1.0 Executive Summary

The main purpose of this report is to create a risk assessment and management recommendations to the Royal Bank of Canada. The report comprises seven risk analyses of this bank, which are respectively strategic risk, credit risk, market risk, credit portfolio risk, interest risk, foreign exchange risk, and liquidity risk.

In order to better analyze the risk, this report will use a large number of data to analyze the risk. The main source of data is the annual report and BankFocus. The report found that the bank faces low credit risk and liquidity risk. However, it also faces high market risk, interest risk, and foreign exchange risk. In order to better manage the risk, it is suggested that the bank should make adjust the structure of assets and liabilities and make some hedging to manage the financial positions.

2.0 Strategic risk

Strategic risk is defined as the possibility of losses resulted from the decision mistake for the company’s business (Packwood 2006). For RBC, the strategic risk can be the mistake of strategic decisions to loans and investment. This risk is easier to occur in the head management, and it may lead to huge losses or suffer the bankruptcy risk for the bank (Njanike 2009).

RBC has established a strategic risk management Group to manage the risk. The Group consists of individual heads of each business segment, operating committees, Group executives, and the Board (2018 annual report). These members need to carefully check each strategic business choice and assess the potential risk for these choices. Therefore, the planning and monitoring mechanism of managing the strategic risk is beneficial to reduce the mistake of business choices.

According to the annual report of RBC, one of the most important business strategies in 2018 is to accelerate its development in the second home market U.S. According to the annual report of this bank, total loans in the U.S in 2018 was C$ 578,261 million, which has increased 17.87% compared to 2017. The increased margin is larger than Canada and Europe’s market.

It is forecast that the business strategy is beneficial to an increase of total revenue for this bank because the revenue from the U.S market accounted for nearly a quarter of the bank’s total revenue. Based on the analysis, RBC faces low strategic risk. However, the deterioration of foreign trade for the U.S due to the trade war will produce a negative impact on the development of the U.S market, which may increase the default risk of borrowers in this market. From this point, the strategic risk is high. On the whole, the strategic risk for RBC is neutral.

3.0 Interest risk

Interest risk is defined as the possibility of losses due to the change of interest rate in the market that will affect its operating costs and benefits through deposits and loans (Wu & Olson 2010). The interest rate on deposits represents the operating cost and the interest rate on loans represents the return of the bank (Wu & Olson 2010). The mismatch of the two in quality, duration, and manner leads to the interest risk.

Interest margin can be used to measure the interest risk, which is the ratio that a bank’s net interest income to its total interest-bearing assets (Koehn, & Santomero 2015). The movement of net interest income is sensitive to the interest rate on deposits and interest rate on loans (Koehn, & Santomero 2015). Figure 1 shows that net interest margin reached the largest value in 2013 and presented a declining trend since the year. In 2018, the net interest margin was 1.53 percent and declined 0.16 percent compared to 2013. This movement is related to the change of interest rate on deposits and loans.

According to figure 2, the interest rate on loans declined 0.075 percent in 2017 than 2015 while the interest rate on deposits increased 0.025 percent compared to 2015. The decline of interest rate on loans will reduce the interest revenue from loans while the increase of interest rate on deposits will increase the interest cost that should be paid to depositors. Then, the net interest margin will be reduced. According to Yahoo Finance (2018), the interest rate on deposits will be forecast to increase in the recent two years. Therefore, RBC faces an increasing interest risk.

Figure 1: Net interest margin (%)

Source: 2018 Annual report for RBC

Figure 2: Interest rate change

Source: WorldBank 2018

4.0 Market risk

Market risk refers to the losses resulted from the market price’s change upon the assets, liabilities, and revenues (Silver 2012). The main market factors include the fluctuation of interest rate, exchange rate and commodities price, and so on (Silver 2012). Value-at-Risk (VaR) can be used to measure the potential losses for a financial portfolio at a given level of confidence and over a defined holding period (Silver 2012).

The larger the market risk VaR, the higher the bank’s market risk will be (Silver 2012). According to figure 3, the market risk VaR is $ 39 million, which increased by $ 21 million than prior. The average market risk VaR is $ 25 million, which increased by $ 4 million in 2017. So, the bank’s market risk increased in 2018, which was mainly driven by the huge volatility of the equity derivative market.

