Risk Adjusted Return on
Capital (RAROC) for a
credit loan portfolio
Considering soverign risk
Presented by
Fernando Hernandez
Consultant and instructor for Latin America
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RAROC
Definition
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.
 The concept was developed by Bankers Trust in
the late 1970s.
 the risk adjustment of Capital is based on the
capital adequacy guidelines as outlined by the
Basel Committee, currently Basel II.

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Definitions
Broadly speaking, in business enterprises,
risk is traded off against benefit.
 RAROC is defined as the ratio of risk
adjusted return to economic capital. The
economic capital is the amount of money
which is needed to secure the survival in a
worst case scenario, that is it is a buffer
against heavy shocks.

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Economic capital
Economic capital is a function of market
risk, credit risk, and operational risk, and
is often calculated by VaR.
 This use of capital based on risk improves
the capital allocation across different
functional areas of banks, insurance
companies, or any business in which
capital is placed at risk for an expected
return above the risk-free rate.

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Formula for our RAROC

RAROC =
EAD
LevRatio
WACC
BUExp
CorpExp
ExpLoss
CPC
=
=
=
=
=
=
=
(EAD * LevRatio * WACC) – BUExp – CorpExp – ExpLoss
(EAD / CPC)
Exposure at default (How much money is exposed to credit default)
Leverage Ratio (Total liabilities / Total Assets)
Weighted average cost of capital (what’s the cost of raising funds)
Business Unit Expense (Expenses allocated at the BU level)
Corporate expense (Expenses allocated at the centralized level)
Expected loss (If customer defaults how much money is lost)
Credit loan portfolio / Capital (a measure of the relative size of the
loan portfolio)
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Where do risks come from in this
model
Loss Given default
 Probability of default

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Loss Given Default



How much money is being recuperated if customer defaults
More than usual, this is a very small percentage of the loan
Based on historical information
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Probability of default
The probability that the customer will not completely pay the
exposure at default amount (EAD)
 Defined by a lambda factor
 Depends on 2 key elements:

◦ Customer’s risk level (regulatory)
◦ Country risk factor (sovereign risk)
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Let’s take a closer look at the
actual results…
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Muito obrigado!
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