Date:01/09/2005 URL: http://www.thehindubusinessline.com/2005/09/01/stories/2005090100181100.htm
Back It's risky not to measure risk

Kuntal Sur

Kuntal Sur on risk-adjusted performance measurement in banks

BANKS and financial institutions look at capital management from two perspectives:

  • Estimation of capital from the regulatory angle (regulatory capital), wherein the aim is to align regulatory and economic capital. The new Basel Accord is focused on determining the regulatory capital.

  • Allocation and consumption of capital (economic capital): This involves the allocation of relatively scarce capital to business units, geographies, risk categories or industries in such a way that shareholders' returns are maximised.

    While the regulators are primarily concerned with the soundness and stability of the banking system, shareholders look to maximise their returns. As a result, regulatory capital focuses on satisfying the objectives of the regulator, while economic capital looks at internal management of the business to maximise stakeholder returns.

    A bank management has to develop a balance between regulatory and shareholder objectives.

    Different risk-return models are being used for allocation of capital. The two most commonly used are risk-adjusted return on capital (RAROC) and return on risk-adjusted capital (RORAC).

    These risk-return models are commonly called risk adjusted performance measurement (RAPM), which provides a uniform measure that top management can use to compare the economic profitability of businesses with different sources of risk and different capital requirements. RAPM = (Net Interest Income + Fee Income + Return on Economic Capital - Expected Losses - Costs)/Economic Capital

    The original motivation of developing a risk-return framework was to measure the risks inherent in the bank's credit portfolio, as well as the amount of equity capital necessary to limit the exposure of the bank's depositors and other debt-holders to a specified probability of loss.

    RAPM systems can be used for risk management and performance evaluation. For risk management purposes, the goal of allocating capital (prioritisation) to individual business units is to determine the bank's optimal capital structure.

    The process involves estimating how much the risk (volatility) of each business unit contributes to the total risk of the bank and, hence, to the bank's overall capital requirements and limit setting.

    For performance evaluation purposes, RAPM systems assign capital to business units as part of a process of determining the risk-adjusted rate of return and ultimately, the economic value added of each business unit.

    Advantages of using a RAPM model

    The primary advantage of an RAPM model lies in the discipline it can bring to lending decisions. It ensures risk and reward remain linked and decision-making is consistent.

    Having calculated risk-return figures for a transaction does not obviate the need for a careful review of all new credits and screening (whether by a committee or some other means) of deals that bring a lot of incremental risk.

    However, an RAPM model/s provides a number of advantages to a discriminating user, including the following:

  • The RAPM models provide a uniform measure of performance that management can use to compare the economic profitability of businesses with different sources of risk and different capital requirements.

  • These models provide a platform to calculate both risk and return and thereby remove the bias from one objective or the other. A risk-return model estimation can bring an added dimension by showing the use and return on capital and bring more objectivity to the decision making process.

  • If provided to all corporate lenders and used appropriately, an RAPM model can almost ensure that decisions made in different locations, at different times, with different relationship managers will be made using the same principles and calculation methodology.

  • An RAPM model tends to level the playing field and give all staff a chance for comparison of their transactions.

  • An RAPM model emphasises that risk must be compensated for, while ensuring that the risk is both measured and appropriately considered through the enforced completion of the calculation.

  • An RAPM model can provide a "what if" capability to the user. In most cases, the relationship manager or the credit officer can solve for the price or the risk and rebalance by adjusting one or the other.

  • An RAPM model helps to set limits and monitor risk-adjusted returns at a point of time for different accounts/portfolios.

  • An RAPM model can be used for benchmarking performance of different divisions and a tool for profit sharing.

    Though these benefits can improve the traditional credit process, the RAPM calculation is not an end in itself.

    In broad terms, the pre-requisites for risk-return model computations are: strong management information system, validated risk rating model/s, robust portfolio management system, sound transfer pricing mechanism and capability to estimate economic or regulatory capital.

    Is it worth the effort?

    The RAPM models are not free from limitations. However, the critical question is whether its introduction will improve the existing lending process, the decision-making ability, and the performance of corporate lending. The answer is specific to each institution.

    For many banks, lending is subsidisation of other business; for those believing in such a strategy, a risk-return model may not be used directly.

    However, this model can be used by banks in its strategic planning processes, where it can measure the amount of subsidy being provided on one business line/geography and how it may be recovered from another.

    For many banks, the calculation of expected loss and economic capital is not on the agenda, and so a RAPM model would similarly be rejected. Many others have such poorly developed information systems that it cannot be successfully integrated for the moment.

    However, banks that have started implementing RAPM models tend to learn a great deal about their management of loan assets.

    They tend to improve on their rating system, put more consistency into structuring and pricing, and are often forced to upgrade their management information systems.

    The introduction of RAPM models will certainly increase the decision-making processes, make it more object-oriented and transparent.

    Overall, it is advantageous for banks/financial institutions to embrace the risk-return model for a healthier portfolio.

    (The author is a Principal Consultant with Misys Risk Management Systems. The views are personal.)

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