Understanding RAROC and Economic Capital with Simple Examples
Imagine you run a small shop, and you're considering adding a new product to your inventory. You want to determine if it's a good idea, considering both the potential profit and the risk involved. This is where RAROC (Risk-Adjusted Return on Capital) helps.
RAROC: Making Smarter Business Decisions
- Return: This is how much money you expect to make from selling the product. Suppose you think you can make ₹100 per sale.
- Risk: What could go wrong? Maybe customers won’t like the product, or its cost could rise due to supply chain issues. This uncertainty creates risk.
- Risk-Adjusted Return: Since there’s a chance things might not go as planned, you adjust the expected return downwards. So, instead of assuming ₹100 in profit, you account for risks and estimate a more realistic return of ₹80.
- Capital Investment: To sell this product, you need to invest some money upfront. Let's say you need ₹50 to stock and promote it.
- Calculating RAROC:
RAROC = Risk-Adjusted Return / Capital Invested
RAROC = ₹80 / ₹50 = 1.6 (or 160%)
RAROC in Banking: Evaluating Loans with a Numerical Example
Imagine a bank is considering lending ₹10 crore to a company. Here’s how RAROC helps assess the loan:
- Expected Return: The bank charges 10% interest per year, generating an income of ₹1 crore.
- Assessing Risk: The company has a 2% chance of defaulting. If they default, the bank expects to recover only 60% of the loan, meaning a 40% loss.
Expected Loss = ₹10 crore × 2% × 40% = ₹80 lakh - Calculating Risk-Adjusted Return: ₹1 crore (interest income) - ₹80 lakh (expected loss) = ₹20 lakh
- Economic Capital Allocation: The bank sets aside ₹1.2 crore as a buffer for unexpected risks.
- RAROC Calculation:
RAROC = ₹20 lakh / ₹1.2 crore = 16.67% - Decision Making:
If RAROC > bank's required return, the loan is profitable. ✅
If RAROC < required return, the bank may reject the loan or increase the interest rate. ❌
Economic Capital: The Bank’s Safety Cushion
Banks face multiple risks:
- ✔ Credit Risk – Borrowers may not repay loans.
- ✔ Market Risk – Investments may lose value.
- ✔ Operational Risk – Fraud, system failures, etc.
To protect against unexpected losses, banks set aside Economic Capital—a "rainy day fund" to ensure they can cover risks and remain stable.
Why RAROC Doesn’t Include the Cost of Deposits
💰 Deposits fund loans but are not economic capital. They are liabilities that the bank owes to customers, while economic capital is a risk buffer for unexpected losses.
🔹 RAROC focuses on the return vs. risk of an activity. Including deposit costs would blur this risk-adjusted performance measurement.
🔹 However, the cost of deposits is considered in overall profitability through:
- ✔ Net Interest Margin (NIM) – The spread between loan interest income and deposit interest expenses.
- ✔ Loan Pricing Decisions – Banks set loan rates considering their funding costs.
Conclusion
- ✅ RAROC helps banks and businesses make informed investment decisions by adjusting expected returns for risk.
- ✅ Economic Capital ensures financial stability by covering unexpected losses.
- ✅ While deposit costs impact profitability, they are separate from RAROC’s risk-adjusted evaluation.
RAROC and Economic Capital are essential tools for making risk-aware financial decisions—whether you're running a small shop or managing a bank! 🚀