# How does RAROC identify capital requirements?

I've read that RAROC is used to set economic capital requirements for different products, projects, business lines etc.

Is it just a matter of solving for the required economic capital level to obtain a desired risk adjusted return on capital with a given risk adjusted return or is there more to it?

$RAROC = \frac{Risk\ adjusted \ return}{Economic\ Capital}$

• Its a glorified sharpe ratio...the hard part is determining the parameters of the equation. Marginal EC is not easy to estimate. – user9403 Oct 21 '15 at 19:22

Raroc is a risk based profitability measure. As you pointed out the connection to Basel is the use of the Capital.

As far as I know, in many banks it is used for steering of the yearly capital allocation. However, I believe that in the near future(see Basel 4) it will become more important to directly steer with economic capital.