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Risk Management and Financial Institutions, 4th Edition by John C. Hull

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CHAPTER 26 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.

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 uses to arrive at estimates of economic capital for particular risk types and particular business units, and how these estimates are aggregated to produce a single economic capital estimate for the whole financial institution. We also discuss risk-adjusted return on capital, or RAROC. This is the return earned by a business unit on the capital assigned to it. RAROC can be used to assess the past performance of business units. It can also be used to forecast future performance of the units ...

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