About

In modern banking and corporate finance, measuring raw profit is no longer sufficient. A high return generated by taking catastrophic risks is not valuable—it's dangerous. The Return on Risk-Adjusted Capital (RORAC) is the gold standard metric for evaluating the true performance of a business line, trading desk, or investment portfolio. It answers the critical question: "Is the return worth the risk?"

RORAC bridges the gap between accounting income and risk management. By adjusting the denominator to reflect the specific capital held against risk exposures (Credit, Market, and Operational risk), it allows banks to compare safe assets (like mortgages) against volatile ones (like derivatives) on an apples-to-apples basis. This tool helps Risk Managers and CFOs optimize capital allocation, ensuring that scarce financial resources are deployed where they generate the highest efficiency, not just the highest nominal cash flow.

Formulas

The RORAC calculation adjusts the capital base based on the risk profile of the assets. The general formula is:

RORAC = Net IncomeAllocated Risk Capital

Where Allocated Risk Capital is often derived as:

Risk Capital = Asset Value × Risk Weight × Capital Ratio_{(e.g. 8%)}

Reference Data

Asset Class / Business Line	Typical Risk Weight (Basel Std)	Target RORAC (Approx)	Risk Factor Description
Residential Mortgages (Prime)	35%	15% - 20%	Secured by real estate, lower probability of default.
Commercial Real Estate	100%	12% - 18%	Higher volatility, sensitive to economic cycles.
Corporate Loans (Inv. Grade)	75% - 100%	10% - 15%	Dependent on corporate credit rating (AAA to BBB).
SME Loans (Unsecured)	75% (Retail) / 100%	18% - 25%	High default risk requires higher return premium.
Sovereign Debt (OECD)	0%	N/A (Risk Free)	Considered risk-free for capital purposes.
Credit Cards (Retail)	75%	25% - 35%	High operational and credit risk, high margins.
Interbank Placements	20% - 50%	5% - 10%	Short term, low counterparty risk.
Equities (Trading Book)	300% - 400%	20% +	High market risk capital charge.
Venture Capital / Private Equity	400% +	30% +	Speculative, illiquid, high capital requirement.

Frequently Asked Questions

ROE (Return on Equity) uses the total book value of equity as the denominator, regardless of what that equity is funding. RORAC uses 'Economic Capital' or 'Risk-Adjusted Capital'—the amount of money the bank strictly needs to hold to cover potential losses. RORAC is a risk-based metric; ROE is an accounting metric.

Generally, a RORAC should exceed the Cost of Equity (Ke). If your Cost of Equity is 10% and your RORAC is 15%, you are creating value. If RORAC is 8%, you are destroying shareholder value, even if you are profitable, because the risk taken justifies a higher return than you achieved.

Basel III provides a standardized framework for assigning risk weights to assets (e.g., 35% for mortgages vs. 100% for corporate loans). Using these standards ensures that the 'Risk Capital' calculation is realistic and compliant with global regulatory expectations.

Yes. If Net Income is negative, RORAC is negative. However, the denominator (Risk Capital) is always positive. A negative RORAC signals an urgent need to restructure the portfolio or exit that business line.