Figure 3: Market Risk VaR

Source: 2018 Annual report for RBC

Market risk Stressed VaR is also used to measure the market risk for the bank, which uses a fixed historical one-year period of extreme volatility (Cornett & Saunders 2017). Figure 3 shows that the average market risk Stressed VaR is $ 79 million in 2018, which increases $ 26 million in 2017.

Both two metrics indicate that the market risk has increased in the recent two years. However, the two metrics are based on historical data to compute the market risk. If the market changes significantly in the future, the two metrics will not be appropriate to predict future losses. Assuming that the future market situation will not move significantly, the current market risk of the bank presents an increasing trend.

In addition, it can be found that foreign trade has deteriorated continuously in recent two years due to the intense international relations. Canada reported that in the first half of the year 2019, its trade totaled about $450.37 billion, down 1.6 percent from a prior year. The deterioration of Canada’s international trade will unavoidably affect the relevant companies’ operating activities and revenues, which will further affect the reimbursement ability of loans. Therefore, Canada’s foreign trade situation also increases the market risk for RBC.

5.0 Credit risk

Credit risk refers to the possibility of losses that is due to the borrowers’ default for various reasons (Adler & Dumas 2014). There are many factors that may lead to the market risk such as the fluctuation of interest rate, exchange rate, and the impact of the macroeconomic environment (Giovannini & Jorion 2015).

When the economy is experiencing a quick expansion, this risk will be lower because it is possible for enterprises to obtain more profits to return the loans (Wetmore & Brick 2016). For banks, the changing trend of impaired loans can reflect the degree of credit risk (Wetmore & Brick 2016). According to the BankFocus (2019), the impaired loans was 2,183,000 CAD in October of

2018, which has decreased 393,000 CAD compared to the same period of 2017. In terms of the rate of impaired loans to the gross loans, it presented the highest value in 2016 and has a decreasing trend since 2016 (see figure 4). This indicates that the credit risk of this bank has declined in recent years.

Figure 4: Impaired loans / Cross loans between 2011 and 2018.

Compared to other commercial banks such as TD, BNS, BMO, and CIBC (see figure 5), it can be found that the impaired loans’ rate is lower for RBC compared to TD and BNS while higher than BMO and CIBC. Therefore, RBC faces higher credit risk compared to BMO and CIBC.

Figure 5: Comparison between different banks for credit risk

According to the international standard, the alarm line of the rate of impaired loans to gross loans is 10% for financial institutions. It is obvious that this rate for all banks is far lower than 10%. Based on the analysis, the Royal Bank of Canada’s credit risk is low.

6.0 Credit portfolio risk

The credit risk of a loan portfolio is defined as the risk that is related to the loan concentration (Wetmore & Brick 2016). It is thought that banks should reduce the concentration degree of loans in certain industries to control the credit risk (Wetmore & Brick 2016). Credit portfolio risk can be used to set maximum loan concentration limits for certain business or borrowing sectors (Wetmore & Brick 2016).

According to the annual report of RBC in 2018, the loans and acceptance contain the retail and wholesale, in which the loans and acceptance in the retail industry accounted for 67% and that of wholesale accounted for 33%. The total exposure is 595392 m Canadian dollars. The residential mortgage is 282471 m Canadian dollars, accounting for 47% of the total exposure of loans and acceptance. The industry’s range includes real estate, consumer goods, services, energy, and so on.

The involved industry range is very wide, which is beneficial to reduce the concentration risk (Dooley & Isard 2017). The largest loans occur in real estate, which accounted for 8.6% of the total loans’ exposure. This ratio is appropriate and can reduce the risk of a real estate bubble.

In addition, the bank also puts its loans by geography’s allocation such as Canada, U.S., Europe, and other international countries, which also can help reduce the total credit risk by the geographical portfolio. Therefore, the credit portfolio risk is relatively low for this bank.

7.0 Liquidity risk

Liquidity risk refers to the risk that a bank cannot timely pay debts when due and meet normal business operations (Dooley & Isard 2017). This risk can be classified into three types, which are respectively macro liquidity oppression, customer liquidity transmission, and accumulation of bad management (Dooley & Isard 2017).

