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Tallying the Costs of Risk

Risk Report 2011: Facing New Realities in Global Banking

December 15, 2011 by Ranu Dayal, Gerold Grasshoff, Douglas Jackson, Philippe Morel, and Peter Neu
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    In This Article
    • Risk costs—defined as the sum of capital charges and loan loss provisions—declined only slightly in 2010.

    • Risk costs, which have been the main drivers of negative value creation since the start of the crisis, are expected to remain high.

    • To thrive in an era of high risk costs and greater oversight, banks need to establish a more sophisticated and forward-looking approach to steering financial resources.

     

    The global banking industry is in a fragile state. The economic recovery has been losing steam in many markets, while a wave of regulatory reform is certain to add more costs and create further barriers to creating value.

    Risk Report 2011

    What Does the Wave of Regulatory Change Mean for the Global Banking Industry, and How Are Banks Responding?

    To gauge how the industry has fared over the past several years, we calculated the economic profit generated by a large sample of banks from Europe, the U.S., and Asia-Pacific. Economic profit (also called value added) provides a comprehensive measure of the financial issues facing banks. It takes a bank’s income and subtracts refinancing and operating costs as well as loan loss provisions (LLPs) and capital charges—two barometers of macroeconomic and regulatory conditions. Together, LLPs and capital charges represent the risk costs incurred by banks.



    Risk costs have grown substantially since the start of the financial crisis and, given the regulatory changes on the horizon, will continue to exert pressure on banks. This leads to two imperatives. To better account for these costs, banks should introduce the risk-to-income ratio (RIR) as a key metric. They should also integrate the regulatory and economic perspectives of the new requirements in order to accurately and effectively steer financial resources.

    Risk Costs Are Undermining Value Creation

    Banks’ low stock prices and price-to-book ratios highlight the difficulty of creating value in this sector. Our analysis bears this out.

    The economic profit of the 145 banks in our study remained negative for the third consecutive year but improved to –€164 billion in 2010, up from –€216 billion in 2009. (See Exhibit 1.) In 2006, by comparison, the same banks had achieved a positive economic profit of €186 billion. Together, these banks held more than €51 trillion in assets in 2010 and accounted for more than 75 percent of the banking assets in Europe and the U.S. and more than 65 percent of the banking assets in their respective markets in Asia-Pacific.

    exhibit

    Banks in every region suffered in the financial crisis, but the toll varied widely. Banks in Asia-Pacific have maintained a positive—albeit continuously declining—economic profit, owing to their business mix and high proportion of deposits, as well as the resilience of emerging markets. European banks experienced the steepest decline in economic profit. From 2006 through 2010, their cumulative economic profit amounted to –€355 billion. Over the same period, U.S. banks generated a cumulative economic profit of –€190 billion.

    The rise in risk costs was the biggest drag on value creation. (See Exhibit 2.) In 2010, banks spent €0.54 on risk costs to generate €1.00 of net income.

    exhibit

    By comparison, they spent €0.59 on operating costs to generate €1.00 of net income. Capital charges, which increased 18 percent in 2010 due to a slight increase in the cost of capital and higher capital ratios, were more than three times what they had been in 2006. Their increase almost completely offset the sharp decline of LLPs. The net effect: the RIR of the banks in our study declined by 6 percentage points, to 54 percent, but it was still more than double what it had been just four years earlier.

    The Pressures on Economic Profit Will Continue

    The risk hangover from the crisis shows no signs of easing. Even if the economic recovery gets back on track, banks should expect risk costs to continue undermining value creation, largely because of the new requirements that Basel II+ and Basel III impose on their trading books. Capital costs, even if they continue to decline, will remain high, and LLPs could begin to rise again if the economic recovery stalls. In addition, some banks are increasing their LLPs as a hedge against legal concerns arising from their actions prior to the crisis.

    Other determinants of economic profit remain skewed from their precrisis norms or face further challenges.

    • Refinancing costs declined by nearly half from 2008 through 2010, as banks trimmed their balance sheets and central banks pursued quantitative easing and expanded the range of instruments eligible as collateral. But refinancing costs reversed course at the beginning of 2011 and have been rising steadily since then.

    • The average cost-to-income ratio rose only slightly in 2010, to 59 percent. This was in line with its precrisis level and 12 percentage points below where it stood in 2008. But regulatory changes could cause operating costs to rise once again, putting pressure on banks to expand their cost-cutting programs and search for new sources of operational efficiency.

    • Revenues declined for a third consecutive year to about €2 trillion—15 percent below the precrisis peak. Revenue growth has been hampered by macroeconomic conditions, as well as banks’ own efforts to “de-risk” their businesses.

    The Need for Action

    Most banks have taken a regulatory rather than an economic view of measuring and managing risk, which was a natural response to the pressures arising from the crisis. Their focus—in terms of responding to the new requirements—is squarely on ensuring compliance rather than managing risk costs and creating economic value. Banks report risk metrics, for example, but have not integrated them into key business processes or used them to influence critical business decisions.

    To thrive in an era of high risk costs and greater oversight, banks need to establish an integrated approach to steering financial resources—one that combines regulatory and economic perspectives and covers risk, profit and loss, the balance sheet, and capital requirements.

    • To develop such an approach, banks will need to move beyond a backward-looking measurement of risk and understand how their risk profiles might change under different circumstances. To this end, most banks will need to enhance their stress-testing, scenario-analysis, and simulation capabilities. These tools can help them develop a clear action plan for mitigating certain risks and optimizing the allocation of capital.

    • Standing between banks and these aspirations for managing risk (and economic profit) are high technical hurdles. Banks will need to upgrade their IT capabilities in order to gather, report, and analyze risk data; run and modify models and calculation engines; and generate scenarios. (The IT requirements associated with regulatory reform were described in a recent BCG report, Moving Beyond Compliance: How Banks Should Leverage Technology to Capitalize on Regulatory Change.)

    • Banks that have developed such capabilities will be in a better position to create a culture where risk is not the domain solely of the chief risk officer but rather affects the overall steering of the organization—for example, by informing the decisions of investment committees. People throughout the bank will have a clearer perception of the bank’s risk positions, and risk in general will come to play a more important role in their decisions.

    In parallel with strengthening their risk-management capabilities, banks must develop a clear understanding of the implications of regulatory reform—in global terms as well as in the context of specific businesses.

    To Contact the Authors

    Asia-Pacific
    • Senior Partner & Managing Director
    • Bangkok
    Western Europe
    • Partner & Managing Director
    • Frankfurt

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