Overview
Consistent with the standard practice of adjusting financial performance measures (see risk adjusted performance) banks will often adjust their performance measures to account for the amount of risk that they are taking.
Risk Adjusted Return on Capital - RAROC
RAROC is a fairly standard measure of bank risk adjusted performance. The formula is
{% \frac{Revenues - Expenses - CECL}{Allocated \; Capital} %}
The name RAROC is a bit of a misnomer, as it suggests that risk is adjusted for twice. In the sense
that the
current expected credit loss (CECL)
is subtracted from the revenues and then the result
is divided by the
allocated capital,
this is true.
However, most risk measures that are described as being risk adjusted, the adjustment typically means that the return measure is divided by the total risk figure. In the case of RAROC, the "risk adjustment" referred to in the name is the process of subtracing out the CECL charge.
Additionally, the denominator is typically taken to be the allocated capital, which typically does not mean the total risk, as a bank can allocate more capital to its assets than is warranted by their risk models. If the denominator used in the measure is a measure of economic capital and not actual allocated capital, then RAROC becomes