For commercial banks, the liquidity risk is caused by excessive misalignment of the maturity of assets and liabilities or excessive losses caused by credit risk, market risk, and exchange rate risk (Dooley & Isard 2017).

The ratio of loans to deposits can be used to measure the liquidity risk of a bank (Jorion 2015). Figure 6 shows that the ratio of Net loans to Deposits presents a declining trend since 2014. In 2018, the ratio of loans to dep. & ST Funding was 64.73% and the ratio of net loans to total deposits is 50.12%, which is lower than the required standard of 75% in the Basel Agreement. From this point, the liquidity risk is low and presents a declining trend for RBC.

Figure 6: Loans / Deposits ratio

Source: 2018 annual report of RBC

Compared to another similar scale of banks, figure 7 shows that RBC owns the lowest ratio of loans to deposits compared to TD, BNS, BMO, and CIBC. In addition, the ratio of liquid assets to total deposits for RBC is the highest compared to other banks, which indicates that RBC owns the strongest liquidity. Based on the liquidity trend analysis and comparative analysis with other banks, RBC’s liquidity risk is low and presents a declining trend.

Figure 7: liquidity ratio comparison

Source: 2018 annual report

8.0 Foreign exchange risk

Foreign exchange risk is defined as the losses that an international financial transaction may incur due to currency fluctuations (Jorion 2015). It describes the possibility that an investment’s value may decrease due to changes in the relative value of the involved currencies (Jorion 2015). RBC has allocated its business in many countries, so its total revenue will be affected by the foreign exchange rate (Jorion 2015).

According to figure 8, the exchange rate for CAD to USD has increased in 2018 and the exchange rate for CAD to British pound declined compared to 2017. The whole impact of the exchange rate change is that the total revenue and total assets will be changed.

According to figure 9, the impact of the average exchange rates change is that the total revenue decreases C$53 million, which is lower than the decrease of C$ 360 million in 2017. In addition, the impact on EPS due to the change of exchange rate is that the EPS decreases.

This indicates that the volatility of the exchange rate has caused a negative impact on the bank’s income and EPS. However, the negative impact presents a declining trend because the losses of revenue and EPS due to the volatility of the exchange rate have decreased in 2018 compared to 2017. This indicates that the RBC faces a huge exchange risk while this risk is presenting a declining trend.

Figure 8: The exchange rate’s change from 2016 to 2018

Source: 2018 Annual report for RBC

Figure 9: The impact of exchange rate on the revenue

Source: 2018 Annual report for RBC

9.0 Conclusions and Recommendation

In conclusion, RBC faces low credit risk, credit portfolio risk, and liquidity risk compared to other banks and these risk also presents a declining trend. However, the interest risk, market risk, and foreign exchange risk are relatively high. For the increasing interest risk and market risk, it is recommended that RBC should make some series of risk management measures.

In terms of interest rate risk, RBC can use on-balance sheet business to control interest risk by changing the size of the balance sheet gap position or adjusting its maturity length. Specifically, RBC can change the investment portfolio and adjust the loan portfolio, using brokerage deposits and borrowing funds to manage the interest risk. In addition, it is also recommended that RBC should use the off-balance sheet business to control interest rate risk, mainly using financial derivatives.

The purpose is to produce an increment contrary to the change in the net value of the items in the balance sheet when the interest rate changes, so as to hedge the bank’s interest rate risk position. Off-balance-sheet instruments include forward contracts, futures contracts, interest rate swaps, and options contracts. In terms of the foreign exchange rate risk, it is suggested to control the risk through managing the foreign exchange exposure.

The net exposure position is close to zero through the mutual allocation of foreign exchange assets and liabilities or foreign exchange transactions. The second is to use financial derivatives for hedging. For the strategic risk, it is recommended that RBC should further strengthen its responsibility for managing the business risk. For any strategic decisions, RBC should have a plan and goals both in the short term and long term.

After making the choice, managers should continuously monitor the effectiveness of strategic decisions and make some corrections and adjustments to the business activities. In terms of liquidity risk and credit risk, it is recommended that the bank should maintain its current assets and liability structure and enhance the pre-loan investigation and post-loan inspection to control the credit risk.