Risk Appetite and Relationship Pricing -Part 2

Welcome back to the session about risk-adjusted return on capital, and the concepts of risk appetite, and relationship pricing. We go right into the subject and pick up where we left off in the last session. Note, if you haven’t seen the overview-Risk Appetite and Relationship Pricing article, I recommend you read it first in order for you to have this content in the right sequence to help you get more out of this one .

Equity Capital, Expected Loss, and Unexpected Loss

We had an example of a USD $10,000 Loan, with a 5% probability of default and a 40% loss given default, a 50% exposure at default, and a 4-year maturity. Our loan requires a total amount of equity capital of $1066.49, of which $ 100 is a reserve (Expected Loss) and $966.49 is the Unexpected Loss. Another word for the unexpected loss is also the economic capital. Additional factors used in this calculation are the Confidence Level, which is set at 99.9% which means that the capital should be sufficient to not default in 999 out of 1000 years. There is also a scaling factor that can be adjusted away from 1 if we assume that the risk should be estimated higher or lower for so far unconsidered factors. A higher scaling factor could apply if the portfolio is very correlated!

The Unexpected Loss or Economic Capital is a factor that we will use later in the Risk Appetite concept. Given that we now have an indicator about the risk related to a specific loan in the form of an equity contribution, we are in the position to calculate a Risk Adjusted Return on Capital or RAROC.

Conceptually, the formula for RAROC looks like this: 

We look at all the revenues that are generated from the loan. This could come from Interest Income and Fee Income. We put all expenses against that. They usually consist of Operating Expenses, Expected Loss, and Funding Expenses, i.e. the cost of borrowed funds to finance the loan. Further, we need to credit the Capital Benefit back. Capital Benefit refers to the fact that our loan is not fully financed with borrowed funds. Parts of the funding, namely the amount equal to the Unexpected Loss, or economic capital, come from equity. As we want to calculate a return on equity, we do not charge funding costs for that part. 

Calculating RAROC: Revenues, Expenses, and Capital Benefit

Let’s look at some numbers:

Let’s assume that our loan carries an interest rate of 10%. In addition, we have a 1% Disbursement Fee ,which we distribute over 4 years. We assume interest income of $1000 as the loan amortization happens at the end of the first year + $25 for a quarter of the fee. We assume operating expenses of $300 per year based on input from the finance/operations team and Funding Cost of 5% or $500 as this is the amount against which we can borrow money. We also calculate a capital benefit of 48.32 which is equivalent to multiplying the 966.49 of unexpected loss with the 5% of cost of funding. Our total revenues 1073.32 against total expenses of 900. This leaves a positive income of 173.32 dividing this income by the total unexpected loss of 966.49 we can calculate a RAROC of 17.93%.

This method is most transparent to document the actual return an investment can achieve. In this case, of course, the investment is the bank’s decision to provide a loan to a customer.

Scenario Analysis: How Changes Affect RAROC

Let’s have a look at a few scenarios to play around with the calculation so far.

Impact of Loan Size

What happens if we increase the size of the loan but leave all other terms and conditions unchanged?

If we double the loan amount from $10,000 to $20,000, our RAROC will increase. The reason for this increase is the assumption that our operating expenses remain stable. This is a fair assessment, considering that the bank most likely has the same operational effort to provide a $20,000 loan versus a $10,000 loan.

Impact of Higher Probability of Default

We can also see the effects of an increase in the risk of an exposure.

This is expressed in the Probability of Default. Our initial loan had a 5% probability of default resulting in a RAROC of 17.9%. If we increase the probability of default to 6%, the RAROC goes down by 2.6% to 15.3%. You can see the significant effect a change in risk profile has on profitability. The reason for this is the increase in the unexpected loss, up from 966.49 to 1021.75. At the same time, the expected loss grew from 100 to 120. The increase in economic capital also led to a small increase in the capital benefit, which does not significantly influence the end result.  An interesting side aspect here is the fact that the profitability of a loan can vary for the institution over time, as the risk profile of a client changes.

Impact of Collateral Improvement

What happens if we can increase the collateral of a loan?

In this case, we can improve the loss given default. Let’s assume that the borrower is able to provide us with another collateral and thereby reduces the loss given default from 40% to 20%. This adjustment significantly reduces the economic capital allocated to the transaction, almost by half, down to 510.88. The expected loss also decreases. The total revenues have increased due to the reduction in expected loss, resulting in a significant increase of the RAROC to 37.3%.

Based on these three simple examples, you can already see the potential that lies within this formula to steer the overall financial institution.  It is really powerful and has many use cases. We are looking at two of them:

Applying RAROC in the Risk Appetite Concept

1. The First one is the Risk Appetite Concept: 

As a background:

Financial institutions tend to optimize processes and workflows to improve efficiency. When it comes to assessing the risk of a counterparty or a transaction, such improvements reach limits, when the thoroughness of an assessment competes with speed. If we assume that we have to assess the credit risk for a specific transaction, and there are many reasons to do that, then our attempt to optimize turnaround time reaches its limits.

