Risk-adjusted performance measurement

SUITS THE C-SUITE By Christian G. Lauron and Belvin L. Armenion

Business World (03/09/2015 – p.S1/4)

IN TODAY’S business environment, we anticipate that the convergence of risk-finance measures will become the performance “norm.” In fact, risk-finance is fast becoming the new language of business, not just in terms of financial stability standards.

Traditionally, investors look at Return on Equity (ROE) as a measure of the profitability of their investments. Management also uses ROE and Return on Resources Deployed to evaluate the performance of business units. ROE is based on generally accepted accounting principles (GAAP) and continues to be an objective measure of historical performance.

Recently, however, companies have faced pressures (both internal and external) that influenced the way they do business. For example, banks now need to follow stringent regulatory standards on risk and capital management. There is a supervisory expectation for banks to involve business units in the budgeting and capital planning processes, and allocate to them the necessary capital to cover their risk-taking activities.

Accordingly, risk capital frameworks are embedded in the business decision-making processes of banks, and this has made the risk management function more prominent. Banks need to move beyond pure regulatory compliance and optimize the use of new tools required by regulations to manage risk and grow the businesses. While the finance function reports on the historical performance of business units, risk managers monitor and report future-oriented figures (e.g., expected loss) to senior management and the Board. They report whether the risk exposures of business units are within the risk appetite of the bank.

These developments have challenged the continuing relevance of traditional performance metrics which are not risk-based. For many institutions, risk and finance frameworks are not yet fully integrated into business operations and decision-making. They continue to measure the profitability of business units using traditional operating profit and ROE. Silo risk management reports are used more for information only, and are not used to drive business units to optimize their risk/return profile and adopt risk-based pricing.

Leading banks responded to these issues by adopting Risk-Adjusted Performance Measurement (RAPM) as the key profitability metric of each of the business units. RAPM progressed ROE to Risk-Adjusted Return on Capital (RAROC). But instead of using accounting net income and accounting capital, RAROC is computed as risk-adjusted income over risk capital. Risk-adjusted income is computed as accounting net income less expected losses, and after internal allocation for funds transfer pricing (FTP) credits/charges, revenue sharing and cost allocation. Risk capital is an amount required by banks to cover unexpected losses from market risk (losses from adverse movements in market prices or rates), credit risk (losses from the failure of counterparty to perform) and operational risk (losses from operational errors, fraud, technical failures, legal and natural hazards). Using internal assessment, risk capital is attributed to individual business units according to their risk profile.

RAPM is useful to companies in many ways. A well-designed RAPM dashboard shows integrated risk and finance views of business units. Its FTP mechanism reflects charges for liquidity and interest rate risks which are managed centrally outside the businesses. Expected losses cover anticipated losses from market, credit (aligned with Basel and IFRS requirements) and operational risks. Revenue sharing and cost allocation attribute common operating income and expenses, respectively, to appropriate business units. Unexpected losses are represented with risk capital. RAPM also shows RAROC and economic profit as relative and absolute returns in excess of cost of capital, respectively. RAROC and economic profit are different measures of performance using the same components. Together, they provide a sound understanding of business performance.

In addition, RAPM can be used to project future performance (budgets) and capital requirements. Strategic planners have used it to evaluate optimal capital and balance sheet structure, and allocate capital resources among business units. RAPM also provides tools for understanding and managing profitability at customer, product and portfolio levels. It recognizes both FTP and expected losses as part of the regular cost of doing business that should be factored in the pricing of products and services (i.e., risk-based pricing).

Further, RAPM satisfies the regulatory expectations on risk-based performance measurement and capital allocation. RAPM also improves external disclosures as it shows a truer economic picture of companies and helps address distortions inherent in GAAP-based results.

Most importantly, RAPM encourages behavior and a culture that is consistent with the organization’s financial objectives, and demonstrates rigor around value-driven financial management. With the appropriate reward mechanism, it drives and aligns the behavior of each business unit toward the creation of maximum value.

All these factors support the reality that RAPM has become a standard business need in today’s industry. It breaks down silos in businesses, finance, risk and strategy, and binds them together to optimize value for shareholders. Banks and non-bank financial institutions now face a very exciting opportunity to realize these tangible benefits as they fully adopt RAPM.

Christian G. Lauron is a Partner while Belvin L. Armenion is an Associate Director, respectively, of SGV & Co.