Return on Risk-Adjusted Capital (RORAC) is a financial performance metric that evaluates the profitability of a project, business unit, or company by relating net income to the amount of capital at risk, where that capital has been specifically adjusted to account for the risks inherent in the activity under review. It enables a direct comparison of returns between different business units, projects, or products that may carry differing risk profiles, allowing for a more precise assessment of economic value creation within risk management frameworks.
Formula for RORAC:
RORAC = \frac {Net Income}{Risk-Weighted Assets}Where risk-weighted assets are often synonymous with the capital allocated to cover potential unexpected losses – commonly referred to as economic capital, allocated risk capital, or even the regulatory value at risk. Unlike Return on Equity (ROE), which uses the company’s entire equity base, RORAC employs a denominator that adjusts for the riskiness of specific lines of business or transactions.
By allocating capital in proportion to risk, RORAC supports:
- Risk-based pricing at the granular (e.g. product or client) level
- Comparability across divisions with different risk exposures
- More effective performance measurement, especially in financial institutions where capital allocation is a critical management decision.
Contrast: RORAC vs. RAROC
RORAC is a step beyond traditional metrics (like ROE) by recognising different risk profiles in how much capital is assigned, but does not fully risk-adjust the numerator. RAROC, by contrast, also incorporates provisions for expected losses and other direct adjustments to profitability, providing a purer view of economic value generation given all forms of risk.
Best Related Strategy Theorist: Dan Borge
Biography and Relevance:
Dan Borge is widely credited as the architect of RAROC, making him instrumental to both RAROC and, by extension, RORAC. In the late 1970s, while at Bankers Trust, Borge led a project to develop a more rigorous framework for risk management and capital allocation in banking. The resulting RAROC framework was revolutionary: it introduced a risk-sensitive approach to capital allocation, integrating credit risk, market risk, and operational risk into a unified model for measuring financial performance.
Borge’s contributions include:
- Establishing RAROC as a foundational risk management principle for global banks, influencing regulatory frameworks such as the Basel Accords.
- Advocating the principle that performance measurement should reflect not just raw returns but also the economic capital required as a buffer against potential losses.
Though Borge is not explicitly associated with RORAC by name, RORAC is widely recognised as an extension or adaptation of the principles he introduced – focusing especially on the risk-based allocation of capital for more effective resource deployment and incentive alignment.
Legacy in Strategy:
Dan Borge’s work laid the groundwork for risk-based performance management in financial institutions, making metrics such as RORAC and RAROC central to how banks, insurers, and investment firms manage risk and measure profitability today. His theories underpin much of contemporary capital allocation, risk pricing, and value-based management in these sectors.
Summary of Key Points:
- RORAC measures return based on risk-adjusted capital and is a bridge between ROE and fully risk-adjusted performance metrics like RAROC.
- RAROC adjusts both return and capital for risk, offering a more comprehensive risk/performance measure and forming the foundation of modern risk-sensitive management.
- Dan Borge is the most relevant theorist, having originated RAROC at Bankers Trust, and his legacy continues to influence the theory and application of RORAC.
