Risk-Adjusted Return on Capital (RAROC) is a risk-based profitability measurement framework for analyzing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust and principal designer Dan Borge in the late 1970s. Note, however, that more and more return on risk adjusted capital (RORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel III.
It is a tool for measuring risk-adjusted financial performance. And it provides a uniform view of profitability across businesses (Strategic Business Units / divisions). RAROC and related concepts such as RORAC and RARORAC are mainly used within (business lines of) banks and insurance companies. RAROC is defined as the ratio of risk-adjusted return to economic capital.
RAROC = (Expected Return)/(Economic Capital)
RAROC = (Expected Return)/(Value at risk)
History of RAROC
Development of the RAROC methodology began in the late 1970s, initiated by a group at Bankers Trust. Their original idea was to measure the risk of the bank’s credit portfolio, as well as the amount of equity capital necessary to limit the exposure of the bank’s depositors and other debt holders to a specified probability of loss. Since then, a number of other large banks have developed RAROC (or RAROC look-alike systems). Their aim is in most cases to quantify the amount of equity capital, necessary to support all of their operating activities. Fee-based and trading activities, as well as traditional lending.
RAROC systems allocate capital for two basic reasons: (1) risk management and (2) performance evaluation. For risk-management purposes, the main goal of allocating capital to individual business units is to determine the bank’s optimal capital structure. This process involves estimating how much the risk (volatility) of each business unit contributes to the total risk of the bank and, hence, to the bank’s overall capital requirements. For performance-evaluation purposes, RAROC systems assign capital to business units. As part of a process of determining the risk-adjusted rate of return and, ultimately, the economic value added of each business unit. The economic value added of each business unit, defined in detail below, is simply the unit’s adjusted net income less a capital charge (the amount of equity capital allocated to the unit times the required return on equity). The objective in this case is to measure a business unit’s contribution to shareholder value. And, thus, to provide a basis for effective Capital budgeting and incentive compensation at the Business Unit level.
Economic Capital and three types of Risk
Economic capital is attributed on the basis of three risk factors:
- Market risk,
- Credit risk and
- Operational risk.
Economic capital methodologies can be applied across products, clients, lines of business and other segmentations. As required to measure certain types of performance. The resulting capital attributed to each business line provides the financial framework to understand and evaluate sustainable performance and to actively manage the composition of the business portfolio. This enables a financial company to increase shareholder value, by reallocating capital to those businesses that provide high strategic value and sustainable returns, or with long-term growth and profitability potential.
Economic profit elaborates on RAROC by incorporating the cost of equity capital. This is based on the market required rate of return from holding a company’s equity instruments, to assess whether shareholder wealth is being created. Economic profit measures the return which is generated by each business line in excess of the cost of equity capital. Shareholder wealth is increased if capital can be employed at a return in excess of the bank’s cost of equity capital. Similarly, when returns do not exceed the cost of equity capital, then shareholder wealth is diminished and a more effective deployment of that capital should be sought.
The Value of Risk Management
Efficient Risk Management can constitute value in the following dimensions (more or less in order of significance):
Compliance and Prevention
- Avoid crises in own organization.
- Avoid crises in other organizations.
- Comply with corporate governance standards.
- Avoid personal liability of managers.
- Understand full range of risk facing the organization.
- Evaluate business strategy risks.
- Achieve best practices.
- Protection of Corporate Reputation.
Shareholder Value Enhancement
- Enhance capital allocation.
- Improve returns through Value Based Management.
Proactive Risk Management
Proactive Risk Management evaluates:
- The probability of risk occurring,
- Risk event drivers,
- Risk events,
- The probability of impact,
- Impact drivers, prior to the risk actually taking place (figure: Proactive Risk Management – Smith and Merritt).
Source: John B. Caouette, Edward I. Altman – Managing Credit Risk
Source: Carol Alexander – Operational Risk: Regulation, Analysis and Management
Source: Michael K. Ong – The Basel Handbook: A Guide for Financial Practitioners
Source: Donald R. van Deventer, Kenji Imai – Credit Risk Models and the Basel Accords (Wiley Finance)Business frameworks like RAROC are invaluable to evaluating and analyzing various business problems. You can download business frameworks developed by management consultants and other business professionals at Flevy here.