RAROC & Economic Capital Calculator

Capital Budgeting & Enterprise Risk

Understanding RAROC & Economic Capital

Key risk-adjusted performance principles governing capital allocation:

• Expected Loss (EL) vs Unexpected Loss (UL): Expected Loss is the predictable cost of risk priced into loan interest margins ($EL = EAD imes PD imes LGD$). Unexpected Loss is the extreme volatility in losses that must be absorbed by equity capital.
• Economic Capital (EC): The equity buffer determined via internal credit VaR models at a high confidence level (e.g. 99.9% 1-year horizon) to protect against insolvency.
• Value Accretion Benchmark: If $ ext{RAROC} > ext{Hurdle Rate}$, the facility generates positive economic profit (SVA), increasing enterprise value. If $ ext{RAROC} < ext{Hurdle Rate}$, the facility destroys capital and must be repriced or collateralized.
• Credit Structuring & Mitigation: Improving collateral (reducing LGD) or obtaining third-party guarantees (reducing PD) lowers both Expected Loss and Economic Capital, dramatically lifting RAROC.

Model credit risk fundamentals in the Credit Risk & Expected Loss Lab.

Mathematical Formulation

RAROC & SVA equations

ext{Expected Loss (EL)} = ext{EAD} imes ext{PD} imes ext{LGD}

ext{Economic Capital (EC)} = ext{EAD} imes ext{EC Ratio %}

ext{Risk-Adjusted Return} = ext{Gross Revenue} - ext{OPEX} - ext{Expected Loss}

ext{RAROC %} = rac{ ext{Risk-Adjusted Return}}{ ext{Economic Capital}} imes 100%

ext{Capital Charge} = ext{Economic Capital} imes ext{Hurdle Rate %}

ext{Shareholder Value Added (SVA)} = ext{Risk-Adjusted Return} - ext{Capital Charge}

Analyze portfolio Value at Risk in the Value at Risk (VaR) Lab.