Apples and Pears: The Comparison of Risk Capital and Required Return in Financial Institutions

Abstract

Risk capital is the contribution of an exposure to the default risk of a financial institution. We investigate its relationship with required shareholder returns, showing that the use of return on risk capital (RAROC) as a risk-adjusted performance measure is inconsistent with the standard theory of financial valuation and that using this one measure to represent at the same time both contribution to default risk and required shareholder returns can lead to substantial loss of shareholder value. We propose an alternative performance measure distinguishing these two aspects of risk and applicable to the efficient allocation of risk capital.

Keywords: RAROC, Risk Management, Economic Capital, Performance Measurement, Financial Regulation

JEL Classification: G21