Margin risk tolerance calculates the minimum net interest income and net interest margin necessary to maintain continuing operations. Minimum margin consists of two basic components: 1) earnings needed to maintain an acceptable capital ratio and pay dividends, and 2) earnings needed for overhead.
Minimum capital formation is impacted by several underlying factors. As a bank grows it will need additional capital to maintain an acceptable capital ratio. Unfortunately, there is no single guideline for that ratio. De novo banks may need a ratio of more than 10%. Large banks may get by on 7% or less. Most community banks fall somewhere in between. Each bank decides its ratio based upon board input or regulatory communications (often informal). If the bank’s current ratio exceeds the minimum, growth may continue for some time without the need for capital formulation. The calculation does require that all dividends be paid out of current earnings, even though there is some regulatory latitude.
The calculation of earnings needed to maintain capital requires a growth projection of total assets for one year. If beginning capital divided by total assets at the end of the projection is less than the minimum ratio, then additional capital must be earned to restore the ratio to the minimum. Projected dividends, it any, are added to the additional amount to get the first component of minimum margin.
The second component of minimum margin is simply the projected overhead of the bank for the next year with a few adjustments. Fee income is subtracted from the overhead because fee income substitutes for dollars that must be earned from margin. Provision for loan losses must be included as well as income taxes, but only taxes on the amount of income needed for capital formulation and dividends.
Once the two components are computed, they are simply added together and then compared to the bank’s projected net interest margin for the next year. If the projected interest margin exceeds the minimum margin, the difference represents the bank’s risk tolerance in dollars. If projected margin is less than the minimum margin, the difference represents the amount by which the bank must modify its performance to avoid deterioration in its capital ratio.
Margin risk tolerance can be expressed as a rate by dividing the margin risk tolerance by the average earning assets for the projected year. This rate equates the maximum change in interest rates that could be tolerated before minimum capital formation would be impaired. Theoretically, regulators should not criticize risk if the bank had identified them and determined that maximum loss would lease adequate capital.
Risk tolerance can be used to judge the acceptable risk in other areas of the bank. For example, if the dollar amount of risk tolerance is $520,000, a bank could incur that amount of loan loss without impairing its capital (holding all other risks constant). Or, a bank could increase its overhead by that amount, or take a reduction of fee income, or increase its dividend. It is important to remember that the analysis covers only the first year. It may be prudent to decrease the minimum margin by the asset growth times the capital ratio. This eliminates the "temporary" cushion of excess starting capital.
Plansmith is happy to share this copyrighted technique with our community bank clients. Each of our interest rate risk products auto-prepares this report as part of a complete interest rate risk package. Feel free to call and find out more.