Risk adjusted return on capital
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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. RAROC is defined as the ratio of risk adjusted return to economic capital. Economic capital is a function of market risk, credit risk, and operational risk. This use of capital based on risk improves the capital allocation across different functional areas of a bank.
RAROC system allocates capital for 2 basic reasons
- Risk management
- Performance evaluation
For risk management purposes, the main goal of allocating capital to individual business units is to determine the banks optimal capital structure (ie. 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.
