Financial Services Industry

Putting the risk into risk-adjusted profitability

RMA Journal, The, Feb, 2003 by Peter Nakada, Brannan Johnston

Risk-adjusted profitabi1ity--whether termed economic capital, RAROC, economic profit, NIACC, or SVA--has become an everyday concern for large, money-center banks over the past few years. But what about regional banks? Do traditional activities like deposit taking, medium-to-small commercial lending, and mortgage origination really require risk-adjusted profitability?

Regional banks often pride themselves on their good customer relations. But putting the customer's needs first sometimes means putting the bank's needs last. There's some truth in the old saw that a regional bank's loan officer has his foot on the gas pedal, the risk manager has her foot on the brake, and the CFO is navigating by looking in the rear-view mirror. Too often, the motor's roaring even as the tires are smoking-and the bank is going nowhere.

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What's needed is a standard that makes sense to all parties--one that doesn't arbitrarily limit revenue opportunities, doesn't expose the bank to excess or uncompensated risk, and looks forward rather than back. Risk-adjusted profitability (RAP), which provides an economically meaningful way of assessing performance, seems like a good solution.

Banks that have embraced RAP measurement can use it to make sure that business decisions are kept consistent with the firm's risk/reward profile in an objective and systematic way. This is true at all levels of the organization--transaction, customer, product, line of business, and total bank.

For example, a loan officer can make a loan only if its RAP beats hurdle, product managers can use RAP to decide which products are the most profitable, and senior management can use RAP to choose which businesses to grow, shrink, or fix. All of this ultimately boosts return on equity (ROE) while ensuring that the bank continues to be paid appropriately for the risks it assumes.

Unfortunately, many efforts to measure risk-adjusted profitability don't really achieve much of value. Many regional banks concentrate on funds-transfer pricing and cost allocation rather than risk-adjusted capital measurement. That certainly makes the project simpler, but it also makes it less relevant.

The Importance of Capital

Not all dollars are created equal. Dollar for dollar, revenues earned through a comparatively risky activity are actually worth less to an institution than those that come from a less risky activity. Traditional banking risk management limits the risk of a given activity by capping the volume of business done, but this is both unreliable and inefficient. Too many institutions find out which business is worth less only after the fact.

A forward-looking measure of profitability that captures an activity's contribution to the bank's overall risk allows different activities to be compared on an equal footing. This risk-adjusted profitability should be applicable at all levels, from business or product line to individual customer or transaction. Its main components include the following:

* Revenues--including both the yield and the fees generated by an activity. For funding units, revenues also include the transfer-priced cost of funds charged to the lending units.

* Expenses--including both interest and non-interest expense. This requires a cost-allocation methodology for allocating indirect and overhead expenses. For lending units, it includes the transfer-priced cost of funds and also the expected loss (not the actual loss or provisions) on the loan book.

* Capital. The risk contribution of the activity can best be described in terms of the amount of risk-bearing capital it requires. RAP is typically expressed either as ROE, where the E component is risk-based capital, or as a net present value (NPV) number, which includes a capital charge based on the unit or transaction's risk.

Regional and community banks developing profitability systems appear to invest heavily in attempts to understand revenues and expenses by developing funds-transfer pricing (FTP) and cost-allocation methodologies. These banks are "playing to their strengths," as FTP and cost allocation are well understood and comfortable areas for them.

The same cannot be said of capital. Many institutions simply rely on regulatory risk-weighted assets, crude rules-of-thumb, or some arbitrary allocation of actual capital.

But for most banks, changes in risk-based capital make a much bigger difference to risk-adjusted profitability than do changes in FTP and cost allocation.

The result is that most "risk-adjusted" profitability measures produce bogus results. A vital piece of the puzzle is essentially missing, and no amount of tinkering with FTP and cost-allocation methodologies can fix that. Banks that start working toward risk-based capital now will be comfortable with its results by the time they are ready to use it for decision making.