RAROC was developed by Banker’s Trust in the late 1970s. It became famous later on and now being used extensively. RAROC is the pricing methodology which helps the Bank to appropriately price the exposure commensurate with the risk assumed and the economic capital at stake. Risk-Adjusted Return on Capital is a financial risk metric used to evaluate the profitability of an investment or business unit while accounting for the risk taken. If the RAROC exceeds the targeted ROE (Return on Equity), the exposure will be considered as worth taking. RAROC calculation takes into account the riskiness of the portfolio or instrument while calculating profitability.
Risk Capital and Economic Capital are the same and is being used interchangeably. Economic Capital is the amount of capital required by Bank to remain solvent and to maintain its day-to-day operations. ROE is the minimum required rate of return or target rate the Bank expect to receive on an instrument or Portfolio. It is called the Hurdle Rate. Thus, if
RAROC > Hurdle Rate. Adds value and Investment is worthy.
RAROC < Hurdle Rate. Destroys value and Investment is not worthy.
Risk Adjusted Return After Tax
RAROC % = Risk Adjusted Return After Tax /Economic Capital at Risk
where,
Risk Adjusted Return After Tax = [(Interest Income+ Fees + Other Income – Cost of Funds – Operating Expenses + Yield on Capital – Cost of Dividend) – (ECL/GP)]*[1-Tax Rate%]
Economic Capital at Risk = [ Credit Risk Capital + Ops Risk Capital + Counterparty Credit Risk Capital + CVA Capital Charge]
Cost of Funds = FTP + Liquidity Premium + Tenor Basis Charge
GP = General Provision
A higher RAROC indicates better risk-adjusted returns. Banks compare RAROC to their Hurdle Rate (minimum acceptable return) to decide whether an investment is worthwhile.
Advantages of RAROC
By providing a clear picture of risk-adjusted profitability, RAROC supports informed decision-making regarding investments, pricing, and resource allocation.
1. Risk Management – RAROC helps Banks and FIs assess and manage risk by aligning returns with the level of risk exposure, ensuring that high returns are not achieved by taking excessive risks.
2. Performance Evaluation- It serves as a key performance indicator (KPI) for evaluating the profitability of different investments and business units. Helps distinguish between businesses that generate high returns safely and those that take hidden and excessive risks. A trading desk with volatile returns may appear profitable, but RAROC reveals if the returns justify the risk.
3. Capital Allocation – RAROC assists in optimizing capital allocation by identifying investments that offer the best risk-adjusted returns.
4. Risk-Based Pricing – It can be used to ensures that loans, investments and products are priced appropriately to cover their risk (higher-risk loans must generate higher RAROC). Banks, Hedge Funds, Insurance all use RAROC regularly.
5. Guides M&A & Portfolio Decisions – Helps assess whether acquisitions or new ventures meet risk-adjusted return thresholds.
6. Meets Basel III & Stress Testing Requirements – Regulators require banks to hold capital based on risk. RAROC ensures profitability even after capital costs.
7. Economic Capital Optimization – Helps firms determine how much capital is needed to cover unexpected losses at a given confidence level.
8. Shareholder Value Enhancement – By focusing on RAROC, firms ensure that returns exceed the ROE, thereby increasing shareholder value.
9. Avoids Value Destruction – Prevents investments that seem profitable but destroy value when risk is considered.
Limitations of RAROC
RAROC is a crucial tool because it links risk, capital, and profitability, enabling smarter business decisions, regulatory compliance, and sustainable growth. Firms that effectively implement RAROC gain a competitive edge by avoiding hidden risks and maximizing risk-adjusted returns. However, it has several limitations as given below:
1. Model Dependency: Accuracy depends on risk measurement (VaR models may underestimate or unable to capture tail risks). Historical data may not be able to predict future risks accurately.
2. Data Quality Issues: Incomplete or inaccurate data can distort risk-adjusted returns. Moreover, small banks may lack the resources for sophisticated risk modeling. Requires Cross-Department coordination from Risk, Finance, IT and Business Units which could prove to be challenging.
3. Subjectivity in Adjustments: Different firms may calculate economic capital differently- using 99% vs. 99.9% confidence levels. Some banks reduce capital requirements due to portfolio diversification, but estimating these benefits is subjective.
