Risk management is sometimes regarded as a mere regulatory requirement by financial professionals, just one more thing on a long list of “have-to-dos.” While its necessity is understandable, it can be viewed as something preventing management from concentrating on the tasks that contribute to the bottom line. Instead, effective risk management should be seen as critical to an institution’s profitability.

Financial institutions vary in their tolerance for risk. Generally, it’s believed that assuming more interest-rate risk leads to higher returns. Risk avoidance can certainly lead to a decreased bottom line but excessive interest-rate risk can get an institution in trouble if the market makes an unfavorable move at the wrong time.

Far from an exact science, predicting interest rates presents a challenge. Even “experts” make the wrong call sometimes. The job of the asset/liability management (ALM) function is to protect the viability of an institution’s business model by reducing the inherent risks of financial intermediation, allowing for scalability and growth in a safe and sound manner.

Rather than attempting to minimize risk, a firm should concentrate on quantifying risk in order to manage it. Ultimately, this ensures the institution generates adequate reward per unit of risk, irrespective of interest rates or competition. High-performing institutions often integrate the risk management and strategic planning functions as they continue to develop new and existing products, services, and processes. And, when risk becomes increasingly elevated, effective communication is key.

Because effective risk management involves timely and efficient reporting functions in order for CFOs and management to have the necessary data to make informed strategic decisions, financial institutions must make substantial investments in technology. This can present significant problems for smaller institutions, especially when they must keep up with the evolving demands for financial services, particularly with innovations in product capabilities and customer experience.

Still, the crux of the depository business model is offering the loan and deposit products consumers want. Never mind all the hype about FinTech firms replacing traditional bank services and Bitcoin becoming a safer, more accepted exchange for goods and services. What’s important to the long-term success of an institution is the ability to measure and manage credit risk, as well as setting rates according to the risk associated with each product. At ALM First, we’ve found that conducting a risk-adjusted analysis is an important function to ensure an institution maintains an adequate risk/reward relationship.

Staying abreast of all the risk-adjusted analysis acronyms may be harder than understanding the processes themselves. With techniques such as RAROC, RORAC, RARORAC and others, it can seem complex. However, despite the potential confusion, the ultimate goal is to get to a risk-adjusted return on allocated capital to facilitate the financial institution’s capital allocation decision-making process.

Generally, capital ought to be allocated to its most efficient use. Efficiency is an idea discussed widely in modern portfolio theory, and it applies in this case to building a balance sheet. The premise is that for any two investments (capital allocation decisions) with the same level of risk, choose the option with the higher expected return. And, 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 graphic below 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 charge. Such is the case in the hypothetical example below; the CMO product has the lowest expected credit cost, operational expense, and risk weighting. Just as one shouldn’t judge a book by its cover, don’t judge an asset by its yield.

Rather than reducing risk management to a box that has to be checked to satisfy regulators, successful institutions use it to boost their profits. Proper risk management provides CFOs and management the necessary information to make better strategic decisions. While history has shown that crises will happen, an effective risk management process can help predict when a firm might be in a vulnerable position, giving time for action to prevent or limit negative outcomes. Using a risk-adjusted product profitability analysis to set rates can lead to better profitability.

Alec Hollis, CFA

Director, ALM Strategy Group at ALM First