What is a good RAROC?

There is no universal figure. A bank compares RAROC with its own hurdle, which reflects what its shareholders expect and its own method: which capital it uses, whether the result is before or after tax, and whether it credits earnings on the capital. A figure from one bank cannot be read against another bank's hurdle. Above the hurdle, the loan adds value on the assumptions used; below it, the bank is giving up return, which it may accept for strategic or relationship reasons.

What is the difference between RAROC and RORAC?

Textbooks often separate them by where the risk adjustment sits: RAROC adjusts the income, taking off expected loss, while RORAC divides unadjusted income by capital that has been sized for risk. In practice the names are used loosely, and many banks call a measure RAROC when it adjusts both. The label tells you less than the definition, so the useful question is what has been deducted from the top line and which capital sits underneath it.

Why is expected loss deducted if the bank also holds capital?

Because they cover different things. Expected loss is the average a bank plans to lose on loans of that kind, so it is treated as a running cost of lending. Capital is held against losses beyond that average, in years when many borrowers fail together. Deducting expected loss from income and dividing by capital therefore charges the loan once for each: the cost of the average year, and the return owed to whoever stands behind the bad ones.

Why would a bank make a loan below its hurdle?

Usually because the loan is not the whole relationship. Transaction accounts, deposits, foreign exchange and other services can earn enough, with little extra capital, to lift the return on the customer as a whole. A bank may also accept a thin return to enter a sector or win a borrower it expects to grow. Each reason carries a cost if the other income does not arrive, which is why a lender records what was assumed and checks it at the next review.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

RAROC: a Worked Example

A thinner margin can be the better loan.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

RAROC answers the question a bank asks of a loan once its margin is known: is this worth the capital it ties up? The measure charges the loan for the losses the bank expects and for the cost of funding and running it, then divides what is left by the capital held against it. In the example here, a business loan at a 2.60% margin returns 12.5% and housing loans at 1.50% return 20%, because the business loan needs three times the capital. Average losses come off the income; capital stands behind the worse years.

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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PART OF How Banks Price a Business Loan

// 01 — WHY A BANK MEASURES RETURN ON CAPITAL

A margin tells a lender what a loan earns on the money lent. It says nothing about what the loan asks of the bank's shareholders. Banks fund most lending with deposits and borrowing, but regulators require part of every loan to be funded by capital, which is shareholders' money and takes losses first. That part differs from one loan to the next, so two loans with the same income can place very different demands on the same limited pool.

Losses come in two kinds, and the measure treats them differently. The average loss on a book of similar loans can be charged for in advance, like an insurance premium: that is expected loss, and it comes off the income. The bad years beyond the average cannot be charged to anyone in advance, and capital is there to absorb them. The Basel framework draws the same line: its internal-ratings risk-weight functions set capital for unexpected loss and deal with expected loss separately.

// 02 — HOW IT IS CALCULATED

Risk-adjusted income = margin + fees

− funding cost above the base rate

− running costs

− expected loss (PD × LGD × exposure)

Capital = risk-weighted assets × capital ratio the bank runs at

RAROC = risk-adjusted income ÷ capital

Banks vary the method in three places. Capital may be the regulatory amount or an internal estimate called economic capital, which models the bank's own portfolio; many look at both. Some add the interest earned by investing the capital itself. And the result may be stated before or after tax, which matters only if the hurdle is stated on the same basis.

The regulatory amount depends on the bank's approach. A bank on the standardised approach applies prescribed risk weights: under Australia's APS 112, for instance, 75% or 85% for an unrated company within its SME definition, depending on the size of the exposure, and, unless the bank has an approved method for splitting them, 100% for other unrated companies. A bank approved for internal ratings estimates each borrower's risk itself, so its capital moves with the risk grade.

// 03 — THE EXAMPLE

An operator of ice rinks, constructed for this page like every figure on it, asks for a US$10m five-year term loan at a margin of 2.60% over the base rate. Beside it sits US$10m of housing loans at 1.50%. Figures are US$ thousands a year. The margins, losses and capital levels are the example's, not market norms.

Ice rinks Housing loans

Margin over base 260 150

Fees 20 0

Funding above base −40 −40

Running costs −50 −25

Expected loss −40 −5

(1.0% × 40%) (0.5% × 10%)

Risk-adjusted income 150 80

Capital held 1,200 400

RAROC 12.5% 20.0%

The thinner margin produces the higher return, because the housing loans use a third of the capital and lose very little. Put the ice rinks on the housing margin and the comparison becomes plain:

Ice rinks at 1.50%: 150 + 20 − 40 − 50 − 40 = 40

40 ÷ 1,200 = 3.3%

The same margin earns one-sixth of the return.

