Risk-Adjusted Return on Capital: Overview & Approaches

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Banks and financial institutions require a different performance measure than just the usual ROI because of the risks inherent in their business. Let's join a bank CEO as she calculates risk-adjusted return on capital for a department of her bank.

Why Risk-Adjusted Return on Capital?

Most students of finance and accounting are familiar with various measures of performance like Return on Assets (ROA), Return on Investment (ROI), and Return on Equity (ROE). For most types of business those performance measures are adequate.

But what about financial institutions like banks? For banks whose primary assets are loans and financial investments, there is much greater risk than for other businesses. They need a performance measure that factors risk in.

Risk-Adjusted Return on Capital (RAROC) not only considers the income from a loan or investment (like the other performance measures do), but also factors in the risk that things could go badly.

Alma is the new CEO for Sunstown Bank. She wants to introduce RAROC as a new performance metric to help allocate her bank's resources. It will also help her evaluate the performance of the executives in charge of the bank's divisions. Let's join her as she works on RORAC for a division of her bank.

The Risks of Banking

Bank and financial institutions face many types of risk such as:

  • Credit risk - a certain percentage of the loan and credit card balances on a bank's books will not be paid back. This is the primary risk.
  • Operating risk - Financial institutions handle a lot of cash, and that opens the door for theft. Fraudulent loan applications and large scale embezzlement can also happen. These a just a few of the risks that arise from doing everyday business at the bank.
  • Market risk - When money is invested in the financial markets, there is always the chance that the market value will drop. Asset bubbles and stock market crashes have lost billions for investors.

Economic Capital

Alma knows full well all of the risks her bank faces. Like all banks, Sunstown is required to set aside a certain amount of money to protect the people who deposit money with them. That is called regulatory capital. The amount is determined by formulas the Federal Reserve has developed. But over and above that, Alma is also interested in economic capital.

Economic capital is the amount of capital the firm needs to stay solvent given its risk profile. It's a more comprehensive concept because it involves not just meeting the needs of depositors, but the needs of the shareholders and the town by keeping the bank in business. It is also a measure of risk. Riskier loans and investments will require larger amounts of economic capital than safe ones.

Alma has three divisions that generate revenue for the bank: mortgage lending, vehicle loans and credit cards. She knows that cards have the most credit risk since there is no collateral, and that mortgages are the safest because people don't like to live on the street! That means it will take more economic capital to operate the credit card department than the mortgage department.

Value at Risk

Most banks have proprietary methods for determining economic capital. Many are based on value at risk (VAR) concepts, which will determine the largest possible losses with a certain confidence level. Alma is working on the mortgage loan portfolio today. She wants a number that will not exceed her losses on the portfolio 95% of the time. Analytic VAR tools will give her the answer.

She also uses historic simulation VAR tools to come up with a number for the risks from theft, fraud and losses that might occur in the investment portfolio. Each division is allocated a share of these risks in the way of economic capital.

Calculating RAROC

Alma's goal is to calculate RAROC for each division of the bank, and use it as part of her appraisal of the performance of the operating executives. It will also identify departments with good returns given their risk. These are divisions that will be identified for growth. Let's go through the formula and join Alma as she calculates it for the mortgage division. Here's the formula and what the pieces mean:


raroc


Where:

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