Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust in the late 1970s. Note, however, that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel II.
Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, that is it is a buffer against heavy shocks. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.
RAROC system allocates capital for 2 basic reasons:
For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.