To provide meaning to rate risk measurements, Plansmith helps by calculate benchmarks against which your sensitivity of risk can be evaluated. The severity of a potential loss depends upon how much the organization can afford to lose without impairing capital. The ability to absorb the losses and still maintain adequate capital is called Risk Tolerance.Risk can be classified as either short term or long term. Short-term risk impacts margin, near term and an institution’s Economic Value Equity (EVE / NPV) reflects the long-term risk to earnings. Margin Risk Tolerance is determined by calculating the minimum net interest margin required to cover all expenses, capital formation, and dividends. 

The Tier 1 Equity Risk Tolerance is simply the difference between the minimum acceptable capital ratio and the institution’s current capital ratio. This value provides a measurement of the institution’s ability to lose capital and still maintain its minimum capital ratio.

In the example below, a minimum capital ratio of 8.00% has been used in the calculations below. The Tier 1 Equity Risk Tolerance is determined by subtracting the minimum capital ratio from its capital ratio. The Tier 1 Equity Tolerance for this example is then .79%‎.
 
Furthermore, the Risk Tolerance tells us how much the net interest margin could change before the organization’s capital would fall below the current or minimum amount needed support capital formation from earnings. A positive Risk Tolerance value indicates the bank has the ability to absorb adverse rate changes in the net interest margin; however, a negative risk tolerance indicates the capital ratio will decline even without rate change. 

Another way to look at the information above is that, worst case, if we calculate the current margin by holding all rates flat, and benchmark it against the required margin above, do we have a positive or negative risk tolerance? A positive tolerance would allow us to absorb that amount of loss in margin before impacting capital. This tolerance, expressed in a ratio, is then displayed within your Rate Shock Margin Graphs, as seen below. The red square indicates the required Minimum Margin of 4.53 calculated from the Risk Tolerance analysis.

The Risk Limit is the maximum percentage NIM change from the Current Margin (under flat rates) before capital would fall below the current amount or the designated minimum required amount, whichever is higher.

In our example, the Minimum Required margin is 4.53%, whereas the Current Margin under flat rate conditions is 5.82, which indicates a Risk Tolerance of 1.10%. Or, in other words, that the organization could afford a loss of $7.2 million and still cover growth, capital formation, and expenses as indicated above.

The Risk Tolerance Minimum Margin will be appear on your NIM Shock Graphs as a desired limit in which to compare all shocked Margin results.
 
Factors Impacting Risk Tolerance‎

The Rate Risk Tolerance calculation addresses asset liability management in a holistic manner. It recognizes that net interest margin and margin risk are not independent of other aspects of the organization’s financial issues. No part stands alone. Focus should be on the bottom line rather than margin or overhead alone. Risk tolerance can explain why so many organizations can operate with narrow margin and continue to generate substantial returns for their shareholders, while others achieve large margins and yet bring only small increases in basis points to the bottom line.

Financial institutions can relieve pressure on the margin by taking steps to reduce those components of risk tolerance that cause the margin to increase. By the same token, an adequate risk tolerance position could find, for reasons other than rate change, their risk tolerance evaporates. This is due, of course, to changes in the components, such as loan losses or increasing operating expenses.

The report then provides the following rather dramatic analysis, singling out specific changes in each component of the minimum margin calculation that could cause the risk tolerance to drop to zero, raising the minimum required margin. If there is a negative risk tolerance, then analysis will indicate the actions necessary to raise the minimum required margin to the current margin, bringing risk tolerance to zero.

Note‎: ‎The individual actions are calculated as a single factor effect‎. ‎Each change is considered to be the only change taking place‎. ‎However‎, ‎in reality changes take place accross several components and this      information is offered only as a guide‎.‎

The events outlined below are risks to current margin and must be considered as worst-case scenarios. In reality, events can, and do, occur simultaneously. Improvements or reductions in performance are dependent upon a combination of events. This list is intended to help you evaluate possibilities.

Sue West
President