Risk-Adjusted Return on Capital (RAROC) is defined as the ratio of risk-adjusted return to economic capital (EC). Economic capital refers to the amount of capital that a bank or financial institution needs to ensure its survival in extreme, worst-case scenarios. It acts as a financial buffer against unexpected shocks in market conditions.
Banks must assess the adequacy of this buffer, which serves to protect them against various business risks. This assessment is central to the concept of economic capital. The process by which a bank allocates economic capital to transactions, products, customers, and business lines is known as risk-based capital allocation. In pursuit of maximizing shareholder value, banks should align their business strategies with risk-based capital allocation principles and link performance incentives to risk-adjusted returns. In this context, RAROC and economic capital are essential risk management tools that help banks and financial institutions (FIs) evaluate both solvency and the performance of various business activities.
Economic capital represents the amount of capital required to absorb unexpected losses in a bank’s credit portfolio. It assesses whether the available capital is sufficient to maintain solvency at a specified confidence level. While regulatory capital is determined by regulatory bodies to ensure the stability of the financial system, economic capital is an internally assessed metric aimed at optimizing the bank’s risk-return profile and enhancing shareholder value. The required level of economic capital depends on the bank’s target debt rating in the market. To appropriately capitalize any business line, the bank must select a confidence level that aligns with its desired credit rating, since a given rating corresponds to a specific probability of capital depletion.
A widely accepted approach for estimating risk capital is the Credit Value at Risk (Credit VaR or C-VaR) method. Economic capital, in this context, is calculated as the difference between the worst-case loss (as estimated by Credit VaR) and the expected loss. It is an estimate of the level of capital needed to operate with a target solvency standard.
In financial mathematics, Value at Risk (VaR) is a commonly used measure for quantifying the potential loss on a portfolio of financial assets. VaR condenses the downside risk of an institution into a single figure, estimating the maximum expected loss over a specific time horizon at a given confidence level. By definition, VaR represents the maximum loss that will not be exceeded with a certain (pre-specified) probability over the target period, under normal market conditions.
Credit VaR and Economic Capital
Economic capital is often defined as the difference between a certain percentile of the loss distribution and the expected loss. This difference is also known as unexpected loss at a specified confidence level and is typically measured using the Value at Risk metric. Therefore, economic capital represents the additional capital required to cover unexpected losses beyond what is predicted as average or expected, thereby enhancing the financial institution’s ability to withstand adverse market conditions.
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