Risk Adjusted Return on Capital (RAROC): The One True Metric

Executives and board members have long searched for the "North Star" of financial services, the one performance metric that summarizes corporate success. In the earliest days these seekers fixated on asset or deposit size. Later, realizing that size does not reflect performance, they turned to Return on Assets (ROA) since both income and size are incorporated in this measurement. Today some FSO leaders remain fixated on ROA, convinced that their search has reached the ultimate destination.

Hearing the siren's call from Wall Street where shareholder interests are paramount, others continued the search. These leaders focused on Return on Equity (ROE) because it concentrates on income relative to the size of shareholder investment (represented primarily by paid-in capital and retained earnings) in the FSO, blending performance with Wall Street's belief that the investor is the only constituency of relevance. A recent study of the largest 1000 companies further strengthened the case for ROE by reporting a 40% positive correlation between the five year average annual total market return (stock price appreciation plus paid dividends) and ROE (Footnote 1). This study also indicated that the average annual total market return for the ten companies with the lowest ROE was 5.6% while that for the ten companies with the highest ROE was 35.8%. Consequently, we should not be surprised that none other than Warren Buffet, the legendary and extraordinarily successful investor, is a consistent proponent of ROE. But, should we be satisfied with ROE?

Wall Street readily argues that the "winner" is the company with the highest ROE. Much like a scoreboard at the conclusion of a football game, ROE quickly shows who won. Return on Equity measures performance by earnings generated relative to the shareholder investment in the FSO. Working much like the yield on a Certificate of Deposit, ROE communicates a return on the investment dollar. The relevance of this return is further strengthened since it is stated as a percentage, allowing comparisons between organizations and shareholder investments of varying sizes. Thus, it is that ROE has become the "North Star" performance metric for many FSO.

ROE, however, considers only half of the critical strategic equation. While ROE captures relative return, risk is completely opaque. ROE is tantamount to asking an investor whether they prefer an annual return of 10% or 5%. Both the measurement and the question are woefully incomplete.

THE CASE FOR RAROC

Every first year finance student learns that over the long-term risk and return are correlated. FSO executives know that tolerance for risk is a key determinant of return. Despite this knowledge, many remain blissfully content with ROE as the key performance metric even though risk is completely ignored in the equation.

Risk-Adjusted Return on Capital (RAROC) must now properly ascend to its central role as the "North Star" metric. Like ROE, it focuses on both the shareholder investment in the FSO and income performance. It quickly differentiates winners from losers. Like ROE it is relative to organizational size. RAROC, however, has the added benefit of communicating return based upon the specific level of risk assumed. RAROC offers greater strategic insight at the organizational, business unit, product, and customer segment levels since it encompasses both the assumption of risk and all elements of return. Indeed, RAROC analysis should be a fundamental consideration for informed product pricing decisions. In short, RAROC is the single most complete and strategically sound performance measurement.

RAROC is calculated as: net income divided by risk-adjusted capital. RAROC can be presented for a total company, business unit, product or customer segment. Risk-adjusted capital (economic capital) is determined based upon an artful evaluation and quantification of each assumed risk. Capital is assigned based upon well-developed judgmental methodologies.

THE EVOLVING ART OF CAPITAL ASSIGNMENT

Capital assignment considers the level of risk assumed, explicitly recognizing that different businesses have different levels of risk. FSO manage several types of financial risk: interest rate, liquidity, credit, and operating. Business units within a FSO have varied levels and mixes of these risks. The risk profile of a credit card division differs significantly from that of a residential mortgage department. It is the same with customer segments too. Entrepreneurs within the commercial customer base have a risk profile that is much different than that of retirees in the retail customer base.

Before discussing the assignment methodologies for capital, it is important to differentiate risk from loss. Loss incorporates both actual writeoffs and charges to income that have been realized as well as expense to establish reserves for estimable probable future charges. FSO leaders readily understand this loss concept as it relates to loans. Risk is the potential variability of expected return or earnings due to future loss in excess of established reserves. An organization's capital is the cushion to absorb risk.

Capital assignment is a judgmental art that continues to evolve. While regulations define organizational capital requirement minimums and general guidelines, FSO executives should look beyond the regulators to determine necessary capital at the business unit, product, and customer segment levels.

Senior management, with or without the aid of industry consultants, most often possesses the knowledge of risks in general as well as company specific risk tolerances and loss history to adequately assign capital. Given recent Sarbanes-Oxley legislation, it is suggested that executives include boards of directors in this capital assignment dialogue. The subjective assignments should be specific to each group's risk assumption, but also relative such that each group's assignment is appropriately ranked when compared to one another.

