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Margin Risk Tolerance: How Much Risk Can your Financial Institution Afford?

Posted by Bill Smith on 4/5/24 2:36 PM

Risk is inevitable in banking; in fact, it’s what makes banking profitable. The question is, how much risk is acceptable? Recognizing that existing techniques of measurement were sometimes misleading and arbitrary, Plansmith developed a simple calculation called "Margin Risk Tolerance" that defines how much risk each bank can take. Despite the wealth of banking information Plansmith has at hand, we believe risk relates to the individual bank, and cannot be measured to any peer standard or magic number.

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 financial institution grows, it will need additional capital to maintain an acceptable capital ratio. Unfortunately, there is no single guideline for that ratio. De novo organizations may need a ratio of more than 10%. Large banks or credit unions may get by on 7% or less. Most community financial institutions fall somewhere in between. Each organization decides its ratio based on board input or regulatory communications (often informal). If the institution’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, if 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 financial institution 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 organization’s projected net interest margin for the next year. If the projected interest margin exceeds the minimum margin, the difference represents the institution’s risk tolerance in dollars. If projected margin is less than the minimum margin, the difference represents the amount by which the organization must modify its performance to avoid deterioration of 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 institution has identified them and determined that maximum loss would lease adequate capital.

Risk tolerance can also be used to judge the acceptable risk in other areas of the bank or credit union. For example, if the dollar amount of risk tolerance is $520,000, an institution could incur that amount of loan loss without impairing its capital (holding all other risks constant). On the other hand, it could increase its overhead by that amount, 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 clients. Each of our interest rate risk products auto-prepares this report as part of a complete interest rate risk package. Click here to learn more and schedule a discussion of your unique needs today!


Topics: interest rate risk, interest rate risk management, asset liability management

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