Risk-adjusted return on capital (RAROC)
What is RAROC, and how does a bank use it?
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BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED
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Risk-adjusted return on capital is the return a loan earns on the capital the bank must hold against it, after the losses the loan is expected to cause: margin and fees, less funding and running costs and expected loss, divided by the capital it uses. Capital is the bank's scarce input, so two loans on the same margin can earn very different returns if one needs three times the capital of the other. It is how a bank compares a company loan with a home loan, and why the rest of a relationship can decide whether a thin-margin loan is worth making.
BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.
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