Economic Capital

Chapter 1. Measuring the Unexpected - Understanding Economic Capital

In this chapter we introduce economic capital: what it is and what the key underlying concepts are. The origin of economic capital usually is traced back to the late 1970s, when Bankers Trust introduced the RAROC (risk-adjusted return on capital) concept for the evaluation of the profitability of its transactions, using economic capital as uniform measure of risk.^[1] Since then, an increasing number of banks have adopted economic capital and RAROC in their decision making. Subsequently, other financial institutions such as insurance companies have caught on to the concept.

When tracing back to the roots of economic capital, an important development was the growth of the trading ...