RAROC AT BANK OF AMERICA: FROM THEORY TO PRACTICE

In 1993, Bank of America's Risk and Capital Analysis Group was charged with the task of developing and instituting a single corporate-wide system to allocate capital to all the bank's activities. Since 1994, that system has been providing quarterly reports of risk-adjusted returns on capital (RAROC) for each of the bank's 37 major business units. By 1995, B of A had also developed the capability to calculate RAROC down to the level of individual products, transactions, and customer relationships. RAROC systems allocate capital for two basic reasons: (1) risk management and (2) performance evaluation. For risk management purposes, the overriding goal of allocating capital to individual business units is to determine the bank's optimal capital structure–the proportion of equity to assets that minimizes the bank's overall cost of funding. This process involves estimating how much the risk (or volatility) of each business unit contributes to the total risk of the bank, and hence to the bank's overall capital requirements. For performance evaluation purposes, RAROC systems assign capital to business units as part of a process of determining the risk-adjusted rate of return and, ultimately, the “economic profit” of each business unit. The objective in this case is to measure a business unit's contribution to shareholder value, and thus to provide a basis for effective planning, capital budgeting, and incentive compensation at the business unit level. Concerns about capital adequacy, along with the Basel risk-based capital requirements, have played some role in the growth of RAROC among commercial banks. But the most powerful impetus to bankers' use of more systematic risk measures is coming from increasingly activist institutional investors. Besides giving senior management an economic basis for evaluating the bank as a portfolio of businesses and for making resource allocation decisions that improve the bank's risk/reward profile, RAROC systems are also expected to produce better performance by holding managers accountable for the amount of investor capital they are putting at risk.     

Bankers Trust and the Birth of Modern Risk Management

A leading financial practitioner traces the origins of the risk management concepts and applications widely used in today's financial institutions to their development at Bankers Trust in the 1970s. The bank became a pioneer out of necessity and entrepreneurship. Lacking the relationships with large corporations enjoyed by J.P. Morgan and Chase, Bankers Trust had to find ways to offer financial products its well‐established competitors could not. The innovations in risk management came from the Bank's “Resources Management” group, which was responsible for its trading and funding activities (but not corporate lending). By applying probability theory to its trading positions, the bank found an effective way to measure “market risk.” Extensions and refinements of this methodology were then used to measure credit risk and, later, liquidity risk and operational risk. These statistical methods and probabilistic concepts were brought together in a metric called Risk Adjusted Return On Capital, or “RAROC,” as it eventually became known throughout the financial services industry. RAROC was a concise way to measure and communicate the economic profits that had been generated by a transaction, product, or business unit, given the amount of “risk‐based” equity capital that was necessary to generate that profit. At Bankers Trust, RAROC eventually was used not only to evaluate profitability, but to guide strategic planning, capital allocation, and incentive compensation. And tools incorporating the same concepts, but with names like Value at Risk (or VaR), were later adopted by many other banks as well as regulators, including the framers of the Basel Accords. The author closes by suggesting how and why Bankers Trust's risk management culture began to deteriorate after 1995, and the bank was acquired by Deutsche Bank in 1998.     

A NEW APPROACH TO CAPITAL BUDGETING FOR FINANCIAL INSTITUTIONS

The classic approach to capital budgeting based on the standard Capital Asset Pricing Model (CAPM) says that the hurdle rate (or cost of capital) for any new project or investment should depend only on the riskiness of that investment. Thus, the hurdle rate, and hence the expected value of the investment, should not be affected by the financial policy of the company evaluating the project. Nor should the hurdle rate be influenced by the company's risk management policy, or by the kind of assets it already has on the balance sheet. This article argues that such a “singlefactor” model may be inappropriate for banks and other financial institutions for two main reasons:

• ? it is especially costly for banks to raise new external funds on short notice;
• ? it is costly for banks to hold a buffer stock of equity capital on the balance sheet, even if this equity is accumulated over time through retained earnings.

The single-factor CAPM ignores such costs and, in so doing, understates the true economic costs of “illiquid” bank investments. Illiquid investments require special treatment because they impose risks that, although “diversifiable” by shareholders, cannot be readily hedged by the bank and therefore require it to hold more equity capital. The authors accordingly propose a “two-factor” model for capital budgeting— one in which banks' investment decisions are linked to their capital structure and risk management decisions. One of the key implications of the two-factor model is that a bank should evaluate new investments according to both their correlation with the market portfolio and their correlation with the bank's existing portfolio of unhedgeable risks. The authors describe several potential applications of their model, including the evaluation of proprietary trading operations and the pricing of unhedgeable derivatives positions. They also compare their approach to the RAROC methodology that has been adopted by a number of banks.     

Optimal capital allocation using RAROC™ and EVA®

Equity capital allocation plays a particularly important role for financial institutions such as banks, who issue equity infrequently but have continuous access to debt capital. In such a context this paper shows that EVA and RAROC based capital budgeting mechanisms have economic foundations. We derive optimal capital allocation under asymmetric information and in the presence of outside managerial opportunities for an institution with a risky and a riskless division. It is shown that the results extend in a consistent manner to the multidivisional case of decentralized investment decisions with a suitable redefinition of economic capital. The decentralization leads to a charge for economic capital based on the division's own realized risk. Outside managerial opportunities increase the usage of capital and lead to overinvestment in risky projects; at the same time more capital is raised but risk limits are binding in more states. An institution with a single risky division should base its hurdle rate for capital allocated on the cost of debt. In contrast, the hurdle rate tends to the cost of equity for a diversified multidivisional firm. The analysis shows that hurdle rates have a common component in contrast to the standard perfect markets result with division-specific hurdle rates.     

