How does the definition of economic capital relate to RAROC?

The correct answer is that economic capital is the capital required to cover unexpected losses. This definition connects closely to Risk-Adjusted Return on Capital (RAROC) in that RAROC is a measure used to assess the profitability of a bank or financial institution's investments taking into account the risks involved. To accurately evaluate this profitability, institutions need to quantify the economic capital, which represents the amount of capital they must hold to absorb potential unexpected losses that may arise from their operations or investments.

Economic capital essentially reflects the institution's risk profile and ensures that it can maintain solvency in the event of losses, contributing to the assessment of performance through RAROC. In such calculations, when an institution considers the return generated relative to the capital at risk, understanding the full extent of economic capital necessary to cover adverse scenarios is paramount. By aligning RAROC with the concept of economic capital, institutions can more effectively evaluate their performance against risk, facilitating better decision-making and capital allocation strategies.