks," potentially leading to an underestimation of true risk.⁴
Subjectivity in Risk Quantification: Quantifying certain risks, especially operational risk or reputational risk, can be subjective and challenging. These risks are often difficult to assign a precise numerical value, which can introduce biases and uncertainties into the RAROC calculation.³
Reliance on Historical Data: RAROC calculations frequently rely on historical data to estimate potential losses. However, the dynamic nature of financial markets and evolving risks means that historical data may not always be a reliable indicator of future losses, potentially making historical-based estimates less accurate over time.²
Limited Scope for Non-Financial Risks: RAROC primarily focuses on quantifiable financial risks, such as credit risk and market risk. It may not comprehensively capture non-financial risks that can significantly impact an organization's overall performance, leading to an incomplete risk profile.¹
Complexity: Implementing and maintaining a robust RAROC framework requires significant investment in data infrastructure, sophisticated risk modeling capabilities, and specialized expertise, which can be costly and complex for some institutions.

Risk adjusted return on capital vs. Return on Capital

While both Risk adjusted return on capital (RAROC) and Return on Capital (ROC) are metrics used to assess performance relative to capital, they differ crucially in their treatment of risk. Return on Capital (ROC) measures the profitability of a business or project as a percentage of the total capital employed, without explicitly adjusting for the level of risk associated with that capital. It provides a straightforward view of how efficiently capital generates profit.

In contrast, Risk adjusted return on capital (RAROC) explicitly incorporates the concept of risk into the return calculation. It adjusts the income generated by an activity for its expected losses and then relates this risk-adjusted income to the amount of economic capital required to support the associated unexpected losses. This fundamental difference means that RAROC allows for a more meaningful comparison of diverse activities with varying risk profiles, as it penalizes activities that consume more capital due to higher risk, even if they show strong nominal returns. ROC, on the other hand, might lead to misinformed decisions by failing to differentiate between a high return generated from a highly risky venture and a similar return from a low-risk one.

FAQs

What is the main purpose of Risk adjusted return on capital?

The main purpose of Risk adjusted return on capital is to provide a standardized metric for evaluating the profitability of different business activities, projects, or client relationships by taking into account the level of risk associated with them. It helps financial institutions make more informed decisions about capital allocation and risk-taking.

How does economic capital relate to RAROC?

Economic capital is the denominator in the RAROC formula. It represents the amount of capital a firm believes it needs to hold to cover potential unexpected losses at a specified confidence level. By linking returns to the economic capital consumed by risk, RAROC incentivizes efficient use of capital and better risk management.

Is RAROC used outside of banking?

While RAROC originated in the banking sector and is most commonly associated with it, its principles can be applied to other industries that need to allocate capital and manage risk, such as insurance, asset management, and even some large corporations when evaluating major investment projects or strategic initiatives. The core idea of evaluating return against the risk-based capital required is broadly applicable.

Does a higher RAROC always mean a better investment?

Generally, a higher RAROC indicates a more efficient use of capital relative to the risk taken. However, it's essential to consider it alongside other financial metrics and the firm's overall risk appetite and strategic objectives. A very high RAROC might sometimes stem from an underestimation of risk or an overly optimistic projection of returns.