In my previous post, I discussed the concept of nominator in RAROC. Now let's move to the denominator of this formula----Risk-based Capital or Economic Capital. This concept was found to have the most confusion when I talked to the people in the past. I don't think most Chinese banks are ready to get their own economic capital amounts right when calculating their RAROCs.

Basically, risk-based Capital is defined as the amount (Q) of capital set to provide a level of confidence that, in a certain period of time, that a bank is likely to survive unexpected losses. Hence, this concept is related to both the timeframe over which the capital is intended to provide protection and the confidence level desired.

In the U.S. banking industry, the selected timeframe is usually one-year time horizon and the confidence level is 90%. In other words, some certain amount (Q) of capital should be big enough to protect the bank from unexpected losses that will bankrupt this bank in 9 years out of 10.

Lately, bond-rating agencies tied up the levels of confidence to banks' desired bond ratings. For instance, for those banks that target their bonds at AA rating, the risk-based capital has to be at a level that will provide coverage for unexpected losses with 99.97% confidence level.