Risk Adjusted Return on Capital (RAROC) is a key tool in strategic cost management. It helps financial institutions measure performance while accounting for risk, guiding decisions on and pricing strategies.
RAROC compares risk-adjusted returns to , providing a more accurate picture of value creation than traditional metrics. By incorporating expected and unexpected losses, it enables better resource allocation and risk-based pricing across different business units.
Risk Components
Understanding Economic Capital and Expected Loss
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Economic capital represents the amount of capital a financial institution needs to remain solvent
Calculated based on the institution's risk profile and desired confidence level
Expected loss refers to the average anticipated loss over a specific time period
Determined using historical data, statistical models, and expert judgment
Financial institutions typically set aside reserves to cover expected losses (loan loss reserves)
Exploring Unexpected Loss and its Implications
Unexpected loss represents potential losses beyond the expected loss
Calculated using statistical methods, often at a high confidence level (99.9%)
Covers extreme events or "tail risks" that could threaten the institution's solvency
Economic capital primarily addresses unexpected losses
Unexpected losses require additional capital beyond reserves for expected losses