PRACTICAL CAPITAL ASSIGNMENT GUIDANCE

The start of the assignment process is to study the loss history of the business units or segments. Loss history should be studied over several business cycles, but certainly for no less than a five-year period. When such loss history is quantified, it may be adequate to assign capital at two to three times the standard deviation of average historic loss provided that the FSO's strategy and risk tolerances have not changed significantly. This methodology often is used for credit risk.

For interest rate risk the historical loss methodology must be slightly modified. Regulations require FSO to "stress test" balance sheets using simulations of varied rate scenarios. Immediate parallel rate curve shocks of plus and minus 200 basis points must be generated and evaluated. The simulated impact of such curve shifts may be used to assign capital for interest rate risk. It is conceptually sound to assign capital sufficient to absorb the estimated economic loss from an immediate 200 basis point curve shift.

Assigning capital for liquidity and operational risks is inherently less conducive to such historic loss quantification methods. Liquidity risk can be studied as part of the interest rate risk simulation process. While repricing opportunities as opposed to strict cash flow and term analysis drive interest rate risk simulation, FSO leaders know that interest rate movements affect cash flow based upon changes in prepayments and option exercises by customers as well as bond issuers. Changes in cash flow precipitated by interest rate movements provide a quantifiable insight into liquidity risk.

Appropriate capital assignment for liquidity risk must, however, go beyond such limited quantification analysis. It also must delve into subjective considerations such as alternative sources of liquidity, investments available for sale, loans eligible for securitization, core deposit analysis, and the FSO's timely ability to stimulate deposit growth with rate enhancements. And finally, a judgmental assessment of the FSO's reputation amongst its depositors and other sources of funds, as well as independent credit ratings, also must be factored into this analysis.

Operational risk must be assessed by detailed study of internal controls. Such assessments most recently have been advocated as part of the New Basel Capital Accord known as Basel II. The internal control assessment process required by Sarbanes-Oxley legislation is an excellent starting point for assigning capital based upon operational risk. Numerous control checklists have been promulgated in the financial services industry to assist in this assessment. It is also recommended that FSO carefully collect data on actual losses incurred to begin forming a documented historic record that will strengthen future capital assignment.

The strengths and weaknesses documented during the required internal control reviews provide subjective insight into needed capital assignment. Evaluating the control environment by business units and then ranking the business units allows for relative consideration in the assignment process. At the end of the analysis, capital assigned for operational risk will be based upon educated subjectivity and well-documented control assessments supplemented by actual historic loss data.

THE DIFFERENCE BETWEEN ECONOMIC CAPITAL AND BOOK CAPITAL

Once capital has been assigned to each business unit, product, and customer segment and both revenues and expenses have been properly allocated, we then are able to calculate RAROC. Our methodologies have assigned capital into numerous sub-units and measurement viewpoints. It might be expected that the total assigned capital, or economic capital, for each measurement unit would sum to the organization's reported book capital. For example, if we sum the economic capital for every business unit, we might expect to reconcile to organizational book capital. The same expectation may exist if we sum economic capital for all customer segments. Invariably, however, the sum of economic capital will most assuredly differ from reported book capital regardless of which measurement viewpoint is aggregated. This difference is both expected and appropriate.

Reported book capital is an accounting number that reflects retained earnings, stock issuances, and certain required mark-to-market adjustments. Aggregate assigned capital, however, is an economic valuation based upon thorough quantifiable and subjective risk analysis. As an economic valuation, total assigned capital is an estimate of the capital that is appropriate and necessary given the organization's specific aggregate risk assumption. Should book capital exceed economic capital, the conceptual implication is that the company is over-capitalized commensurate with the level of risk it has assumed. The converse would suggest under-capitalization.

If leaders have carefully constructed a sound and thorough capital assignment methodology, implied over or under-capitalization should be carefully evaluated by senior management and the board of directors. The message being sent is that the aggregate of the organization's risks warrants more or less capital than presently exists.

Prudent business leaders can select varying responses to this implied message. Adjustments to risk levels and/or book capital levels reflect core strategic options which may lead to greater profitability, but will always lead to a more balanced and appropriately correlated risk and return performance. As yet another response to this message, FSO leaders can thoroughly re-evaluate and modify their capital assignment methodologies if valid, new information supports such modification.

What prudent business leaders cannot afford to do, however, is to ignore the message by rationalizing that the difference simply represents the chasm between subjective theory and real world practice. In actuality, real world practice, as well as generally accepted accounting principles and regulatory guidance, is fundamentally subjective and constantly subject to change based upon new experience.

CONCLUSION

The recent experiences of WorldCom, Enron, Freddie Mac and others indicate that we must use sound judgment to evaluate risk and return. Sarbanes-Oxley legislation reinforces the appropriateness of thorough analysis, sound methodologies, and prudent subjective as well as objective evaluations. Enlightened leaders should embrace RAROC as the ultimate "North Star" of performance measurement, the one metric that communicates FSO success much more effectively than any other singular tool.