Risk Management and Financial Institutions, + Web Site, 3rd Edition

CHAPTER 23

Economic Capital and RAROC

Up to now, we have focused on the development of procedures for evaluating different components of a financial institution’s risk (credit risk, market risk, operational risk, liquidity risk, etc.). We now consider how risks can be aggregated and allocated to different business units.

It is important that financial institutions develop a holistic approach to risk management. This involves the specification of a risk appetite or level of risk tolerance, the creation of a strong risk management culture throughout the organization, and a sense of risk ownership among senior managers. This process is referred to as enterprise risk management. A key aspect of enterprise risk management is the calculation of total economic capital and its allocation to the managers of business units.

Economic capital (sometimes referred to as risk capital) is a financial institution’s own internal estimate of the capital it needs for the risks it is taking. It is different from regulatory capital, which in the case of banks is based on one-size-fits-all rules determined by the Basel Committee. Economic capital can be regarded as a ``currency’’ for risk-taking within a financial institution. A business unit can take a certain risk only when it is allocated the appropriate economic capital for that risk. The profitability of a business unit is measured relative to the economic capital allocated to the unit.

In this chapter, we discuss the approaches a financial institution ...