Risk adjusted performance management

The emergence of better risk-return and capital management techniques has been a big step forward for the banking industry. It is a positive signal that financial institutions are thinking more about the sorts of activities that they are willing to undertake. Institutions are also increasingly cognisant of the risks associated with various activities.
Accordingly, many institutions are beginning to allocate capital on a risk-adjusted basis instead of relying on simplistic measures such as the return on assets or the return on the book value of equity.
By improving the capital allocation process - even by simply realising the need for one in the first place - it is possible that the returns earned on that capital may improve.
Correspondingly, risk, return and capital management techniques are becoming increasingly complex with institutions and regulators, alike, facing an uphill battle in keeping pace with new developments. Despite this challenge, it is paramount that institutions fully understand the models in place and, most importantly, are able to use these in managing their business.
The industry is currently at an important turning point in the development of risk-return measurement and capital allocation models. This has to do with the fact that management behaviour, in recent times, has tended to be driven, to a much larger degree, by return on equity and the creation of shareholder value.
In turn, this has led to a much greater emphasis on capital management within financial institutions, as well as to the development of sophisticated profitability, risk and capital allocation models in an integrated performance measurement framework.
The focus of management in any organisation, including financial institutions, is the maximisation of the risk-adjusted returns that shareholders receive on their equity investments.
FACED WITH THIS OBJECTIVE, BANKS HAVE TWO CHOICES:
-- they can increase the amount of return per dollar of equity, or;
-- they can decrease the amount of equity required per dollar of target return.
Essentially, the target return is driven by market expectations; exceeding the market's expectations will result in an increase in shareholder value, whereas failing to meet those expectations will result in a destruction of value.
Although not 'rocket science', until recently this focus on return was surprisingly absent from the Boardrooms of most banks. Instead, many institutions chose to focus on asset growth. Before the Asian Crisis of 1997, for example, the primary focus of many banks was on increasing the size of the institution, as measured by the volume of assets on the balance sheet.
Correspondingly, the typical goal assigned to a loan officer was to increase the bank's market share (ie asset growth) and to increase interest earnings (ie profit growth).
CAPITAL ALLOCATION FOR PERFORMANCE MANAGEMENT: At the simplest level, the role of capital in any company, be it a deposit-taking institution or a corporation, is to provide creditor protection. This requires that the company's assets exceed its liabilities such that the company is solvent.
For a bank, the role of capital is to act as a buffer against future, unidentified losses, thereby protecting depositors. Hence, the amount of capital held must cover both 'normal' or expected losses, as well as unexpected or improbable losses, whilst leaving the institution able to operate at the same level of capacity.
While this simple rule is well established, determining the amount of capital to set aside is complex. With the introduction of Basel II accord it will become even more complex but provide substantial benefits as the accord deliberately builds in rewards for stronger and more accurate risk measurement.
In short, there is no magic formula to determining the appropriate amount of capital that a financial institution should hold. Whatever capital level is chosen, against it must be set a target return. The higher the amount of capital maintained, the larger the profit that must be generated in order for the target return to be met.
In a dynamic capital allocation process the allocation of capital and the measurement of performance are necessarily inter-twined. This requires that a direct link be established between return on capital measures and the performance-related remuneration of individuals within the institution.
Hence, at the heart of all performance measurement frameworks, regardless of their complexity, is a comparison of returns (such as profit or revenue) against some measure of capital. Traditionally, these capital measures have not been adjusted for risk.
In fact, until quite recently when comparing the performance of two business areas, banks would divide the return earned by each activity by the dollar amount of physical capital invested. Of course, comparing performance on the basis of return alone is like comparing apples with oranges in that it ignores the all too important influence of risk.
RISK ADJUSTED PERFORMANCE MANAGEMENT: Clearly, high returns may simply result from investing in risky assets. If individuals are to be remunerated on the basis of performance (ie on the basis of wise investment decisions), the return that is generated per unit of risk assumed should form the basis of the performance assessment, rather than return alone.
It is important to give sufficient regard to the term 'risk adjusted performance management', or RAPM, has become a widely used buzzword in the banking industry of late.
Although there are many different methodology, all RAPM techniques share the same underlying idea: return is compared against allocated capital by adopting some form of risk adjustment based on the institution's assessment of exposure in the business that is undertaken.
IN BROAD TERMS, THIS DESCRIPTION GIVES RISE TO THREE QUESTIONS:
-- how to measure the returns?
-- what measure of risk should this adjustment be based on?
-- how should the risk adjustment be made?
Two of the most widespread risk-adjusted performance techniques are return on risk-adjusted capital (RORAC) and risk-adjusted return on capital (RAROC). As would be expected given their similar names, the two techniques differ only slightly: although both use return on capital as a base, the RAROC measure adjusts the numerator (return) for risk, while the RORAC measure adjusts the denominator (capital).
A GENERIC RAPM FRAMEWORK WOULD TAKE THE FORM: Expected losses typically cover expected credit losses that cannot be regarded as 'risk'. Note that expected losses are subtracted from revenues. Commonly this step is forgotten; expected defaults are confused with the real risks involved in the credit business (not adjusting for expected losses is like an insurance company taking in premiums and hoping that nobody ever makes a claim).
The incidence of defaults is part of the business of credit, and the cost of those defaults is a routine cost of doing business. The term in the denominator, the amount at risk, is usually defined as the capital necessary to cushion against unexpected credit losses, operating risks and market risks, and is often called risk capital or what was earlier referred to as economic capital.
Regardless of the degree of sophistication of the performance management technique used, the sensible allocation of capital must be superior to an approach that leaves this to chance.
Even using the simple risk weights of the regulatory framework as a base will produce superior returns to a strategy based on pure balance sheet amounts, as some measure of risk is incorporated into the assessment - some adjustment for risk is better than no adjustment.
DO YOU HAVE THE REQUISITE CAPABILITIES? Before Risk Adjusted Performance Management framework can be implemented, financial institutions need to resolve a number of significant issues.
THESE PRIMARILY RELATE TO:
-- data issues such as availability, quality and consolidation;
-- models for measuring profitability, risk and capital allocations.
Today data about the customer and the customers business with the financial institution is fragmented in many core-banking systems. The quality of the data is suspect, as many of the fields are not used in the day-to-day customer sales/service activities.
The problem has not been helped by the fact that even within individual institutions, much useful historical data has simply not been captured or stored. Many institutions have not begun warehousing the requisite data in a repository that is designed to support the RAPM framework.
The data issues are closely interlink to the models for RAPM that includes Interest Income/Expense Allocations, Cost of Funds Calculations, Cost Allocations, Expected Loss Allocation and Capital Charge Calculations.
THE FUTURE ....Looking to the future, once a performance management framework has been agreed, the focus of the institutions can quickly shift to the capture of the appropriate data and implementation of the appropriate models to measure and manage all the different part of the business.
This ability to 'slice and dice' cost and revenue by organisation unit, branch, product and customer; and then allocate capital on a risk-adjusted basis to business that add value. This we believe is a key responsibility of every senior executive in your institution.
Indeed, many financial institutions are already doing this today with a comprehensive suite of data model to capture the detail data, applications software and the technology from Oracle Corporation.
(The writer is Senior Director - Financial Services Industry, Oracle Corporation Asia Pacific Division)