At the same time, we are conscious that we are preparing the Financial Institution for a fully upgraded Business Strategy. Such a strategy should be complemented by the definition of a risk appetite. A financial institution’s risk appetite is typically defined through a combination of quantitative and qualitative factors and is influenced by risk tolerance, business strategy, regulatory environment, and the overall risk management framework. If designed and executed well, the risk appetite will help to establish a clear boundary within which the financial institution could operate, without exposing itself to excessive or unacceptable levels of risk. Developing the risk appetite is an exercise that is best done with an outside advisor or consultant such as those provided by Q-Lana.  

Components of Risk Appetite

There are several components that are combined to develop the risk appetite: 

i. Risk Capacity

We start with the risk capacity: This is the maximum level of risk that an institution can take before breaching constraints related to regulatory capital, liquidity, and other operational restrictions or external obligations, such as covenants. The risk capacity clearly sets the framework for an institution’s ability to take risks. 

ii. Risk Appetite

The actual risk appetite is the aggregate level and types of risk the institution is willing to assume within the framework of this risk capacity. The risk appetite needs to be aligned with the perspective to achieve the strategic objectives and the business plan. 

iii. Risk Limits

Risk limits are quantitative measures based on forward-looking assumptions that allocate the financial institution’s aggregate risk appetite statement to business lines, legal entities, specific risk categories, concentrations, etc.

Factors Influencing Risk Appetite

The overall Risk Appetite is influenced by:

i. Regulatory and Compliance Considerations:

• The risk appetite should be in line with regulatory requirements and guidelines. Financial institutions need to ensure that their risk-taking activities comply with relevant laws and regulations.

ii. Business Strategy Alignment

• Risk appetite is closely tied to the institution’s business strategy. It outlines how much risk the institution is willing to take in order to achieve its strategic objectives. For example, a growth-oriented strategy might involve a higher risk appetite compared to a strategy focused on stability and preservation of capital.

iii. Stakeholder Expectations

• Risk appetite can also be influenced by the expectations of various stakeholders, including shareholders, customers, regulators, and the broader market.

iv. Risk Culture and Awareness

• The risk appetite statement helps shape the institution’s risk culture by setting expectations for risk awareness, communication, and behavior across the organization.

Quantifying Risk Appetite Using Economic Capital

The most straightforward way to quantify risk appetite is to use the Economic Capital / the unexpected loss as the unit of measurement. The institution can first assess the total amount of Economic capital it needs for its current operations and its current risk profile. In this exercise, the institution can also better understand where, i.e. in which risk categories, which sectors or regions risk is allocated to. This existing risk profile can then be compared to the target risk profile, derived from the business strategy and the other input factors mentioned above. With this, a potential shift in risk allocation is defined and executed. Changing a risk profile for a local or regional financial institution can be a slow process, particularly as the shifts in credit risk can only happen through natural maturities and the allocation of new business. This is different from hedge funds or other investment vehicles where changes in risk appetite and profile can happen through trading activities. 

Turning Risk Appetite Into Real Credit Decisions

Now that we have a new target allocation of the risk appetite, these numbers can be broken down into sectors, products, and regions, but ultimately also to individual counterparties. If done well, you define a very specific risk appetite in the form of Economic Capital allocation to a borrower. Then you can leave it to the business to fill this appetite with specific risk products and collateral. At the time a new transaction is processed, the risk appetite helps accelerate the credit decision as it is clear whether there is capacity to take on more risk. It is required though that the institution regularly updates the borrower’s risk profile to understand the actual Economic Capital allocation and that there is an escalation mechanism to handle exceptions.

As a result, not only does our institution have a much better business strategy, but it also has significantly upgraded its way of assessing and allocating risks to the business.

2. This brings us to the second concept, the relationship pricing.

Shifting from Fixed to Relationship Pricing

Traditionally, financial institutions used fixed pricing tables to quote interest rates and fees for their financial products. This approach neglected the overall relationship component and led to missed business opportunities. In the framework of a customer-centric banking operation, the key focus of the pricing for financial products is on the overall relationship. The financial institution needs a pricing model in which it can derive at any stage the actual and projected revenues for a business relationship on a standalone basis or consider additional, related clients. For example, the pricing of a financial product for a company could be lowered if the employees of the company also maintain a relationship with the institution. 

RAROC as a Pricing Tool

For this purpose, the pricing concept of a Risk-Adjusted Return on Capital (RAROC) is best fitted. Let’s go back to the concept and the calculations we have introduced before. The overall revenues per product and the direct cost are considered. The total amount of risk capital consumed in the client relationship and the target returns are calculated. The methodology to calculate the overall risk mirrors the calculation of the risk appetite as defined before. Having such a system online and in real-time available allows the institution to adjust pricing on an ad hoc basis for specific clients, to secure an overall beneficial relationship.

Example of Relationship Pricing

Let’s look at an example: We start with the loan from before. It achieved a 17.93% RAROC. Let’s assume that we add to this client a current account for the borrower and his wife. We charge $10 per month per account and estimate $5 per account and month as cost. Since the current account does generally not add credit risk, we don’t need to adjust the risk capital. The RAROC increases to 30.35%. In this case, in case the client demands it, we could lower the interest rate on the loan by 1% and still be more profitable than without the current accounts.

You can see the potential of this calculation if the data is available, and the tools are in place.

What’s Next in the Series

This concludes our deep exploration of some of the concepts of our business strategy. In the next chapter, we look at some of the tools and partnerships that help you implement the business strategy.