15 Numerical RAROC
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Venkatsubramanian R Iyer15 Numerical RAROC
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Venkatsubramanian R IyerRAROC - RISK ADJUSTED RETURN ON CAPITAL - EXAMPLE
Suppose, a bank has Rs.1000 crore to invest or lend. Let us look at four different scenarios as follows
Particulars of investment/ lending CASE 1 CASE 2 CASE 3 CASE 4
Investment in Govt. Sec. with yield 5% and RW 5% 1000 400 300 300
Lending to AAA rated Co. with yield 8% and RW 20% 0 600 300 300
Lending to AA rated Co. with yield 10% and RW 50% 0 0 400 200
Lending to A rated Co. with yield 12% and RW 100% 0 0 0 200
TOTAL INVESTMENT 1000 1000 1000 1000
Particulars of income / cost / profit / return I II III IV
Annual Income based on yield on invested amount 50.00 72.00 82.00 86.00
Annual Cost of borrowing @ 3% per annum 30.00 30.00 30.00 30.00
Net income net of borrowing cost ( Income – cost) 20.00 42.00 52.00 56.00
ROA in % = ( Net Income / Investment ) * 100 2.00% 4.20% 5.20% 5.60%
Total Risk Weighted Assets 50.00 120.00 260.00 360.00
Capital Required @ 8% (Rs. In Crore) = Expected loss 4.00 9.60 20.80 28.80
Annual Income net of expected loss 16.00 32.40 31.20 27.20
Risk adjusted return on Assets 2.00% 3.24% 3.12% 2.72%
= (Annual Net Income net of expected loss / Investment ) * 100
Risk Adjusted Return on Capital (RAROC) 400.00% 337.50% 150.00% 94.44%
= (Annual Net Income net of expected loss / Capital) * 100
ROA = (Revenue – Expenses) / Assets
ROA adjusts profits for the ‘associated’ book value of assets and does not factor the riskiness of the asset
ROE = (Revenue – Expenses) / Equity
ROE adjusts profits for the ‘associated’ book value of equity and this performance measure is not sensitive to risk
ROC = (Revenue – Expenses) / Capital
RAROC = (Revenue – Expenses - expected loss + Income from capital) / Economic Capital
Returns net of risk (RAROC) would be the best way to compare investments and / or loans with different risks. ROA and ROE
does not factor risks taken in earning the return.
