Risks in branch networks
Category: Branches
The liquidity risk
Branches are at the heart of the liquidity flow of a bank, and the main issue for the bank’s treasury department is to keep track of the overall changes in cash flows, aggregating flows from all units (branches + head office commercial business)
The interest rate risk
The interest rate risk consists in the possibility that the interest rate obtained from a loan is lower than expected, or the cost of borrowed resources (including deposits) is higher than expected.
Here again branches are a very sensitive point in this interest rate risk management, as they apply commercial rates to customers and negotiate maturities of transactions.
For all interest sensitive transactions, the reporting system from branches has to collect and aggregate interest rates and maturities of transactions. Only then, a bank can assess its overall sensitivity and be able to carry out an interest rate policy.
The currency (or FX) risk
The FX risk is very similar in its behaviour to the interest rate risk. The policy to manage it is then very similar. Since branches’ business can be carried out in various currencies (local currency, US dollar, other hard or soft currencies), the bank needs to have a well determined FX policy, especially in terms of open positions, and have it well widespread to branches. The currency position needs to be reported daily and the central treasury manages the equilibrium, taking into account regulation and possible active currency position for the bank as a whole.
Stress the growing importance of global risk management and coordination between head office and branch network in implementing the risk management strategy.
Allocating capital to branches
Capital needs to be allocated to risky transactions. Capital is here to cover possible losses. The final use of capital is the responsibility of bank’s top management and closely depends on the ease or difficulty to raise capital.
In respect with the recommendations of the Basel Committee, an amount of capital of 8% of the loan amount is required to hedge the borrower’s default risk.
Banks can have either a simple capital allocation system based on the Basel recommendations, or a more sophisticated system based on its own assessment of credit risk. The only constraint then is, at the end of the process, to meet the overall regulatory requirement.
Examples of capital allocation
The 2 main rationales in having capital are financing the growth of new businesses or investments in the bank, and to cover losses generated by risks.
But capital is a scarce resource, by far the most costly because the most difficult one to obtain. The capital allocated to business units, profit centers or branches have a cost, which must be covered by the transactions using capital.
Risk weighted performance measurement
Return on capital: methods to take into account the cost of risks
RAROC (Risk adjusted return on capital) had been created as a monitoring tool by Bankers Trust in the late 80s. This is a system that measures the profitability of a transaction, after it has been completed, by including the cost of capital in the direct costs attached to the transaction. This risk adjusted profitability (return) is used to calculate a risk weighted return on capital.
RORAC (Return on risk adjusted capital) to the contrary is a pricing method, used to set the price for a transaction before it starts. Capital is increased by the amount of risk and then, profitability is compared with this risk adjusted capital
Exercise: calculating RAROC and RORAC
Assumptions
A bank’s profit center grants a 1 M RUR over 1 year at an 18% interest rate in fine. Head office grants this profit center 500 000 RUR in capital, priced at 15% per year. The BIS ratio for the transaction is 8% of capital over 100% of the loan.
Calculate the risk-weighted profitability of this transaction:
RAROC method:
| Interests earned: | 180 000,00 |
| Refinancing cost of the profit center: | 12% |
| Which means a cost of: | 120 000,00 |
| Gross return on equity of the loan: ROE = | 12% |
| Amount of capital at risk used for the loan: | 8% (100% loan ) = | 80 000,00 |
| Remuneration of risk capital: | 15% (risk capital) = | 12 000,00 |
| Then the risk-weighted return for the loan is: | 48 000,00 | |
| The loan then shows a RAROC of: | 10% |
RORAC method:
Calculation is done ex ante, when the profit is not yet known but the transaction’s return is being defined:
| The refinancing cost of the profit center is: | 12% | |
| the capital at risk for the transaction is: | 8% (100% (loan) ) = | 80 000 |
| Remuneration of risk capital: | 15% (risk capital) = | 12 000 |
Which means, as a percentage of the amount of the loan, an extra refinancing cost of: 12 000 / 1 M RUR = 1,20%
| The total cost for the loan is then: | 12% + 1,2% = | 13,20% |
| The profitability of the loan, risk adjusted, is then: | 4,80% | |
| And the risk adjusted profit is then: | 4,8% (1 M RUR) = | 48 000 |
| RORAC for the loan is then | 10% | |