Economic Capital and RAROC analysis are increasingly spreading into the mainstream. We offer important evidence that banks that dont deploy economic capital analytics will suffer from inadequate insight into their organizations and ultimately fall behind their competitors.

many of the worlds leading banks Embrace economic capital and raroc

Over the past ten years, the banking industry has adopted Economic Capital as a standard approach to linking risk to capital. Here is a sample of the banks that have publicly stated that they are measuring Economic Capital and RAROC.

• ABN*Amro
• Bank of America
• Bank of Ireland
• Bank of Montreal
• Barclays
• CIBC
• Citigroup
• Credit Lyonnais
• Deutsche Bank
• First Union
• Hansapank
• ING
• Key Corp
• Pacific Century
• SE Banken
• Swiss Re
• Tokai Bank
• Toronto Dominion
• Union Bank of California
• Wachovia

Perhaps the most important use of Economic Capital and RAROC at these organizations is in guiding strategic decisions about growing, shrinking, or fixing businesses. Well-managed banks are integrating Economic Capital and RAROC into their strategic planning processes, as described in this article by Oliver, Wyman & Company.

However, banks are also using RAROC for tactical decisions like setting target loan pricing. As reported in a 1998 article in CFO Magazine, Increasingly, banks are focusing on a key measure of client profitability: risk-adjusted return on capital (RAROC). The RAROC calculation permits a bank to determine not only whether it is pricing an individual loan correctly, but whether its overall portfolio of loans is priced correctly or if it is carrying too much risk.

Rating agencies recognize economic capital

Rating agencies are interested in viewing and understanding the results of risk-based capital models. Though capital adequacy is just one of the many criteria that the agencies take into account when assigning a rating, an economic capital framework can be an important signal of not only an institutions financial strength but also of its management strength. Rating agencies maintain frequent and open communication with providers of risk-based capital models to understand and make use of the results of the models when assessing an institution.

ERisk and strategic partner Oliver, Wyman & Company have discussed economic capital modeling with Moodys, Standard & Poors and A.M. Best, who have all agreed with the fundamentals of the models. Some have expressed a desire to review output from internal economic capital models as an input to the ratings process.

Equity analysts endorse economic capital

Equity analysts have long embraced RAROC as a means to understand the risk-adjusted profitabilities of the firms they cover. In addition, equity analysts can use line of business RAROC to compare profitability in similar businesses across banks. More and more banks are beginning to report line of business ROEs based on economic capital methodologies. Finally, many equity analysts believe that economic capital and RAROC are a sign of good management.