Cost of Risk
Cost of Risk · Provisions · Coverage Ratio · Credit Cycle
The annual cost a bank creates as a provision for non-performing loans — a key indicator of portfolio quality and the phase of the credit cycle.
What it is
Cost of Risk (CoR): New provisions for a given period / Average loan portfolio × 100 bps (basis points).
Example: a bank creates €500M in provisions on a €100 billion portfolio → CoR = 50 bps.
Typical ranges:
- →Below 30 bps: exceptionally low cost of risk (peak of cycle or conservative portfolio)
- →30–70 bps: normal operating environment
- →70–150 bps: elevated risk / recession
- →Above 150 bps: crisis situation
Provisions: An accounting charge the bank reserves in advance for expected loan losses. Reduces net income but not cash. IFRS 9 requires provisions based on expected losses (Expected Credit Loss model).
Coverage Ratio: Provisions / NPL × 100%. Shows how well non-performing loans are covered by reserves.
- →Below 60%: risky — bank is under-provisioning potential losses
- →60–100%: standard
- →Above 100%: conservative — bank is reserving more than current NPLs
Why track it
Cost of risk is a direct "translation" of loan portfolio quality into earnings and ROE. A change in CoR of 10 bps can change net income by 5–15% depending on the size of the loan portfolio relative to revenues.
Credit cycle: CoR is typically lowest in expansion (banks underestimate risks) and highest in recession (NPLs jump sharply). Normalized CoR (cycle average) is the correct input for valuation — not the current value at the peak of the cycle.
Monitor:
- →CoR trend over 3–5 years (falling or rising?)
- →Comparison with peers (is the bank more conservative or aggressive?)
- →Coverage ratio trend — declining coverage signals deteriorating asset quality
Real-world example
Stress scenario — mild recession: Bank with a €80 billion portfolio and current CoR of 40 bps:
- →Normal year: provisions = €320M → impact on net income −€320M
- →Recession (CoR 120 bps): provisions = €960M → impact −€960M → ROE falls by ~4–6%
If the bank enters recession with a high coverage ratio (>90%), excess reserves may be released back (reserve releases) in recovery → a temporary earnings boost.
Watch out for
IFRS 9 introduced procyclical swings — banks build provisions upfront based on forecasts, not just current NPLs. This rattles the market even when actual losses have not materialized. Monitor the separation of "model-driven provisions" from actually written-off receivables.
Low CoR during a boom does not necessarily indicate a strong business — it may indicate under-provisioning of risk. Compare the bank's CoR with its historical cycle average, not just the current value.