What it means
Ranking opportunities by return alone rewards whoever takes the most risk, which is why finance teams built ratios that put risk into the denominator. Each ratio in the family answers the same question with a different definition of what risk means.
Investment ratios usually measure risk as variability of returns. The Sharpe ratio uses total volatility, the Sortino ratio counts only downside movements, and the Treynor ratio uses sensitivity to the market as a whole, so a single portfolio can score differently on each.
Corporate and banking ratios instead measure risk as the amount of capital that must be held to survive a bad outcome. RAROC divides expected profit, after deducting expected losses, by that economic capital, which lets a bank compare a mortgage book with a corporate lending desk on the same basis.
The practical use is allocation. When a business has more approved projects than money, ranking them by a risk-adjusted return ratio pushes funding towards the activities that produce the most reward per unit of risk rather than simply the biggest headline numbers.
The nuance to hold onto is that these ratios compress a lot of judgement into one number. Expected loss estimates, capital allocations and volatility windows all involve assumptions, so the ratio is only ever as sound as the inputs behind it.
In practice
Real-world examples.
Example
An asset manager reports both raw return and Sharpe ratio for each of its five funds in the quarterly factsheet. One fund with a modest 7% return but a ratio of 1.3 attracts new money from cautious institutional clients who would otherwise have overlooked it.
Example
A bank compares two lending books with identical margins. The unsecured book requires three times as much capital, so its RAROC is a third of the secured book's, and the credit committee reprices the unsecured product rather than shrinking it.
Example
A manufacturer applies the idea to capital projects, dividing the expected profit of each project by the worst-case cash exposure it would create. A high-return but heavily front-loaded export venture drops down the ranking once the exposure is included, and a smaller domestic upgrade is approved instead.
Think of it
“Risk-adjusted return shows performance relative to risk taken-return per unit of risk.
Formula
Calculation
RAROC = (Expected Return - Expected Loss) / Economic Capital
A commercial lender is reviewing a new equipment finance division. The division is forecast to generate $1,200,000 of annual profit before credit losses, and historical data suggests expected losses of $200,000 a year on that type of lending. The risk team calculates that $5,000,000 of capital must be held against the division to absorb an unusually bad year. RAROC is ($1,200,000 - $200,000) / $5,000,000 = $1,000,000 / $5,000,000 = 20%. Since the lender's cost of capital is 12%, the division clears the hurdle by 8 percentage points and gets funded ahead of a mortgage desk producing a RAROC of 14%.Case study
Seen in the real world.
Silverpoint Mutual is a fictional insurer created for this illustrative example. Its three underwriting teams competed for capital each year, and the allocation went to whichever team forecast the largest premium growth.
The new chief risk officer introduced a RAROC measure. The commercial property team, which had won the most capital for three years running, turned out to generate $4,000,000 of profit after expected losses on $40,000,000 of allocated capital, a RAROC of 10%. The small specialist marine team produced $1,800,000 on $9,000,000 of capital, a RAROC of 20%, and had been starved of funding throughout.
Silverpoint reallocated $9,000,000 of capital from property to marine over two years, with strict limits on how quickly the marine team could grow. Group profit rose while total capital stayed flat. The illustrative moral is that comparing teams on growth alone quietly rewards the ones consuming the most capital.
Watch out
Common mistakes.
- Comparing a Sharpe ratio with a RAROC figure as if they were interchangeable, when one is a unit-free multiple and the other is a percentage return on capital.
- Allocating economic capital by revenue share rather than by actual risk, which quietly transfers the benefit of low-risk activities to high-risk ones.
- Setting expected loss from a benign period only, which makes every ratio look strong right up to the point when conditions turn.
Questions
People also ask.
Which ratio should I use?
Use a volatility-based ratio such as Sharpe for tradeable portfolios and a capital-based measure such as RAROC where risk is best expressed as the capital you must hold against it.
What counts as a good RAROC?
A meaningful answer only comes from comparing it with the organisation's cost of capital, since any figure above that hurdle is creating value and anything below it is destroying value.
Do these ratios work for small businesses?
A simplified version does, such as dividing expected annual profit from a project by the maximum cash you could lose on it, which is enough to stop the riskiest option winning by default.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%