Skip to content
All library documents

RAROC as a Risk-Based Profitability and Capital Allocation Measure

Article Quant Q&A · Author: AfterWorkGuinness
Read the original

Summary

RAROC compares risk-adjusted return with economic capital, making it a risk-based measure of profitability. The document asks whether a target RAROC can be used to solve directly for the capital required, but the response does not provide a calculation procedure or define how risk-adjusted return and economic capital should be estimated.

Instead, it describes RAROC’s stated role in banks as a tool for steering annual capital allocation across products, projects, or business lines. It also suggests that economic capital could play a more direct role in future capital steering as regulation evolves. These are broad observations rather than a detailed account of regulatory rules, model inputs, or implementation. The material is useful for understanding RAROC’s purpose, but it does not establish a method for setting capital requirements from a desired return threshold.

Key ideas

  • RAROC measures profitability by relating risk-adjusted return to economic capital.
  • Banks may use RAROC to guide annual capital allocation across business activities.
  • A target RAROC alone does not explain how to estimate the underlying return or capital inputs.
  • The response anticipates a stronger role for economic capital in capital steering but gives no implementation details.

Tags

Risk managementPortfolio constructionFixed income
Full text
# How does RAROC identify capital requirements?


# How does RAROC identify capital requirements?












I've read that RAROC is used to set economic capital requirements for different products, projects, business lines etc.

Is it just a matter of solving for the required economic capital level to obtain a desired risk adjusted return on capital with a given risk adjusted return or is there more to it?

$RAROC = \frac{Risk\ adjusted \ return}{Economic\ Capital}$

## Answer by Carol.Kar (score 1)

https://quant.stackexchange.com/a/21365

Raroc is a risk based profitability measure. As you pointed out the connection to Basel is the use of the Capital.

As far as I know, in many banks it is used for steering of the yearly capital allocation. However, I believe that in the near future(see Basel 4) it will become more important to directly steer with economic capital.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.