What it means
A simple profit figure can be misleading because it ignores how risky the money was. Two business lines might each earn $5,000,000, but if one needed twice as much capital to cover its potential losses, it earned a poorer return for the risk.
RORAC corrects for this by dividing profit by risk-adjusted capital rather than by total assets. Risk-adjusted capital, often called economic capital, is the amount of money a firm estimates it needs as a buffer against unexpected losses at a chosen confidence level.
It is calculated from models of credit, market and operational risk, and it differs from the regulatory capital that supervisors require. The more volatile or uncertain an activity is, the more capital it is assigned.
Managers use RORAC to decide where to put the next dollar of capital. If a lending desk produces 14% and a trading desk produces 8% on risk-adjusted capital, the firm may shift resources to lending.
RORAC can also help set pricing, because a loan to a riskier borrower must carry a higher margin to earn the same return on the extra capital it uses. A hurdle rate is the minimum return the firm accepts, usually linked to its cost of capital.
An activity with a RORAC above the hurdle creates value, and one below destroys it. This makes RORAC a bridge between day-to-day performance and the owners' required return.
RORAC is related to RAROC, or risk-adjusted return on capital. In RAROC the profit in the numerator is adjusted for expected losses, while in RORAC the adjustment is made in the denominator through the capital.
The two names are sometimes used loosely, so a reader should check how each firm defines them. The main limitation is that the answer depends on the risk model.
Different assumptions about confidence levels and correlations can change the capital figure a lot, so RORAC should be used as a guide rather than as a precise measure.
In practice
Real-world examples.
Example
A bank compares its mortgage unit and its commercial property lending unit. Mortgages earn $8,000,000 on $80,000,000 of risk capital, a RORAC of 10%, while commercial property earns $9,000,000 on $50,000,000, a RORAC of 18%. The bank decides to expand its commercial property team.
Example
An insurer uses RORAC to compare its home and its marine lines. Marine insurance has bigger swings in claims, so it is assigned more capital. Even though marine premiums are higher, its RORAC is lower, so the insurer raises prices.
Example
A lender prices a loan to a high-risk borrower. The model assigns $2,000,000 of capital to the loan, and the bank needs a 12% return, so the loan must earn $240,000 a year after costs. That amount sets the minimum interest margin the bank will accept.
Formula
Calculation
RORAC = Net income / Risk-adjusted capital
Suppose a bank's commercial lending unit earns net income of $12,000,000, and its models say the unit needs $100,000,000 of risk-adjusted capital. RORAC = 12,000,000 / 100,000,000 = 0.12, or 12%. If the bank's hurdle rate is 10%, the unit earns 2 percentage points above the minimum return, which is a value-creating result.Case study
Seen in the real world.
Meridian Trust Bank is an illustrative, fictional lender with three business units: retail, corporate and treasury trading. The board noticed that treasury trading made the biggest profit, $20,000,000, and wanted to give it more funding.
The risk team calculated RORAC for each unit. Trading used $250,000,000 of risk-adjusted capital, so its RORAC was 20,000,000 / 250,000,000 = 8%. Corporate lending earned $15,000,000 on $100,000,000, or 15%, and retail earned $9,000,000 on $75,000,000, or 12%.
With a hurdle rate of 11%, trading was the only unit falling short, despite its large profit. The illustrative lesson is that the biggest profit is not necessarily the best return for the risk taken. The board moved $50,000,000 of capital from trading to corporate lending over the next year, and it asked the risk team to report RORAC for every unit each quarter. The change also made the trading head review which positions were consuming the most capital for the least return.
Watch out
Common mistakes.
- Using total assets instead of risk-adjusted capital in the denominator, which ignores differences in risk between activities.
- Treating the capital figure as a hard fact when it comes from models with many assumptions.
- Confusing RORAC with RAROC, where the risk adjustment is made in a different place in the calculation.
Questions
People also ask.
Who uses RORAC?
It is mainly used by banks, insurers and asset managers that hold capital against risk and need to compare many different activities.
What is a good RORAC?
One that exceeds the firm's hurdle rate, which is usually based on the cost of equity, so a higher figure means more value created.
How is risk-adjusted capital worked out?
It comes from internal models that estimate unexpected losses at a chosen confidence level across credit, market and operational risks.
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