Economic risk adjusted return

What Is Economic Risk-Adjusted Return?

Economic risk-adjusted return is a measure used primarily by financial institutions, particularly banks, to assess the profitability of a business activity or portfolio in relation to the amount of economic capital required to support it. It falls under the broader financial category of risk management and portfolio theory. Unlike traditional return metrics that focus solely on profit, economic risk-adjusted return incorporates the inherent risks associated with generating that return, aiming to provide a more holistic view of performance. It helps an institution understand if the returns generated adequately compensate for the unexpected losses it might incur given its risk exposures⁴³. This metric is crucial for strategic decision-making, capital allocation, and evaluating the true economic performance of various business segments.

History and Origin

The concept of economic capital, which underpins economic risk-adjusted return, has roots in the financial industry's evolving understanding of risk and capital adequacy. Historically, banks primarily relied on regulatory capital requirements set by authorities. However, as financial markets grew in complexity and new risks emerged, institutions recognized the need for internal measures to manage capital more effectively. The development of economic capital frameworks accelerated in the late 20th century, driven by internal capital management needs and advancements in risk quantification methodologies⁴².

The Basel Committee on Banking Supervision (BCBS) played a significant role in this evolution. While economic capital is an internal measure, Basel II and subsequent accords, like Basel III, encouraged banks to develop and use their own internal capital adequacy assessment processes, which often leverage economic capital models⁴¹,⁴⁰,³⁹. These regulatory frameworks, particularly Pillar 2 of Basel II, emphasize a bank's assessment of its economic capital framework. This shift highlighted the importance of a consistent and comprehensive economic model to evaluate overall capital adequacy in relation to an institution's risk profile.

Key Takeaways

• Economic risk-adjusted return measures the return of an activity relative to the economic capital needed to support its risks.
• It provides a more comprehensive view of performance than traditional return metrics by incorporating risk.
• Primarily used by financial institutions for internal capital allocation, performance assessment, and strategic decision-making.
• The concept evolved alongside regulatory frameworks like the Basel Accords, which encourage robust internal risk management.
• It helps ensure that returns adequately compensate for potential unexpected losses.

Formula and Calculation

The most common approach to calculating economic risk-adjusted return, especially in the context of banking, involves comparing the net expected profit (or net income after expected losses) to the economic capital. A widely used metric is Capital Risk-Adjusted Return on Capital (CRAROC).

The formula for CRAROC is:

$\text{CRAROC} = \frac{\text{Net Income After Expected Losses}}{\text{Economic Capital}}$

Where:

• Net Income After Expected Losses (NII - EL): This represents the profit generated by an activity or portfolio after accounting for anticipated losses. Expected losses are generally covered by provisions and are considered a cost of doing business.
• Economic Capital (EC): This is the amount of capital a firm assesses it requires to cover unexpected losses over a specific time horizon at a given confidence level. It represents the capital buffer needed to absorb losses beyond those that are expected³⁸,. Economic capital can encompass various types of risk, including credit risk, market risk, and operational risk.

Other risk-adjusted performance measures, such as the Sharpe Ratio, Treynor Ratio, and Jensen's Alpha, are also used to evaluate investment performance by considering risk. However, CRAROC is specifically tailored to the capital allocation decisions within financial institutions based on internally determined economic capital.³⁷,³⁶,

Interpreting the Economic Risk-Adjusted Return

Interpreting the economic risk-adjusted return involves evaluating whether the returns generated by a business activity or investment adequately compensate for the economic risk undertaken. A higher economic risk-adjusted return generally indicates better performance, as it suggests that the activity is generating more profit for the amount of economic capital it consumes.

For a financial institution, this metric helps in making informed decisions about capital allocation. For instance, if two business units generate similar absolute returns, the one with a higher economic risk-adjusted return is more efficient in its use of capital, as it requires less economic capital to achieve those returns. This allows management to compare the risk-adjusted profitability and relative value of businesses with widely varying degrees and sources of risk³⁵.

It's important to consider the firm's risk tolerance and strategic objectives when interpreting these figures. An activity with a lower economic risk-adjusted return might still be strategically important, but the institution must be aware of the higher capital charge it incurs. Ultimately, the goal is to optimize the overall portfolio of activities to achieve the highest possible aggregate economic risk-adjusted return while staying within acceptable risk limits.

Hypothetical Example

Consider a hypothetical bank, "Diversified Financial," with two distinct business units: Corporate Lending and Retail Banking. Diversified Financial uses economic risk-adjusted return to evaluate the performance of these units.

Corporate Lending Unit:

• Net Income After Expected Losses: $15 million
• Economic Capital Allocated: $100 million (due to higher concentration risk and potential for large credit defaults)

Retail Banking Unit:

• Net Income After Expected Losses: $12 million
• Economic Capital Allocated: $60 million (due to a highly diversified portfolio of smaller loans and deposits)

Now, let's calculate the Economic Risk-Adjusted Return (CRAROC) for each unit:

Corporate Lending CRAROC:
$CRAROC_{Corporate Lending} = \frac{\$15 \text{ million}}{\$100 \text{ million}} = 0.15 \text{ or } 15\%$

Retail Banking CRAROC:
$CRAROC_{Retail Banking} = \frac{\$12 \text{ million}}{\$60 \text{ million}} = 0.20 \text{ or } 20\%$

In this example, although the Corporate Lending unit generated a higher absolute net income after expected losses ($15 million vs. $12 million), the Retail Banking unit has a higher economic risk-adjusted return (20% vs. 15%). This indicates that the Retail Banking unit is more efficient in its use of economic capital. Diversified Financial would interpret this to mean that for every dollar of economic capital deployed, Retail Banking generates a higher risk-adjusted profit. This insight could lead to strategic decisions, such as allocating more economic capital to the Retail Banking unit or seeking ways to optimize the risk-return profile of the Corporate Lending unit.

