Lesson 40 - Advanced Accounting Course

Lesson 40: Risk-Adjusted Return on Capital (RAROC)

💡 What is RAROC?

RAROC (Risk-Adjusted Return on Capital) is a financial metric that helps a business evaluate whether the return from an investment or loan is worth the risk taken.

It tells us:

💬 “How much profit are we making after accounting for risk?”

🔁 RAROC = Net Profit / Economic Capital

🧠 Why Use RAROC?

Traditional return metrics (like ROI or ROE) don’t consider risk. But in real life, not all activities are equally risky!

RAROC helps companies:

• 📏 Compare risk across products, clients, or divisions
  
  

• 💰 Price products based on risk
  
  

• 🚦 Decide where to invest or avoid
  
  

• 📊 Allocate capital more efficiently
  
  

🧮 RAROC Formula (Simple Version)

Where:

• Risk-Adjusted Return = Revenue – Expenses – Expected Loss
  
  

• Economic Capital = Capital set aside to absorb unexpected losses
  
  

📘 Key Terms Explained:

📊 RAROC Example:

Imagine a bank gives a $1 million loan to a corporate client.

• 🧾 Interest income = $80,000
  
  

• 💸 Operating costs = $10,000
  
  

• ⚠️ Expected credit loss = $20,000
  
  

• 🛡️ Economic capital = $200,000
  
  

✅ Risk-Adjusted Return = $80,000 – $10,000 – $20,000 = $50,000
📊 RAROC = $50,000 ÷ $200,000 = 25%

👉 If the bank’s target RAROC is 15%, this loan is profitable and should be accepted!

📌 RAROC Benchmarks

💼 Applications of RAROC 

📘 RAROC vs Other Metrics 

📘 Recap