4. Focus on Short-Term Performance: May miss Long-Term Investments. RAROC focuses on risk-adjusted returns in a given period, potentially undervaluing long-term strategic projects.
5. Procyclical Effects: During downturns, RAROC may give wrong indications. Banks may be forced to reduce lending due to higher perceived risk because of worsening economic conditions. Too much focus on RAROC could lead to overly conservative strategies, missing profitable opportunities.
6. Ignores Liquidity & Market Risks: Traditional RAROC models focus on credit and market risk but overlook funding liquidity risks. Moreover, Market Shocks & Tail Risks are not fully captured by VaR.
7. Conflict with Accounting Metrics: GAAP vs. Economic Profit Mismatch. Accounting profits may differ from risk-adjusted earnings, causing confusion in performance evaluation.
8. Regulatory vs. Economic Capital Differences: Basel III capital requirements may not align perfectly with internal RAROC models.
9. Gaming the System: Managers might manipulate risk models to improve RAROC artificially.
Mitigating the Limitations
To address these issues, firms can:
1. Combine RAROC with Stress Testing & Scenario Analysis to capture tail risks and Extreme Events.
2. Use multiple risk metrics like RORAC, ROE, Liquidity Ratios for a holistic view.
3.Regularly validate models and update risk parameters.
4. Align RAROC with long-term strategy by adjusting time horizons.
Real World Applications of RAROC
(a) JPMorgan Chase – uses advanced Stress Testing & Scenario Analysis
Uses CCAR (Comprehensive Capital Analysis and Review) to supplement RAROC with forward-looking stress scenarios. Adjusts RAROC models for economic cycles to avoid excessive capital constraints in recessions.
(b) HSBC – uses granular Risk Segmentation
Breaks down RAROC by: Geographic regions (Asia vs. Europe risk profiles) and Loan types (Corporate vs. Retail Lending). Uses machine learning to refine probability of default (PD) and loss given default (LGD) models.
(c) Deutsche Bank – integrating Liquidity Risk into RAROC.
Adjusts RAROC for funding costs: uses “Adjusted RAROC” to include Liquidity premiums on long-term loans.
(d) Allianz Insurance – usesDynamic Risk-Adjusted Pricing
Uses “Economic Capital Models” to adjust RAROC for Catastrophic risks and Policyholder behaviour risk. Prices policies using confidence intervals (99.5% Solvency II standards).
(e) AIG Insurance – Blends RAROC with Reinsurance Strategies
Offloads high-risk exposures to reinsurers, lowering economic capital needs. Uses “Return on Risk-Adjusted Capital (RORAC)” to compare profitability across business lines.
(f) BlackRock – Combines RAROC with ESG Risk Adjustments by integrating climate risk stress tests into RAROC for long-term asset holdings. Uses “Shadow RAROC” to assess how regulatory changes impact capital efficiency.
(g) Bridgewater Associates – uses Adaptive Risk Parity Approach. Adjusts RAROC dynamically based on Macroeconomic regimes (inflation vs. recession) and leverage constraints to avoid overconcentration.
(h) Goldman Sachs – Trading Desk RAROC Adjustments. Applies “Stressed RAROC” during volatile markets (2020 COVID crash). Uses “Scenario-Based Capital Allocation” to avoid procyclical cuts in trading positions.
RAROC Reports
There are different types of RAROC Reports as given below:
1. Yearly Gross RAROC
2. Yearly Net RAROC
3. Lifetime Gross RAROC
4. Lifetime Net RAROC
5. Projected Vs Actual RAROC at Facility Level
6. Projected Vs Actual RAROC at Counterparty Level
7. Projected Vs Actual RAROC at Group Level
Last or Previous 12 months are used for Actual RAROC calculation while next 12 months and Lifetime of the deal is used for Projected RAROC.
Lifetime RAROC computation- Amortization Schedule can be generated using one of the following amortization types:
Straight Line Amortization
Bullet Repayment
Tranche Repayment
Step Up Pricing by Amount
Step Up Pricing by Tenure
Fixed Principal
Interest Only
Custom Repayment Schedule