What is economic capital?
Economic capital (EC) is the amount of capital that a financial institution needs to hold in order to withstand its risks and remain solvent. It is a measure of the institution’s risk appetite and its ability to absorb losses.
What is RAROC?
Risk-adjusted return on capital (RAROC) is a performance measure that is used to evaluate the profitability of a financial institution’s activities after taking into account the risks involved. It is calculated as the ratio of the institution’s risk-adjusted return to its economic capital.
Why are economic capital and RAROC important?
Economic capital and RAROC are important for a number of reasons, including:
- They help financial institutions to manage their risks and remain solvent.
- They help financial institutions to make informed decisions about their activities.
- They help financial institutions to comply with regulatory requirements.
- They help financial institutions to protect their shareholders’ interests.
What are the similarities between economic capital and RAROC?
Both economic capital and RAROC are used to measure the profitability of a financial institution’s activities after taking into account the risks involved. They are also both used to help financial institutions to manage their risks and remain solvent.
What are the differences between economic capital and RAROC?
The main difference between economic capital and RAROC is that economic capital is a measure of the amount of capital that a financial institution needs to hold, while RAROC is a measure of the profitability of its activities.
M&Qs on economic capital and RAROC
1. What is the main purpose of economic capital?
The main purpose of economic capital is to measure the amount of capital that a financial institution needs to hold in order to withstand its risks and remain solvent.
2. What is the main purpose of RAROC?
The main purpose of RAROC is to measure the profitability of a financial institution’s activities after taking into account the risks involved.
3. What are the two main components of economic capital?
The two main components of economic capital are:
- The probability of loss: This is the likelihood that the financial institution will incur a loss.
- The severity of loss: This is the amount of loss that the financial institution could incur.
4. What are the two main components of RAROC?
The two main components of RAROC are:
- Risk-adjusted return: This is the amount of profit that the financial institution generates after taking into account the risks involved.
- Economic capital: This is the amount of capital that the financial institution needs to hold in order to withstand its risks and remain solvent.
5. What are some of the limitations of economic capital?
Some of the limitations of economic capital include:
- It can be difficult to estimate the probability and severity of losses.
- It can be difficult to allocate economic capital to different activities.
- It can be difficult to use economic capital to make decisions about pricing and risk management.
6. What are some of the limitations of RAROC?
Some of the limitations of RAROC include:
- It can be difficult to measure risk-adjusted return accurately.
- It can be difficult to compare RAROC across different financial institutions.
- RAROC can be insensitive to changes in risk.