There is a sea of acronyms to measure profitability. Some are more widely known in the industry, such as ROE, ROTE or ROA. However, the more r’s they have, the more complicated things get (RORWA, RAROC, RORAC, RARORAC). But, which ratio is the most reliable to measure a bank’s profitability? Let’s go over each one of them to understand their meaning and apply the most appropriate one in each case.
One of the pivotal challenges the financial industry is facing is going back to pre-crisis profitability levels. This is proving a daunting task, especially taking into account that interest rates are at all-time lows, and that regulators and investors are imposing increasingly demanding requirements. All this has an additional cost that does not make the task any easier.
So, financial institutions need to be extremely careful and pursue those businesses capable of yielding the highest possible return, based on the capital invested and the risk assumed.
Here we will be looking at a series of ratios that make it easier to adopt said decisions, while providing more accurate information about the returns they yield, taking into account elements such as the risk they assume or the capital they invest.
Traditionally, to determine a bank’s profitability returns are measured against equity or assets. In the first equity group, a series of standard ratios such as the ROE (Return on Equity) or the ROTE (Return on Tangible Equity) are used extensively. The second group of ratios differs from the first one in that it excludes intangible elements from the capital, such as goodwill, convertible issuances or preferred stocks. To compare an institution’s profitability against its assets, the most commonly used ratio is the ROA (Return on Assets), which compares its performance against its total assets.
In this case, we are talking about very general ratios that do not include elements such as the risk or the invested capital, elements that provide a more adjusted measure of the actual profitability of an institution.
Another factor that is being taken more and more into consideration when calculating an institution’s profitability is risk. The highly regulated financial sector has to meet a series of requirements. In fact, to prove their solvency, the regulator requires financial institutions to keep a percentage of capital with respect to its risk-weighted assets. And, as we also discussed in said article, not all banking assets have the same risk. Therefore, not the same amount of capital should be required for each one of them.
It seems logical that, in order to determine the profitability of a product, portfolio or institution, it should be calculated taking into account the risk that is being assumed. Thus, the decision regarding the activity that is to be pursued becomes of key importance. An efficient assignment will maximize the returns generated based on the risk assumed (and therefore the capital consumed).
The risk-weighted profitability can be calculated very easily through the RORWA (Return on Risk-weighted Assets) ratio. This ratio is an evolution of the ROA discussed above. The essential difference is that, instead of comparing capital against total assets, it compares them against risk-weighted assets, which already take into account a correction factor, based on the risk assumed by the bank.
A more complicated thing is to assess the performance and link it to the risk-weighted capital. This is where the RAROC (Risk-adjusted Return on Capital) comes in, a method intended to help efficiently allocate capital and that was developed by Bankers Trust in the 1970s.
Thanks to this method, financial institutions are capable of calculating the actual profitability of each one of the activities they develop, by comparing them against the consumption of capital they entail. And this allows them to choose and promote those that generate a higher value and maximize their profit levels globally.
The RAROC method allows institutions to adjust the ROE’s numerator and denominator based on risk. This is how three ratios arise, which are the most commonly used by financial institutions.
- RAROC: Risk-adjusted Return on Capital
- RORAC: Return on Risk-adjusted Capital
- RARORAC: Risk-adjusted Return on Risk-adjusted Capital
Other interesting stories