Risk-Adjusted Return and Economic Capital

Risk-adjusted return analysis asks two related questions: how much internal capital is needed for the risk, and is the expected return adequate for that capital? Economic Capital addresses the first question. RAROC addresses the second.

These measures are used mainly inside banks and other financial institutions. They can support pricing, portfolio limits, capital allocation, business-line planning, and performance review, but their formulas are not standardized across firms.

How the Concepts Connect

1. Estimate recurring costs, including expected loss.
2. Estimate unexpected loss and other material risks.
3. Assign economic capital to the activity.
4. Calculate risk-adjusted income.
5. Compare RAROC with an internal hurdle rate and qualitative constraints.
6. Test whether adverse scenarios, concentrations, liquidity needs, or model limits change the decision.

Example

Suppose a portfolio produces $9 million of income after funding and operating costs. Expected loss is $2 million, and economic capital is $35 million.

• Risk-adjusted income: $9 million - $2 million = $7 million
• RAROC: $7 million / $35 million = 20%

The result is useful only if the income, loss, and capital estimates use compatible periods and defensible assumptions. It should be reviewed with stress testing, concentration analysis, liquidity needs, and regulatory constraints.

What to Check

• whether the numerator includes funding, operating costs, expected loss, taxes, and overhead
• which risk types and legal entities the capital estimate covers
• the horizon, confidence standard, and diversification assumptions
• whether economic and regulatory capital are being confused
• how the hurdle rate was selected
• whether model validation and sensitivity analysis support the result

Educational Use

These pages explain internal risk and performance concepts. They do not determine an appropriate capital level, hurdle rate, price, credit decision, portfolio allocation, or investment.

In this section

Choose a subsection first. Deeper term pages live inside each subsection, which keeps large topic hubs readable.