Practical Applications

Economic risk-adjusted return is a fundamental metric with several practical applications within financial institutions, particularly in the realm of financial planning and strategic management:

• Capital Allocation: Financial institutions use economic risk-adjusted returns to allocate scarce economic capital across different business lines, products, or transactions. This ensures that capital is deployed to activities that offer the most attractive returns relative to the risks they introduce,³⁴.
• Performance Measurement: It serves as a key performance indicator for evaluating the true profitability of individual business units, portfolios, or even specific customer relationships. By adjusting for risk, management gains a clearer picture of which activities are genuinely value-accretive³³.
• Pricing Decisions: Economic risk-adjusted return analysis informs pricing strategies for loans, derivatives, and other financial products. A higher required economic capital for a particular transaction implies a higher risk, which should be reflected in a higher price or spread to achieve an adequate risk-adjusted return.
• Risk Appetite Frameworks: The target economic risk-adjusted return is often linked to an institution's overall risk appetite. This helps ensure that the risks undertaken align with the institution's capacity and willingness to bear risk.
• Strategic Planning: Management teams leverage economic risk-adjusted return to guide strategic decisions, such as expanding into new markets, divesting underperforming assets, or optimizing existing business models. For example, a study discussing risk-adjusted returns in emerging markets highlights how diversification across asset classes and factor-based approaches can enhance these returns³².

Limitations and Criticisms

While economic risk-adjusted return is a powerful tool for financial institutions, it is not without limitations and criticisms:

• Model Dependence and Assumptions: The calculation of economic capital, and thus economic risk-adjusted return, heavily relies on complex internal models. These models are based on various assumptions about risk measurement, correlation, and loss distributions. If these assumptions are flawed or the models are not robustly validated, the resulting economic capital figures and risk-adjusted returns may be inaccurate or misleading³¹,³⁰. For example, issues can arise from inadequate data quality for certain risk types or challenges in aligning measurement horizons across diverse risks²⁹.
• Difficulty in Risk Aggregation: Aggregating different types of risks (e.g., credit, market, operational) into a single economic capital figure is complex. Incorrectly modeling the correlation between these risks can lead to underestimation or overestimation of overall capital needs, impacting the accuracy of the economic risk-adjusted return²⁸.
• Validation Challenges: Validating economic capital models, especially their ability to forecast tail losses (extreme, rare events), remains a significant challenge due to limited historical data for such events. This can limit the usefulness of economic risk-adjusted return for aggregate capital calculations²⁷.
• Non-Standardization: Unlike regulatory capital, there is no universally agreed-upon standard for calculating economic capital. This lack of common definition can make it difficult to compare economic risk-adjusted returns across different institutions,²⁶.
• Backward-Looking Bias: While used for forward-looking decisions, economic risk-adjusted return calculations often rely on historical data, which may not accurately predict future risk and return profiles, especially in rapidly changing market conditions²⁵.
• Potential for Misinterpretation: As with any sophisticated metric, there is a risk of misinterpretation or misuse, potentially leading to suboptimal business decisions if the underlying methodology and its limitations are not fully understood²⁴. Some research suggests that economic capital models may have contributed to financial institutions having less capital than needed during severe stress conditions due to issues like correlation treatment and understating "tail" risk²³.

Economic Risk-Adjusted Return vs. Regulatory Capital

Economic risk-adjusted return and regulatory capital are both crucial concepts for financial institutions, particularly banks, but they serve distinct purposes and are calculated differently.

While distinct, there is an ongoing dialogue and increasing convergence between economic capital and regulatory capital, particularly with the evolution of Basel II and Basel III, which encourage banks to align their internal risk management practices with regulatory expectations⁴. However, economic capital remains primarily a business tool for internal risk management, whereas regulatory capital sets the mandatory minimums³,.

FAQs

What is the primary purpose of economic risk-adjusted return?

The primary purpose of economic risk-adjusted return is to help financial institutions, particularly banks, evaluate the profitability of a business activity or portfolio by considering the amount of economic capital required to support the risks associated with it. This metric aids in strategic capital allocation and performance assessment.

How does economic risk-adjusted return differ from simple return on equity?

Simple return on equity (ROE) measures net income as a percentage of shareholder equity without explicitly factoring in the specific risks undertaken to generate that income. Economic risk-adjusted return, conversely, directly incorporates the economic capital needed to absorb unexpected losses, providing a more granular and risk-sensitive view of performance for capital-intensive businesses.

What types of risks does economic capital typically cover?

Economic capital models typically cover a broad range of risks, including credit risk (e.g., loan defaults), market risk (e.g., fluctuations in asset prices), and operational risk (e.g., losses from inadequate internal processes or systems). Some frameworks may also include other risks such as business risk, strategic risk, or liquidity risk.²

Is economic risk-adjusted return a regulatory requirement?

No, economic risk-adjusted return, based on economic capital, is primarily an internal management tool for financial institutions. While regulators encourage robust internal risk management and capital adequacy assessments (as seen in Basel II's Pillar 2), the specific calculation and use of economic capital and its derived returns are determined by the individual institution.

Why is economic risk-adjusted return important for banks?

Economic risk-adjusted return is vital for banks because it enables them to make more informed decisions about capital deployment, product pricing, and business strategy. It helps ensure that the returns generated by different activities are commensurate with the economic risks assumed, fostering a more efficient and resilient allocation of capital across the enterprise.¹