Risk‐Adjusted Return on Capital and Economic Profit

The risk-adjusted return on capital (RAROC) is a framework for analysing the risk-adjusted financial performance, with the aim of providing a consistent view on profitability across businesses. RAROC is a powerful tool that enables financial institutions to manage their businesses. The best thing about it is that, once you understand the concepts behind economic capital, RAROC is easy to grasp. Although RAROC stands for the risk-adjusted return on capital, in practice it tends to specify the expected return on economic capital rather than the expected return on available capital. This chapter also illustrates main items to be taken into account when determining the RAROC, which are free funding adjustment, risk costs, hybrids, goodwill and taxes. Moreover, RAROC enables financial institutions to compare relative performances of businesses that are very different in size. This is the main pitfall of economic profit. A more sizeable business can have higher economic profits than a smaller business even though its relative performance (RAROC) is worse.