A Fundamental Look at Economic Capital and Risk-Based Profitability Measures

Sebastian Fritz, Michael Kalkbrener and Wilfried Paus

Economic capital (EC) and risk-based profitability measures such as risk-adjusted return on capital (RAROC) and economic profit (EP) are widely used throughout the finance industry. As their definitions have evolved over time, they – in our view – appear to lack a formal foundation and, at times, guidance for their application.

In this chapter, we take a step back to look at EC requirements and profitability measures from a slightly more rigid perspective – elaborating on procedures to determine justifiable capital requirements as well as linking their measures to modern portfolio theory.

The chapter is structured as follows:

• the next section discusses if and how the right amount of EC for a bank can be determined.

• the following section, we present a formal description of the calculation of EC with some focus on its allocation.

• the penultimate section deals with the integration of EC into popular risk-based profitability measures.

• finally, in the last section, we derive an alternative risk-based profitability measure based on the capital asset pricing model (CAPM) and study how it ties in with profitability measures currently used.

A summary of our main