RISK-REWARD VS. RISK — A Key Distinction

By Kamal Mustafa, Founder & Chairman

A bank may satisfy a regulatory requirement for an interest rate stress test, yet end up in a situation that’s detrimental to the bank’s long-term viability, cautions Invictus Chairman Kamal Mustafa.

Regulatory interest rate stress tests are designed to measure the risk profile of a bank under a severely adverse scenario. Those tests are an important part of the regulatory mission.

But what is even more important for a bank is the risk-reward profile of its assets and liabilities under changing interest rate conditions, Mustafa argues.  The focus should be on a likely interest rate change, and not necessarily the most extreme circumstances that regulators request.

“Management needs to look at the total picture. That’s their long-term job,” Mustafa says. “Regulators want to see discrete pieces under extremely adverse conditions. That’s a totally different scenario. By doing an interest rate stress test, a bank can meet its regulatory requirements, but have a group of assets and liabilities that are so mismatched that they are not maximizing the bank’s potential.”

Smart banks need to make sure they have the right profile to not only meet regulatory requirements, but also to position the bank for success.  “You can’t confuse a regulatory interest rate stress test as a proxy for a risk-reward analysis,” Mustafa cautions. “A lot of banks are doing that. They are not looking at the right combinations that would still allow them to pass regulatory scrutiny.  That is a highly theoretical exercise and not a replacement for a risk-reward strategy.”