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Insight Newsletter
Risk Adjusted Returns on Bank Capital
Credit risk drives capital requirements, which ultimately affects loan pricing.
by Michael T. Newsome
Two things are clear in today's credit
market. First, adequacy of bank capital
continues to be a prominent issue as
regulators continue to look over the shoulders
of bankers to confirm their assessments of
credit risk and the adequacy of their capital.
Second, commercial and industrial (C&I)
loans are the favored asset class among banks.
Demand among banks for middle-market
C&I loans far exceeds the appetite of quality
borrowers for additional credit. This scramble
to put money to work has resulted in a conflict
between banks’ long term return on capital
goals and the short term realities of the
marketplace. Understanding how banks determine
the amount of capital to be allocated
to each credit and the implications for pricing
will help CFOs assess the state of the market
and their own credit arrangements.
Banks employ sophisticated Economic
Valued Added (EVA) models that take into
account credit risk in an effort to determine
the return on capital earned by a business
unit, (e.g. commercial banking), a product
line (e.g. asset based lending), or the bank’s
relationship with a specific customer (e.g.
XYZ Corp.). This concept was first introduced
by Bankers Trust (now, Deutsche Bank) in
the mid-70’s and is commonly known as Risk
Adjusted Return on Capital or "RAROC."
The purpose of this effort is four fold:
- Judge how much capital is needed to buffer
the risk of unexpected losses in the bank's
various credit exposures;
- Help quantify decisions to embrace or
shed risk;
- Provide guidance for charging a rational
price for the risk the bank assumes; and
- Allocate capital from under-performing
activities or customers toward those that earn
better risk-adjusted returns.
For a borrower, understanding a bank's
RAROC machinations can offer insight as to
how credit is priced.
CREDIT RISK AND CAPITAL
Making loans requires a lender to take on
risk for which it expects to earn an adequate
return. Greater risk requires more capital to
buffer against unexpected loss. So, it makes sense that capital requirements should be
predicated on actual credit exposure. Under
the current Basel II capital guidelines, many
larger banks are qualified to calculate their
own regulatory capital requirements using
a rating-based approach to account for the
credit risk in their portfolios.
In significant part, the process of credit
approval or review boils down to assessments
made on an amalgamation of factors: historical
performance, capitalization, perception
of management, industry trends, credit
structure and term, quality of collateral, and
strength of third-party support. The result is
an assignment of a specific risk rating to individual
loans or exposures. The above chart
summarizes the risk rating categories (tiers 4
through 7) that apply to the vast majority of
middle-market companies and loans. Tiers
one through three are reserved for investment
grade borrowers, while tiers eight through ten
reflect troubled credit situations.
Past performance of similarly rated borrowers
and loans, as well as the maturity and
duration of the loan, provide the basis for
determining the bank's Exposure at Default (EAD). Two key factors are used in the calculation
of risk-weighted capital.
- Probability of default (PD) This is an
estimate of average (measured over a long
term) one-year default rates for assets within a
given risk-rating category. PD estimates reflect
the expected performance of borrowers derived
from historical default data.
- Loss Given Default (LGD) The LGD
factor is based on a determination by the bank
of the potential principal loss if the borrower
defaults, after accounting for the benefits of
collateral, guaranties, and hedges. The LGD
factor in the chart on page 2 assumes a 10%
loss. LGD factors will be proportionally higher
as the estimate of potential loss increases. For
example, a tier 5 LGD with an estimated 10%
loss exposure is 21.1%. A loss estimate of 50%
raises the LGD factor to 105.5%.
M, PD, and LGD drive the determination
of the statistical probability and magnitude of
expected and unexpected losses that may occur
upon default. From that comes the determination
of risk-adjusted capital under Basel
II, which relies on a complex mathematical
formula that we'll avoid dragging the reader
through.
..........
Understanding how banks
determine the amount of capital
to be allocated to each credit
and the implications for pricing
will help CFOs assess the state
of the market and their own
credit arrangements.
..........
HOW DOES THIS WORK?
To illustrate how this works in a real situation,
consider a typical middle-market borrower
with a $20 million multi-year revolving
line of credit facility. The borrower is rated by
the bank as a Tier 5 risk, with an expected loss
of 20% on default. The tables on page 2 show
a calculation of EAD, Risk Adjusted Capital,
and the implied credit spread required to earn
a 12% return on capital. Given regulatory required
capital structures, a typical bank will
expect to earn a return on capital of approximately 12%. In this example, a spread over
Libor of 260 basis points is required to generate
the target return. The following graph illustrates
that stronger or weaker risk rating dramatically
impacts the amount of risk-adjusted
capital allocated to a $20 million loan and the
pricing that justifies that capital.
Pricing in the credit markets is a function
of competitive pressure, but when bankers
perceive that pricing is inadequate to compensate
their capital providers, internal forces
will drive efforts to increase returns. The
banking industry is in the midst of a transition
period. In time, some combination of economic
strengthening and industry restructuring
will tip the balance back toward pricing
that will earn the returns on bank capital that
investors demand. Although timing is difficult
to predict, this analysis shows that higher
credit spreads and fees will be needed to generate
adequate returns on bank capital.
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