Importance of Risk Capital to Bank of America
Bank of America maintains a portion of its capital as a buffer to cover for potential losses that are likely to arise from risky investments that are undertaken by the company. The amount of risk capital that the bank maintains is defined by the capital adequacy policies within the bank and the financial sector within the industry. As a corporate organization, Bank of America strives to deliver for its shareholders and improve their overall value in the company (Bank of America Corporation, 2016). They achieve this not only through the reliance on its operating income, but also investment income that it earns from its investments in other sectors. Therefore, it undertakes risky investments in expectation of higher return that improves the shareholders' wealth.
Risk capital is necessary to the Bank of America, as it assists the bank to reduce the impact that the losses from risky investment might have on their operations. The capital covers the possible losses that are likely to arise either from within the firm or from the external sources. Hence, risk capital is useful to the bank in managing the risks that it faces from its investors. Secondly, capital risks assist the bank to invest in the speculative activities, which are likely to increase the returns or lower to a considerably less than the original capital. It is, therefore, essential in providing funds for market speculation with an aim of improving the expected returns on investments by the bank (Opdyke & Cavallo, 2012).
Relationship between the Risk Capital and Bank of America’s Ability to Remain Solvent
Bank of America's solvency is defined by its capability to honor its long-term financial commitments. The stability level of the bank is determined by the relationship between its earnings and obligations over time. As earlier noted, risk capital provides a buffer capital for the company to cover for the uncertainties. Therefore, based on this argument, risk capital is maintained by the Bank of America to cover for its possibility of failing to meet the financial obligations during its operations. The capital is related to the bank's ability to remain solvent in the sense that if the bank becomes unable to pay its debts, it can use it to clear such obligations; thereby, maintaining its solvency in the market (Gallati, 2015). For instance, in the fiscal year ended 2015, Bank of America had a relatively solvency position as given by the high liabilities compared to the income. It implies that it would become insolvent due to its inability to repay these liabilities. Therefore, through the risk capital, it can repay the obligations and maintain its solvency.
Steps Were Taken By the Bank of America to Ensure It Remains Solvent
There are several steps that the bank takes to ensure that it remains solvent throughout its operations. First, it makes sure that it conducts continuous assessments as a risk management practices to limit its risk exposure. A high-risk exposure lowers the solvency position of the bank. An example is a Risk and Control Self Assessments (RCSAs) processes that the bank carries out to maintain its stability (Bank of America Corporation, 2016). The bank has also developed a stable risk management culture that ensures it remains stable through limited risk exposure and at the same time earn high returns from its investments.
Secondly, the bank adopts a sound capital management process through its program, Internal Capita; Adequacy Assessment Process (ICAAP). The program allows the bank to project its capital needs and resources that it will need for its operations (Bank of America Corporation, 2016). Thirdly, the Bank of America conducts stress tests as a way of assessing the possible impacts that its investment strategies have on their profits. Finally, as a regulatory requirement by the Federal Reserve, the bank prepares capital plans and makes requests to the Fed for capital actions. The steps enable the bank to ensure that it has adequate funds to meet its obligations. Hence, avoiding being insolvent (Bank of America Corporation, 2016).
Some of the possible steps that the bank can take to remain solvent are to restructure its capital structure. This means that it should reduce the level of debts in its capital structure since these debts lower its solvency position. Bank of America could also increase its investments as a way of increasing its asset base. An increase in the asset base for the company makes it have the necessary capital resources that it can use to meet the short-term financial obligations and remain solvent (Borio & Zhu, 2012). The bank can also set up policies that guide its capital requirements. This way, it can control the possible losses that might result in high insolvency.
How Bank of America uses RAROC
The risk of Adjusted Return on Economic Capital (RAROC) is employed by the Bank of America to determine its returns that have been adjusted to the possible risks and the funds that it requires ; hence, ensuring that it survives harsh investment outcomes. The ratio assists the bank to evaluate the potential returns and the associated risks, which are likely to influence the stability and lower its solvency. Furthermore, Bank of America uses RAROC to allocate capital across its functional operations. Through the capital allocation, the company can evaluate the risks and relates it to the performance; thus, lowering the possibility of losses due investment risks. Finally, the bank uses RAROC in establishing its optimal capital structure. It assists the company to determine the proportion of debt to equity capital that it should maintain its capital structure to achieve its optimality (Gallati, 2015).
Bank of America Corporation. (2016). Bank of America | Investor Relations | Annual Reports & Proxy Statements.
Borio, C., & Zhu, H. (2012). Capital regulation, risk-taking, and monetary policy: a missing link in the transmission mechanism? Journal of Financial Stability, 8(4), 236-251
Gallati, R. (2015). Risk Management & Capital Adequacy.
Opdyke, J. D., & Cavallo, A. (2012). Estimating operational risk capital: the challenges of truncation, the hazards of MLE, and the promise of robust statistics. The Journal of Operational Risk, Forthcoming