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The definition of a minimum required return for shareholders is a well-known topic with well-known solutions, as mentioned above when referring to the CAPM and APT models of required returns on equity given risk. We focus more here on its implications, first with respect to terms of pricing and second with respect to the capital base. There is a third issue, related to any gaps between the price of risk within the bank and the market, that we tackle in the next section.

Target Profit on Economic Capital

The required profit, after expected losses, cost of debt and operating costs, is 20% of capital. With regulatory capital, the required profit does not change with the risk of those counterparties that share the same weight for calculating the regulatory capital. In Figure 53.1, the target profit is 20% times capital. However, the regulatory capital remains a forfeit while economic capital increases with risk. This is the old Cooke ratio framework. Using regulatory capital as a base for pricing results in systematic mispricing, sometimes underpricing risky borrowers and overpricing the lower-risk borrowers. This is equivalent to attracting risky borrowers and rejecting good borrowers. This demonstrates why an adequate risk-based pricing, and an adequate base for measuring risk, is a true competitive advantage.

The Capital Base

Since the capital base differs when considering regulatory capital, available capital and economic capital, the target profit changes, depending on which one we use as a reference, even though the required percentage return is the same. Hence, it is necessary to choose which capital base serves for defining the target pre-tax profit. Presumably, the goals relate to regulatory or available capital because they are already there. However, risk-based target profitability should refer to economic capital, while being consistent with these other amounts of capital.

If regulatory capital is lower than economic capital, and if the required return over capital is 20%, the return on regulatory capital is higher than 20%, and vice versa. For instance, with a regulatory capital of 120, the target profit is 20% x 120 = 24. If economic capital is lower, for example 100, using the regulatory capital as a reference results in an effective return on economic capital that is higher and equal to 24/100 = 24%. If economic capital is 140, the resulting return on economic capital is lower than 20% and equal to 24/140 = 17.14%. The return on economic capital results from the return on regulatory capital through the relationship:

Return of economic capital = 20% x (regulatory capital/economic capital)

If the reference capital base is different from regulatory capital, for instance the available capital, because it is higher, a similar relationship applies. If the reference capital is the economic capital, we use this reference to determine the target profit. The resulting return on regulatory or available capital follows as above. For example, requiring 20% on an economic capital of 140 implies a target profit of 20% x 140 = 28 and a 23.3% return on economic capital of 120.

A side issue is whether such discrepancies make sense economically. For instance, is it normal to require 20% on economic capital because it is greater than regulatory capital? This makes sense only if economic capital decreases down to regulatory capital. The discrepancy is an incentive to take fewer risks because regulatory capital understates the true risk of the portfolio. This is what is going to happen if the available capital is 120 only. In the end, economic capital should tend towards regulatory/available capital. Once they converge, there is a common base. Otherwise, there is room for arbitraging economic and regulatory capital, resulting in mispricing with respect to economic targets.