RAROC is a risk-based profitability framework that measures the risk-adjusted return earned per unit of economic capital, enabling like-for-like performance assessment, pricing, and capital allocation across activities with different risk profiles. Formally, RAROC equals risk-adjusted return (often after-tax, net of expected losses and other risk adjustments) divided by economic capital, where economic capital is the buffer held against unexpected loss across credit, market, and operational risk, commonly linked to VaR-based internal models:
RAROC = \frac {\text{Risk-Adjusted Return}}{\text{Economic Capital}}Key components and calculation
- Numerator: risk-adjusted net income (e.g., expected revenues minus costs, taxes, expected losses, plus/minus transfer charges or return on risk capital), capturing the economic profit attributable to the position or business unit.
- Denominator: economic capital—the amount required to sustain solvency under adverse scenarios; it reflects unexpected loss and is often derived from portfolio risk models across credit, market, and operational risk.
- Decision rule: a unit creates value if its RAROC exceeds the cost of equity; this supports hurdle-rate setting and portfolio rebalancing.
What RAROC is used for
- Performance measurement: provides a consistent, risk-normalised basis to compare products, clients, and business lines with very different risk/return profiles.
- Capital allocation: guides allocation of scarce equity to activities with the highest risk-adjusted contribution, improving the bank’s economic capital structure.
- Pricing and limits: informs risk-based pricing, transfer pricing, and limit-setting by linking returns, expected loss, and required capital in one metric.
- Governance: integrates risk and finance by aligning business performance evaluation with the firm’s solvency objectives and risk appetite.
Contrast: RAROC vs RORAC
- Definition
- RAROC: risk-adjusted return on (economic) capital; adjusts the numerator for risk (e.g., expected losses and other risk charges) and uses economic capital in the denominator.
- RORAC: return on risk-adjusted capital; typically leaves the numerator closer to accounting net income minus expected losses, and focuses the adjustment on the denominator via allocated/risk-adjusted capital tied to capital adequacy principles (e.g., Basel).
- Practical distinction
- RAROC is the more “fully” risk-adjusted metric—both sides are risk-aware, making it suited to enterprise-wide pricing, capital budgeting, and stress-informed planning.
- RORAC is often an intermediate step that sharpens capital allocation by tailoring the denominator to risk, commonly used for business-unit benchmarking where the numerator is less extensively adjusted.
- Regulatory link
- RORAC usage has increased where capital adjustments are anchored to Basel capital adequacy constructs; RAROC remains the canonical internal economic-capital lens for value creation per unit of unexpected loss capacity.
Best related strategy theorist: Dan Borge
- Relationship to RAROC: Dan Borge is credited as the principal designer of the RAROC framework at Bankers Trust in the late 1970s, which became the template for risk-sensitive capital allocation and performance measurement across global banks.
- Rationale for selection: Because RAROC operationalises strategy through risk-based capital allocation—prioritising growth where risk-adjusted value is highest—Borge’s work sits at the intersection of corporate strategy, risk, and finance, shaping how institutions set hurdle rates, manage portfolios, and compete on disciplined risk pricing.
- Biography (concise): Borge’s role at Bankers Trust involved building an enterprise system that quantified economic capital across credit, market, and operational risks and linked it to pricing and performance; this institutionalised the two purposes of RAROC—risk management and performance evaluation—in mainstream banking practice.
How to use RAROC well (practitioner notes)
- Ensure coherent risk adjustments: align expected loss estimates, transfer pricing, and diversification effects with the economic capital model to avoid double counting or gaps.
- Compare to cost of equity and peers: use RAROC-minus-cost-of-equity spread as the decision compass for growth, remediation, or exit; incorporate benchmark RAROC bands by segment.
- Tie to stress and planning: reconcile business-as-usual RAROC with stressed capital needs so that pricing and allocation remain resilient when conditions deteriorate.
Definitions at a glance
- RAROC = after-tax risk-adjusted net income ÷ economic capital.
- Economic capital = capital held against unexpected loss across risk types; often VaR-based internally, distinct from accounting equity and regulatory minimums.
- RORAC = (net income minus expected losses) ÷ risk-adjusted/allocated capital; commonly aligned to Basel-style capital attribution at business-unit level.
Risk-Adjusted Return on Capital (RAROC) measures the risk-adjusted return earned per unit of economic capital, enabling like-for-like performance assessment, pricing, and capital allocation across activities with different risk profiles.