// 04 — HOW IT DIFFERS FROM RETURN ON EQUITY

Return on equity is a whole-bank figure from the accounts: profit after tax over shareholders' funds, for a year already finished, with that year's actual impairment charge in it. RAROC is usually worked loan by loan, looks forward, and uses expected loss in place of whatever the impairment line happened to be. A bank's return on equity can look healthy in a quiet year while the book beneath it is underpriced, because few loans have failed yet.

Two relatives use the same inputs. Economic profit states the test in dollars: income less capital multiplied by the hurdle. Return on risk-weighted assets divides the same income by risk-weighted assets rather than capital. Funds transfer pricing is not a rival measure at all; it supplies the funding line.

DEFINED IN ONE PARAGRAPH → · HOW BANKS PRICE A LOAN → · RISK-BASED PRICING →

// 05 — WHERE IT DECIDES A FILE

The result is set against a hurdle, commonly built from what shareholders expect to earn on their capital. Take 12% for this example, and US$ thousands again.

Income needed at 12%: 1,200 × 12% = 144

As quoted, 2.60%: 150 ÷ 1,200 = 12.5% clears by 6

Lowest margin that clears: 2.60% − 0.06% = 2.54%

Competitor's 2.20%: 110 ÷ 1,200 = 9.2% falls short

Plus account income of 45: 155 ÷ 1,200 = 12.9% clears

Matching a competitor at 2.20% fails on the loan alone and clears only with the rink operator's transaction account and deposits, worth US$45,000 a year in the example. So the file turns on whether that income is measured or merely hoped for, and on whether anything in the deal keeps the accounts at the bank.

Structure can do what price cannot. Better security reduces expected loss and may reduce capital too, by a route that depends on the bank's regulatory approach. But RAROC only says what a loan earns if the assumptions hold. Whether the bank will be repaid is a separate and earlier question, answered in the cash flow and the security.

EXPECTED LOSS, WORKED → · RISK-WEIGHTED ASSETS →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Basel Committee on Banking Supervision, Basel Framework, CRE30 IRB approach: overview and asset class definitions (version effective 1 January 2023) — paragraph 30.2 — The IRB risk-weight functions produce capital requirements for unexpected loss, and expected losses are treated separately — section 01.
Australian Prudential Regulation Authority, Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk — Attachment B — Sets risk weights of 75% and 85% for unrated SME exposures, by size and type, and 100% for other unrated corporates absent an approved investment-grade method — section 02.

// QUESTIONS PEOPLE ASK

What is a good RAROC?: There is no universal figure. A bank compares RAROC with its own hurdle, which reflects what its shareholders expect and its own method: which capital it uses, whether the result is before or after tax, and whether it credits earnings on the capital. A figure from one bank cannot be read against another bank's hurdle. Above the hurdle, the loan adds value on the assumptions used; below it, the bank is giving up return, which it may accept for strategic or relationship reasons.
What is the difference between RAROC and RORAC?: Textbooks often separate them by where the risk adjustment sits: RAROC adjusts the income, taking off expected loss, while RORAC divides unadjusted income by capital that has been sized for risk. In practice the names are used loosely, and many banks call a measure RAROC when it adjusts both. The label tells you less than the definition, so the useful question is what has been deducted from the top line and which capital sits underneath it.
Why is expected loss deducted if the bank also holds capital?: Because they cover different things. Expected loss is the average a bank plans to lose on loans of that kind, so it is treated as a running cost of lending. Capital is held against losses beyond that average, in years when many borrowers fail together. Deducting expected loss from income and dividing by capital therefore charges the loan once for each: the cost of the average year, and the return owed to whoever stands behind the bad ones.
Why would a bank make a loan below its hurdle?: Usually because the loan is not the whole relationship. Transaction accounts, deposits, foreign exchange and other services can earn enough, with little extra capital, to lift the return on the customer as a whole. A bank may also accept a thin return to enter a sector or win a borrower it expects to grow. Each reason carries a cost if the other income does not arrive, which is why a lender records what was assumed and checks it at the next review.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Treasury analystFunds the bank and manages the interest rate and liquidity risk created by its own balance sheet.
Product managerOwns what the bank sells rather than who it sells to — the design, pricing, terms and lifecycle of a lending, deposit or payments product.
Business relationship managerCarries a book of trading businesses — wins them, keeps them, and is the bank's voice when the answer is no.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE CALL · THE LOAN · PRICE

A borrower wants a five-year fixed rate. The bank funds itself at floating rates.

What has the bank taken on if it simply agrees?

5 MORE ON THE LOAN · PRICE →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHRisk-adjusted return on capital (RAROC) What is RAROC, and how does a bank use it?