December 5, 2017
Can Risk Management Be Profitable?
By Alec Hollis, Director – ALM Strategy Group, ALM First Financial Advisors, LLC
As regulated as the banking industry is, risk management can seem like a “check-the-box” activity. In a great piece titled “The Profitable Side of Risk Management,” Michael Giarla rejects the perception of risk management as a necessary evil that detracts from bank profitability, and instead promotes the idea that proper risk management is an important factor to an institution’s success. While overregulation certainly is a hot topic today, proper risk management remains a timeless element in long-run profitability.
Central to most risk management programs is managing interest-rate risk (IRR), although strategies to manage and target this risk vary across the industry. Ultimately, an institution’s tolerance for IRR is set by its board. Given that some institutions are comfortable operating with higher levels of IRR than others, it’s worth asking whether higher levels of IRR are correlated with higher levels of profitability.
The answer is not so straightforward. There are many other, more material factors driving long-run profitability, such as lending standards and cost management. As such, one can see IRR management not so much as a profit center, but as a natural hedging response of a business focused in financial intermediation. Great institutions have strong risk governance programs in place, allowing them to scale and grow in a safe manner, and continue to do what they do best – serve their customers and their institutions without betting on interest rates.
As with any risk management program, minimizing risk isn’t a valid goal, all else equal. Risk avoidance can create shortfall risk, which can be detrimental to profitability. Instead, asset-liability management (ALM) programs should focus on quantifying risk and managing it to ensure the institution is making informed decisions. Ultimately, earning adequate reward per unit of risk is the name of the game. High-performing institutions often do this by integrating risk management with strategic planning, through the development of new products, services and processes.
High-performing institutions are also very aware of the current profitability and risks of their product lines. As the old saying goes, “a bank’s assets are its liabilities, and its liabilities are its assets” – meaning a stable cost of funds is a valuable asset, and credit concerns stemming from the asset side can bring a bank down. Having superior expertise in managing credit risk is extremely important to long-run profitability, which is why many institutions rely on risk-adjusted return on capital analysis.
Keeping track of all the risk-adjusted analysis acronyms might be harder than understanding the techniques themselves – RAROC, RORAC and RARORAC to name just a few. But despite the potential confusion, the goal is to get to a risk-adjusted return on allocated capital, which can in turn help the institution become a better capital allocator.
When making capital allocation decisions, capital is best allocated to its most efficient use. Efficiency is an idea discussed in modern portfolio theory, and one that applies to building a balance sheet. The general rule is that for any two investments (capital allocation decisions) with the same level of risk, the institution should choose the option with the higher expected return; conversely, given the same expected return, the investment with lower risk should be chosen. Additionally, the investment’s risk-adjusted expected return – adjusted for the associated marginal operating and credit costs – should exceed the marginal financing costs of the institution.
The table above shows a return on capital comparison of three potential investments – two loans and a securitized product. Despite the disparity between the three assets, all potential investments should be boiled down to their marginal impact on return on allocated capital to allow for cross-comparison. While an asset may have a lower gross yield, it may demonstrate a higher return on allocated capital after accounting for its risk-adjusted expected return, its marginal costs and its leverage resulting from the required capital allocation.
Such is the case in the following hypothetical example – the agency CMBS product has a lower yield than the auto loan, but after adjusting for expected credit cost, operational expense and capital allocation, it ultimately has a higher return on capital. Just as one shouldn’t judge a book by its cover, don’t judge an asset by its yield.
Risk management is important for many reasons, and shouldn’t be reduced to a regulatory task or seen as solely playing defense. To the contrary, proper risk management can provide CFOs and management with the confidence needed to support a robust offensive strategy. As history has shown, crises come and go – risk management should serve to protect the institution from the fluctuations of the business cycle, which is why risk-adjusted product profitability analysis is paramount.
Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.
About the Author
Alec Hollis is a Director in the ALM Strategy Group at ALM First, where he performs asset-liability management strategy research, implements firm-wide ALM modeling procedures and helps execute balance sheet hedging programs for financial institutions