What is Risk Adjusted?

To keep it simple, I provide the text from two links to explain adjustment for risk:

  • (i)March 28, 2025: Outlining and Measuring the Benefits of Risk Sensitivity in Bank Capital Requirements https://www.federalreserve.gov/econres/notes/feds-notes/Outlining-and-measuring-the-benefits-of-risk-sensitivity-in-bank-capital-requirements-20250328.html

    Page-1: Benefits of risk sensitivity : “Risk sensitivity enhances the efficiency of capital requirements through two related arguments (1) risk-sensitive capital requirements allow regulators to achieve a given level of conservatism across banks at the lowest cost, and (2) for a set amount of aggregate capital in the banking system, risk-sensitive capital requirements provide better targeting of loss absorbency capacity.”

    • RAOP Author: The above paragraph is tweaked in the context of banking operations:
  • Risk adjusted operational performance measures allow managements to accomplish their:
  • targeted business growth and competitive position goals and
  • operational resilience objectives for a defined set of constraints.
  • (ii) Page 15 of 20 of Risk Management Manual of Examination Policies: Federal Deposit Insurance Corporation
    https://www.fdic.gov/risk-management-manual-examination-policies/capital-section-21.pdf

    • “Increased Earnings Retention Management may attempt to increase earnings retention through a combination of higher earnings or lower cash dividend rates. Earnings may be improved, for example, by tighter controls over certain expense outlays, repricing of loans, fees, or service charges, upgrading credit standards and administration to reduce loan or investment losses, or through various other adjustments.”

The author humbly submits that the five risk adjusted operational performance measures helps the bank management to improve sustainable business growth and profitability.
Examples of risk adjustment:
  • Credit Valuation Adjustment (CVA) An adjustment to the measurement of derivative assets to reflect the credit risk of the counterparty.
  • Debt Valuation Adjustment (DVA) An adjustment to the measurement of derivative liabilities to reflect the own credit risk of the entity.
  • Funding Valuation Adjustment (FVA) An adjustment to the measurement of derivatives to reflect an entity’s funding cost.
    • Risk-Weighted Assets

    https://www.osfi-bsif.gc.ca/en/about-osfi/osfi-knowledge-centre/risk-weighted-assets-rwas

    Quote
  • When banks lend money or invest, they take on risk. Some loans are safer than others—for example, a loan to an established business is usually less risky than a loan to a startup. To make sure banks are prepared for potential losses, regulators use a system called risk-weighted assets (RWAs).
  • RWAs help measure how risky a bank’s assets are. Instead of treating all loans and investments the same, RWAs assign different “weights” based on how likely the bank is to lose money on them. The riskier the asset, the higher the weight. RWAs are important because they help determine how much capital a bank needs to hold. Capital is the bank’s own money that acts as a cushion against losses. The more risk a bank takes on, the more capital it needs to keep.
  • This system helps protect depositors and the financial system. It ensures that banks don’t take on too much risk without having enough of their own money to cover potential losses. Unquote

    • Risk Adjusted Operational Performance is necessary for:
  • Managing Operational Resilience;
  • Operating Readiness – this is linked to Enterprise resilience i.e. liquidity and solvency risks;
  • Process and Enterprise Operating Model efficiency;
  • Process and Enterprise Operating Model effectiveness.
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