Those other forgotten components of risk are all those expenses that Net Interest Income must cover to generate a profit, a profit sufficient to maintain an adequate capital ratio. These include all of the non-interest expenses net of non-interest income as well as loan losses and even taxes. The NIM must also cover dividends. Finally, depending on the overall asset growth and capital level, the NIM must generate enough to maintain equity. If the sum of all these is smaller than the NIM under rate change condition, then we say the institution has a positive Risk Tolerance, meaning that the change in NIM will not adversely impact equity. If, on the other hand, the sum of these is greater than the NIM, we say the Risk Tolerance is negative and the capital ratio will fall. The risk is really how much will it fall and will it fall below the minimum level.

Having said all this, let’s look at some simple applications. For example, an institution with these statistics, an 8.3% capital ratio and a 3.30% NIM growing at 5%, no dividend and all other net expenses of 2.90% on assets has a Risk Tolerance of 0.40% on assets. This means that the institution’s margin could fall up to 40bp before its 8.3% capital ratio would begin to fall. The margin would have to fall 126bp to reach the minimum capital ratio of 7%. Clearly this institution would have to have some catastrophic event to find itself with a minimum capital ratio.

Using Risk Tolerance as a key management ratio provides community bank management with more options to manage risk than just the NIM. Often the NIM is due to outside factor such as rates and the environment. Looking at the components such as Net Overhead, Dividends, Loan Losses and even growth rate gives ways to mitigate risk to the institution’s total capital position.

In brief, managing risk is more effective using Risk Tolerance than just the Margin and should be used in the community bank’s policy.