For an efficient business strategy and to improve performance, many financial institutions such as banks use bank performance metrics. These metrics help measure the profitability of business units, manage the risks involved in allocating capital, and evaluate the performance of each business unit.
The increasing prevalence of technology and the complexity of the market drive many institutions to improve their performance. In a world full of competition, survival is a goal for many companies, both new and progressive, while those at the top also aspire to sustain their glory.
Success in a competitive environment has thus become a challenge among companies. Possibly to achieve this, companies, such as banks, must measure their performance in order to find solutions once the result of the measurement seems unfavorable. Bank performance metrics can be used to help managers make complex decisions.
Among the performance metrics used by many banks and other companies to generate financial information for decision making and evaluation are economic value added and risk-adjusted return on capital, or RAROC.
Economic value added, known simply by its acronym, is an estimate of an entity’s actual economic profit after making corrective adjustments to generally accepted accounting principles or GAAP accounting, including deduction of opportunity cost of equity capital. According to estimates, the use of GAAP in companies ignores a certain value in opportunity costs to shareholders.
A company’s EVA can be measured by deducting the monetary cost of capital from Net Operating Income After Tax. The money cost of capital in EVA refers to the amount of money rather than the proportional rate cost of capital.
Stern Stewart & Co. develops its trademark, Economic Value Added performance metrics.
Meanwhile, the RAROC, or risk-adjusted return on capital, is used to analyze a company’s risk-adjusted financial performance and to provide insight into profitability. It is a risk-based framework for measuring profitability.
A ratio of risk-adjusted return to economic capital, RAROC, is used to determine a company’s economic profit. This system is used to allocate capital for risk management and performance evaluation.
Banks and other financial institutions use the risk-adjusted return on capital. As a risk management tool, RAROC is used to determine the bank’s optimal capital structure by allocating capital to individual business units.
Additionally, RAROC is used as a bank performance metric to allow banks to allocate capital to companies and business units, as determined by each unit’s economic value added, or EVA. Risk-driven capital utilization improves banks’ capital allocation. Capital that is put at risk is expected to provide a return in excess of risk-free.
EVA and RAROC are among the bank performance metrics used by banking business units to determine profitability in the economic sense. Economic value added is used in corporate finance to determine the value that is created beyond the required return. On the other hand, the risk-adjusted return on capital is determined for capital allocation for risk management and performance evaluation purposes.