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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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  • 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.