Traditionally profitability metrics assess investment returns under normal conditions, but often ignore exceptional risks, such as the 2020 Covid-10 pandemic’s financial impact.To address this, investors often turn to Risk-Adjusted Return on Capital (RAROC) as a metric to evaluate a company's resilience in extraordinary circumstances.
This article will cover the following areas:
- What Is Risk-Adjusted Return on Capital (RAROC)?
- Calculating RAROC
- Examples of RAROC
- Limitations of RAROC
What Is Risk-Adjusted Return on Capital (RAROC)?
The term RAROC originated from an employee of Bankers Trust in the 1970s. In essence, RAROC is a return on investment (ROI) metric that factors in potential losses, particularly in high-risk projects.
Image source: Syntellis Performance Solutions
RAROC serves multiple valuable purposes:
Comparing Projects and Companies: It aids in contrasting various projects within the same company or in evaluating companies within similar industries, enabling informed investment decisions.
M&A Evaluation: RAROC plays a crucial role in assessing a company's potential profitability before acquisition, helping acquirers gauge the investment's viability.
Financial Institution Use: Financial institutions, notably banks, frequently employ RAROC for project evaluation, as it offers a comprehensive view of risk-adjusted returns.
Companies with substantial capital reserves are better equipped to mitigate unforeseen losses. Yet, some risks remain unaddressed, prompting businesses to reduce their exposure. While banks typically manage anticipated risk losses through loan loss provisions, they resort to economic capital to handle unforeseen risks, albeit at a higher cost due to shareholder expectations exceeding debt funding or savings interest rates.
To safeguard against these potential losses, many institutions utilize RAROC and other risk-inclusive metrics. In the banking sector, RAROC signifies the relationship between net loan income and economic capital, offering insights into the return on each invested dollar while considering associated risks.
Risk-adjusted capital finds its place in two contexts:
Economic Model: This context assesses the minimum capital required to maintain solvency in the face of abrupt and substantial losses.
Regulatory Model: Here, the focus is on quantifying the minimum capital needed to comply with existing regulations and legal requirements.
It's important to note that RAROC differs from a similarly named metric called return on risk-adjusted capital (RORAC). RORAC specifically evaluates returns on projects associated with high risk levels, considering the share of capital at risk. It is regarded as a valuable tool in risk management, adjusting capital to account for risk, while RAROC addresses the risk associated with the rate of return itself.
The formula is:
R = Revenue
E = Expenses
EL = Expected loss, which represents the average loss expected over a specific period.
IFC = Income from capital, calculated by multiplying capital charges with the risk-free rate.
C = Capital.
This formula provides a clear framework for assessing a project or investment's risk-adjusted return on capital.
Examples of RAROC
Let's take a look at a brief example:
- Bank Ex reports a revenue of $5,000,000 within a specified period.
- Total expenses amount to $3,000,000.
- Expected losses are estimated at $400,000.
- Income from capital reaches $200,000.
- The economic capital for this scenario stands at $200,000.
Using the RAROC formula:
RAROC = ($5,000,000 – $3,000,000 – $400,000 + $200,000) / $200,000 = 13.5%
For context, a beneficial RAROC level is often considered to be around 10%. In this example, Bank Ex exceeds this threshold, indicating a favorable evaluation of the investment.
Limitations of RAROC
Like most profitability metric, RAROC has its share of limitations:
Data Availability Challenges: Gathering the necessary data for RAROC can be cumbersome. It requires five distinct figures, and obtaining this data for entities or projects under consideration isn't always feasible. Calculating expected losses, in particular, can be complex.
Image source: Redbridge Debt & Treasury Advisory
Data Accuracy Concerns: Even if you manage to obtain all the required data, its accuracy can be questionable. Inaccurate data can result in a RAROC ratio that doesn't truly represent the actual situation. Relying on incorrect assumptions and models during RAROC calculations can lead to misleading evaluations.
Misinterpretation Risk: RAROC is a highly specific metric, and its meaning can be misconstrued. It should not be viewed as a direct measure of profitability. Misinterpreting it in this manner could lead to erroneous conclusions. A high RAROC indicates good returns for a company at a specific risk level but doesn't guarantee excellent overall returns.
Temporal Data Challenge: RAROC relies on historical data, which might not accurately reflect the real-world situation. It assumes a hypothetical perfect market that doesn't exist in reality. Without accounting for factors like inflation and other price drivers, the RAROC ratio may not align with the current environment.
Understanding these limitations is essential when utilizing RAROC as part of the decision-making process, ensuring a more informed and realistic assessment of investments and projects.
In conclusion, risk-adjusted return on capital (RAROC) retains its value as a metric for assessing potential returns, even acknowledging its inherent limitations. Particularly in scenarios where risks play a significant role, RAROC serves as a valuable tool.
Given that unforeseen risks can remain in the realm of hypothesis, it is prudent to complement RAROC with traditional metrics like Return on Investment (ROI) or Return on Assets ROA. This combination provides a more comprehensive perspective, helping to anticipate returns from a project or company under standard conditions.
For those well-versed in these metrics, the integration of RAROC can further enhance the precision of evaluations, contributing to more informed decision-making in complex and risk-laden environments.
Why is RAROC important?
RAROC is crucial because it assesses a company's risk level, providing insights into potential returns even in adverse conditions.
Is RAROC good for evaluating business outside the financial sector?
While primarily used in financial institutions, RAROC can evaluate any business, considering its unique risk profile.
What are the advantages of RAROC?
RAROC enhances capital allocation in high-risk sectors and serves as a risk management tool, aiding better investment decisions in unstable markets, unlike standard metrics.