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Risk-Based Capital Measurement

Published: November 7, 2008 by Guest Contributor

By: Tom Hannagan

Much of the blame for the credit disaster of 2007 and 2008 has been laid at the risk management desks of the largest banks. A silver lining in the historic financial disaster of today may be the new level of interest in management of risk — particularly, of the relationship between capital and risk. Financial institutions of all sizes must measure and monitor their risk-based capital for three critical reasons.

Ownership interest
First, equity capital represents the ownership interest in a bank. Although a relatively small portion of the balance sheet, equity capital is the part that actually belongs to a bank’s owners. Everything else on the liability side is owed to depositors or lenders. All of the bank’s activities and assets are levered against the funds contributed by the equity investors. This leverage is roughly 10-to-1 for most commercial banks in the United States. For the five major investment banks, this risk-based leverage reached 30-to-1. Their capital base, even with new infusions, could not cover their losses.  It is necessary and just good business sense to regularly let the owners know what’s going on as it relates to their piece of the pie—their invested funds. Owners want to know the bank is doing things well with their at-risk funds. Banks have a duty to tell them.

Funding expenses
Second, equity capital is by far the most expensive source of all funding. Transaction deposit funds are usually paid an effective rate of interest that is lower than short-to-intermediate-term market rates. Time depositors are competitively paid as little as possible based on the term and size of their commitment of funds. Most banks are able to borrow overnight funds at short-term market rates and longer-term funds at relatively economical AA or A ratings. Equity holders, however, have historically received (and typically expect) substantially more in the way of return on investment. Their total returns, including dividends, buybacks and enhanced market value, are usually double to triple the cost of other intermediate-to-long-term sources of funds. From a cost perspective, equity capital is the dearest funding the bank will ever obtain.

Risk factor
This brings us to the third reason for measuring and monitoring capital: the risk factor. A very large portion of banking regulation focuses on capital sufficiency because it directly affects a bank’s (and the banking industry’s) continued solvency. Equity capital is the last element of cushion that protects the bank from insolvency. Although it is relatively expensive, sufficient equity capital is absolutely required to start a bank and necessary to keep the bank in good stead with regulators, customers and others. Equity holders are usually conscious of the fact that they are last in line in the event of liquidation. There is no Federal Deposit Insurance Corporation (FDIC) for them, no specific assets earmarked to back their funding and no seniority associated with their invested money. We all know what “last in line” means for most shareholders if a failure occurs — 100 percent loss.

There is a clear and direct relationship between equity risk and cost—and between equity risk and expected return.  It is now more important for bank executives to monitor and measure their organization’s activities based on the relative risk of those activities and based on the equity capital required to support those risks. This means using return on equity (ROE) a lot more and return on assets (ROA) a lot less. Because of the critical need and high cost of risk-based equity and the various risks associated with the business of banking, decisions about the effective deployment of capital always have been the primary responsibility of bank leaders. Now, the rest of the world is focusing more on how well, or poorly, management of risk has been done.

I’ll comment on using ROE more in later posts.

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By: Staci Baker Just before the holidays, the Fed released proposed rules, which implement Sections 165 and 166 of the Dodd-Frank Act. According to The American Bankers Association, “The proposals cover such issues as risk-based capital requirements, leverage, resolution planning, concentration limits and the Fed’s plans to regulate large, interconnected financial institutions and nonbanks.” How will these rules affect you? One of the biggest concerns that I have been hearing from institutions is the affect that the proposed rules will have on profitability. Greater liquidity requirements, created by both the Dodd-Frank Act and Basel III Rules, put pressure on banks to re-evaluate which lending segments they will continue to participate in, as well as impact the funds available for lending to consumers.   What are you doing to proactively combat this? Within the Dodd-Frank Act is the Durbin Amendment, which regulates the interchange fee merchants are charged. As I noted in my prior blog detailing the fee cap associated with the Durbin Amendment, it’s clear that these new regulations in combination with previous rulings will continue to put downward pressures on bank profitability. With all of this to consider, how will banks modify their business models to maintain a healthy bottom line, while keeping customers happy? Over my next few blog posts, I will take a look at the Dodd-Frank Act’s affect on an institution’s profitability and highlight best practices to manage the impact to your organization.

