Cost of risk
Sector Deep DivesA bank's loan impairment charge expressed in basis points of average gross loans, the standard unit for comparing credit costs across lenders.
Also written: cost of risk ratio, credit cost ratio
Cost of risk is the income statement impairment charge divided by average gross customer loans, quoted in basis points. Converting a euro charge into a rate is what makes a large bank and a small one comparable, and what allows the current charge to be read against the bank's own long run average.
Reading it against that average is most of the analysis. A cost of risk far below a bank's through the cycle level is not evidence of better underwriting, it is evidence of a benign point in the cycle, and it will normalise. The same logic applies in reverse during a downturn, when a charge far above the long run level is not proof that the franchise is broken.
It also has to be read against the margin. A wide net interest margin is partly compensation for taking credit risk, so a lender earning a high margin on unsecured consumer credit and one earning a thin margin on prime mortgages are not comparable until the credit charge is netted off. Net interest margin after cost of risk is the comparison that means something.
Under an expected loss standard the charge is a forecast, so cost of risk moves when the macroeconomic scenario changes even if no borrower has missed a payment. That is a property of the accounting standard rather than a signal about the loan book, and confusing the two is the error the metric most often produces.
Worked example
Illustrative: a bank charges 90 of impairments against average gross loans of 30,000, so cost of risk is 30 basis points.
Its own long run average is 45 basis points, which on the same book would be a charge of 135. Reported profit therefore contains roughly 45 of cyclical benefit before tax.
An analyst capitalising those earnings in a multiple is capitalising a favourable point in the cycle. Normalising the charge toward the long run level is the standard correction.