RORAC Demystified

Price Waterhouse's Ken Ferrara and Shyam Venkat explain how Return on Risk-Adjusted Capital is now helping nonbank financial institutions and corporates build customized, firmwide risk and performance measurement methodologies that go beyond VAR and other market risk methodologies.

With the recent increased emphasis on value-at-risk and firmwide risk management, many leading financial and nonfinancial institutions are turning their attention to incorporating a risk perspective in attributing capital and measuring performance on a risk-adjusted basis. Return on Risk-Adjusted Capital (RORAC)-or Risk-Adjusted Return on Capital (RAROC) as the concept was first coined and introduced by the Bankers Trust Co. into the financial services industry's lexicon over a decade ago-represents the next area of focus for financial institutions as they continue to extend the best-practices frontier of risk management. Today most commercial banks and a few trading houses use some variation on the RORAC/RAROC concept.

As with risk measurement in general and value-at-risk in particular, RORAC is also making its way into how nonbanking corporations are beginning to view their businesses and evaluate performance. Many corporates in particular are interested in finding new ways to measure their cost of capital that may include credit, market and operational risk. For example, a company could assign different costs of capital measures to individual business units, based on how "risky" each business might be. Risk factors could also be applied to the calculation of return on equity (ROE).

This article will briefly explain what exactly RORAC does, how it is typically implemented and why it helps companies look at risk from a vantage point that will benefit executive management, business managers and the financial function.

A brief history of RORAC

RAROC was initially conceived within Bankers Trust's trading business in the late 1970s prior to migrating to the traditional lending businesses in the early 1980s. By the mid-1980s the RAROC concept had caught fire and was increasingly found within the traditional lending businesses of large commercial banks. Today most of the sophisticated global banking institutions have incorporated this framework into both their lending and capital markets trading businesses.

From a conceptual standpoint RORAC simply includes the fundamental risk/reward tradeoff required to effectively measure economic return on equity. While determining risk-adjusted returns under a RORAC framework is relatively straightforward, the other component of this metric (that is, attributed economic risk capital) is driven by volatility-defined at most institutions as losses according to some defined level of confidence. This approach is flexible and can be successfully applied to a wide range of risk measures, from determining the attributed market risk capital for the most simple fixed income bond to assessing the attributed credit risk capital of a highly leveraged structured swap transaction. Institutions have also begun to introduce operational risk into capital attribution calculations to cover earnings volatility arising from operating leverage and other operational exposures.

The flexibility of RORAC is also such that it can easily incorporate business models, cash flow projections and other corporate financial conventions within the RORAC measurement structure. As a result many nonfinancial institutions are looking into RORAC as a way to integrate risk management from diverse areas. For example, at most firms today, credit risk management, market risk management and operational risk management are all handled separately by different managers with different goals. RORAC can blend these different elements of risk into a single risk framework, giving business managers a decision-support tool that takes a comprehensive view of these different risks for strategic and tactical decision making.

Top-down risk management

Of course, the real challenge in implementing RORAC lies in taking a holistic approach that effectively links an institution's risk management infrastructure to its business management processes. This creates an institution-wide discipline that becomes the guiding principle for long-term strategic thinking, tactical performance measurement and transactional deal making. In this respect, RORAC behaves somewhat differently from value-at-risk (VAR), which today is used most frequently as a market risk measure applied specifically to trading businesses. While VAR is a good starting point for corporations that want to start quantifying their risk, it does not attempt to integrate market, credit and operational risks the way that RORAC does. In short, RORAC requires a more extensive risk management infrastructure to work properly than does VAR.

The chart at right provides a diagrammatic schema of this holistic approach. Whereas the methodological definitions of the RORAC calculations can be developed relatively expediently, institutions that seek to implement this discipline can find themselves bogged down by either a lack of infrastructure, disjointed business management processes or both (for example, in their MIS department or their risk-rating models). Before RORAC-related models and calculations can be effectively implemented, companies must build the tools necessary to identify risk on a company-wide basis.

Step by step

A strong risk management infrastructure begins with a set of well-articulated policies, procedures and standards that are clearly understood within the organization and that shape its culture. These guidelines are a critical first step that must be taken by top managers before specific risk management tasks are delegated around the company; otherwise "local" risk management initiatives may not work in sync with high-level goals simply because local managers do not know what top management wants.

Once guidelines are in place, the next step is to build a risk management organization that balances the needs of business managers with the needs of risk managers. Risk data collection procedures, for example, should not be so intrusive that they actually slow down core business activities, and there should be an ongoing dialogue between business and risk managers relating to the interpretation of risk reports and the required risk management actions. Collaboration between business managers and risk managers can also be critical to developing models that accurately reflect the company's experience in the marketplace. These models comprise the necessary assessment tools that an institution uses to assess relative levels of counterparty, transaction and operational risks.

Another key step in building RORAC-friendly infrastructure is to create information systems that produce timely and accurate information, which may be used to support decision making and value-added management reporting of multiple views of risk (for example, by counterparty, risk grade, maturity, product, market sector, industry, country, etc.).

The accompanying business management processes that rely on this infrastructure must also be sound. Ensuring that all risks are being appropriately identified in upfront financial and risk planning of the target risk profile, and are being incorporated within a consistent pricing strategy, helps to create a level playing field among different product areas competing for scarce capital resources. Limit setting and monitoring should also be dynamic with the ability to incorporate portfolio risk management approaches that include risk mitigation techniques for both credit and market risks (for example, collateral, netting, correlation, stress testing, etc.).

Benefits of RORAC

In addition to the discipline of building a comprehensive risk management infrastructure, RORAC can help companies make more informed decisions on many levels and create long-term strategies with risk in mind.

(1) Compare comparable returns. RORAC provides a way of quantifying and comparing returns from more and less risky business ventures. These measures are particularly important for companies when they are trying to decide between several potential new businesses to invest in. For example, a new project with a high-risk component might, according to RORAC, have to bring substantially greater returns than a more stable venture to justify its start-up expenses.

(2) Quantify company-wide risk. Unlike VAR and other market risk measures, RORAC allows companies to incorporate market risk, credit risk and operational risk within a single comprehensive framework. Using RORAC, managers can see the interrelationships between these different sorts of risk and avoid situations where the firm might have an unacceptable concentration of risks. Furthermore, a comprehensive model can suggest strategies for mitigating risk.

(3) Build a risk-conscious compensation structure. By considering return on risk-adjusted capital, rather than conventional accounting-based profit-and-loss calculations, it is possible to compensate managers for minimizing risk and maximizing return. Including RORAC in a company's compensation structure gives risk management "teeth," encourages responsible, longer-term decision making and discourages the short-term "quarterly profits" mentality.

Of course, no methodology can take the place of old-fashioned common sense and sound business judgment. But by helping managers to see both the forest and the trees, RORAC can give companies a heightened level of confidence that they are making judgments according to the most complete available information.

Ken Ferrara and Shyam Venkat are, respectively, a managing director and a principal consultant in Price Waterhouse's capital and treasury practice in New York.

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