Published: February 3, 2012 by Guest Contributor

By: Tom Hannagan Understanding RORAC and RAROC I was hoping someone would ask about these risk management terms…and someone did. The obvious answer is that the “A” and the “O” are reversed. But, there’s more to it than that. First, let’s see how the acronyms were derived. RORAC is Return on Risk-Adjusted Capital. RAROC is Risk-Adjusted Return on Capital. Both of these five-letter abbreviations are a step up from ROE. This is natural, I suppose, since ROE, meaning Return on Equity of course, is merely a three-letter profitability ratio. A serious breakthrough in risk management and profit performance measurement will have to move up to at least six initials in its abbreviation. Nonetheless, ROE is the jumping-off point towards both RORAC and RAROC. ROE is generally Net Income divided by Equity, and ROE has many advantages over Return on Assets (ROA), which is Net Income divided by Average Assets. I promise, really, no more new acronyms in this post. The calculations themselves are pretty easy. ROA tends to tell us how effectively an organization is generating general ledger earnings on its base of assets.  This used to be the most popular way of comparing banks to each other and for banks to monitor their own performance from period to period. Many bank executives in the U.S. still prefer to use ROA, although this tends to be those at smaller banks. ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or risk-based capital. This has gained in popularity for several reasons and has become the preferred measure at medium and larger U.S. banks, and all international banks. One huge reason for the growing popularity of ROE is simply that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero. Hopefully your Equity account is always greater than zero. If not, well, lets just say it’s too late to read about this general topic. The flexibility of basing profitability measurement on contribution to Equity allows banks with differing asset structures to be compared to each other.  This also may apply even for banks to be compared to other types of businesses. The asset-independency of ROE can also allow a bank to compare internal product lines to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business that are almost complete opposites, like lending versus deposit services. This includes risk-based pricing considerations. This would be difficult, if even possible, using ROA. ROE also tells us how effectively a bank (or any business) is using shareholders equity. Many observers prefer ROE, since equity represents the owners’ interest in the business. As we have all learned anew in the past two years, their equity investment is fully at-risk. Equity holders are paid last, compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its successful deployment is critical to the profit performance, even the survival, of the bank. Indeed, capital deployment, or allocation, is the most important executive decision facing the leadership of any organization. So, why bother with RORAC or RAROC? In short, it is to take risks more fully into the process of risk management within the institution. ROA and ROE are somewhat risk-adjusted, but only on a point-in-time basis and only to the extent risks are already mitigated in the net interest margin and other general ledger numbers. The Net Income figure is risk-adjusted for mitigated (hedged) interest rate risk, for mitigated operational risk (insurance expenses) and for the expected risk within the cost of credit (loan loss provision). The big risk management elements missing in general ledger-based numbers include: market risk embedded in the balance sheet and not mitigated, credit risk costs associated with an economic downturn, unmitigated operational risk, and essentially all of the strategic risk (or business risk) associated with being a banking entity. Most of these risks are summed into a lump called Unexpected Loss (UL). Okay, so I fibbed about no more new acronyms. UL is covered by the Equity account, or the solvency of the bank becomes an issue. RORAC is Net Income divided by Allocated Capital. RORAC doesn’t add much risk-adjustment to the numerator, general ledger Net Income, but it can take into account the risk of unexpected loss. It does this, by moving beyond just book or average Equity, by allocating capital, or equity, differentially to various lines of business and even specific products and clients. This, in turn, makes it possible to move towards risk-based pricing at the relationship management level as well as portfolio risk management.  This equity, or capital, allocation should be based on the relative risk of unexpected loss for the different product groups. So, it’s a big step in the right direction if you want a profitability metric that goes beyond ROE in addressing risk. And, many of us do. RAROC is Risk-Adjusted Net Income divided by Allocated Capital. RAROC does add risk-adjustment to the numerator, general ledger Net Income, by taking into account the unmitigated market risk embedded in an asset or liability. RAROC, like RORAC, also takes into account the risk of unexpected loss by allocating capital, or equity, differentially to various lines of business and even specific products and clients. So, RAROC risk-adjusts both the Net Income in the numerator AND the allocated Equity in the denominator. It is a fully risk-adjusted metric or ratio of profitability and is an ultimate goal of modern risk management. So, RORAC is a big step in the right direction and RAROC would be the full step in management of risk. RORAC can be a useful step towards RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level.  This  can also be broken down for any and all lines of business within the organization. Thence, it can be further broken down to the product level, the client relationship level, and summarized by lender portfolio or various market segments. This kind of measurement is invaluable for a highly leveraged business that is built on managing risk successfully as much as it is on operational or marketing prowess.

Published: November 19, 2009 by Guest Contributor

ROE vs ROA | Return on Equity (ROE) is generally net income divided by equity, while Return on Assets (ROA) is net income divided by average assets. 

Published: December 5, 2008 by Guest Contributor

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