RISK-ADJUSTED RIDE

It has certainly been a fun ride this week. The last few articles have spent time discussing the shortcomings of both NIM and ROE and key components large banks use to price loans. Today, our ride comes to an end, as we close off this 4 part series with a discussion of some of the nuances of risk-adjusted return on equity. As we all know, the purpose of regulatory capital is to enforce certain minimum requirements on the banking industry. However, with the pending adoption of BASEL II, most large national banks have begun shifting to an economic capital position, which could allow them to hold lower minimum capital levels (if it can be supported) than independent banks. For proof of how substantial the impact will eventually be, look no further than recent market competition and corresponding pricing on CRE loans. Wherever independent banks compete with national banks, understanding risk-adjusted ROE is going to be extremely important. Over the years, national banks have refined their use of risk-adjusted ROE, primarily in an effort to determine appropriate capital charges for specific lines of business, products or transactions (such as a given loan). By setting a minimum hurdle rate (say 15% or better risk-adjusted ROE), lenders can quickly determine which loans to book and which ones to further negotiate. Given the limited amount and overall cost of raising capital, it is particularly important for independent banks to manage and allocate this precious resource to areas that will have the biggest impact on performance and consistently apply it throughout the organization. In short, banks use risk-adjusted ROE to get a better handle on their economic risk to capital, as they try to maximize return to shareholders. The key with using risk-adjusted ROE when evaluating a given business line or transaction is to choose a proper time horizon, so that stabilized cashflows can be captured and incorporated into the decision making process. This is particularly important when such activities are expected to lose money in early years, yet turn profitable in subsequent ones. To calculate risk-adjusted ROE, bankers can begin with something as simple as a spreadsheet and the discounted cashflows that are produced from the existing ALM process. To do so, take revenue minus expenses minus expected loss plus income from capital (allocated to the business line or transaction) and divide it by total equity. Once you have compiled the results, you now have the capability to rank risk and return for any asset, liability, product, or business line. If you don't have time to do this, be sure to inquire about the Banc Investment Group's loan pricing model. It incorporates all of these components and is available to independent banks via the internet. This tool gives every lender an immediate application to calculate risk-adjusted ROE. As the roller coaster slows down and approaches the station, our 4 part series ends and we notice the screaming has now stopped.