商业银行二级分支行经济资本管理的问题与对策

随着商业银行进入资本管理时代，经济资本管理逐渐成为商业银行核心管理模式，也是转型道路中同业经济资本管理水平和能力的博弈。商业银行二级分支行位于市场竞争最前沿，是整个经济资本管理体系执行层的着力点，其资本管理如何事关全局。本文以工商银行为例，简述了工商银行经济资本管理的主要运行情况，从二级分支行的视角，指出管理层应通过设计经济资本运作管理流程，给予二级分支行相应配套的支持和制度完善，二级分支行要将EVA和RAROC指标及意义渗透到经营管理的考核、评价和资源分配中，在资本管理流程内规范化和程序化运作，引导和约束经营行为，实现新的健康的经营转型目标。     

商业银行二级分支行经济资本管理的问题与对策

随着商业银行进入资本管理时代,经济资本管理逐渐成为商业银行核心管理模式,也是转型道路中同业经济资本管理水平和能力的博弈。商业银行二级分支行位于市场竞争最前沿,是整个经济资本管理体系执行层的着力点,其资本管理如何事关全局。本文以工商银行为例简述了工商银行经济资本管理的,主要运行情况,从二级分支行的视角,指出管理层应通过设计经济资本运作管理流程,给予二级分支行相应配套的支持和制度完善,二级分支行要将EVA和RAROC指标及意义渗透到经营管理的考核、评价和资源分配中,在资本管理流程内规范化和程序化运作,引导和约束经营行为,实现新的健康的经营转型目标。     

EVA AND ITS CRITICS

This paper responds to the article by Biddle, Bowen, and Wallace (BBW) by suggesting that their study of EVA and earnings has three potential shortcomings:

• (1)

   A closer look at BBW's regression analysis suggests that investors, while apparently ignoring the cost of equity, put great weight on the cost of debt —a puzzling result in need of an explanation.
• (2)

   The attempt by BBW to "level the playing field" effectively makes the NOPAT model into a NOPAT and capital model. Thus, it is really an EVA model in disguise and offers no insight into the explanatory power of NOPAT or earnings by itself.
• (3)

   BBW's model of expectations is too simple. The ability of EVA to explain shareholder returns depends upon the accuracy of the model of expected EVA performance, and BBW make no attempt to derive a model of expected EVA improvement from the EVA valuation equation.

     

经济资本管理:理论分析及我国实践

近年来,经济资本管理作为优化资源配置、提高风险调整收益的核心工具,在国际先进银行中得到广泛应用。通过经济资本可以量化各类业务敞口的风险水平,计算抵御风险所需的资本金额,银行决策层可据此调整风险偏好与发展战略,制定更为科学、合理、清晰的政策组合,确保银行价值最大化目标的实现。本文阐述了经济资本管理的基本理论、国内外实践情况,分析了我国银行业实践中存在的问题,提出了相应的政策建议。     

Beyond EVA

A former partner of Stern Stewart begins by noting that the recent acquisition of EVA Dimensions by the well‐known proxy advisory firm Institutional Shareholder Services (ISS) may be signaling a resurgence of EVA as a widely followed corporate performance measure. In announcing the acquisition, ISS said that it's considering incorporating the measure into its recommendations and pay‐for‐performance model. While applauding this decision, the author also reflects on some of the shortcomings of EVA that ultimately prevented broader adoption of the measure after it was developed and popularized in the early 1990s. Chief among these obstacles to broader use is the measure's complexity, arising mainly from the array of adjustments to GAAP accounting. But even more important is EVA's potential for encouraging “short‐termism”—a potential the author attributes to EVA's front‐loading of the costs of owning assets, which causes EVA to be negative when assets are “new” and can discourage managers from investing in the business. These shortcomings led the author and his colleagues to design an improved economic profit‐based performance measure when founding Fortuna Advisors in 2009. The measure, which is called “residual cash earnings,” or RCE, is like EVA in charging managers for the use of capital; but unlike EVA, it adds back depreciation and so the capital charge is “flat” (since now based on gross, or undepreciated, assets). And according to the author's latest research, RCE does a better job than EVA of relating to changes in TSR in all of the 20 (non‐financial) industries studied during the period 1999 through 2018. The article closes by providing two other testaments to RCE's potential uses: (1) a demonstration that RCE does a far better job than EVA of explaining Amazon's remarkable share price appreciation over the last ten years; and (2) a brief case study of Varian Medical Systems that illustrates the benefits of designing and implementing a customized version of RCE as the centerpiece for business management. Perhaps the most visible change at Varian, after 18 months of using a measure the company calls “VVA” (for Varian Value Added), has been a sharp increase in the company's longer‐run investment (not to mention its share price) while holding management accountable for earning an adequate return on investors’ capital.     

What Determines TSR

Researchers have long wrestled with the question of what determines a company's total shareholder return, or TSR, and their results have been decidedly mixed. Some empirical studies come down in favor of dividends or earnings per share, while others favor return on capital or other profitability measures. In this article, the author takes a “first principles” approach that begins by demonstrating that TSR should be a function of a company's economic profit, or its Economic Value Added (or EVA). He shows that, from a theoretical standpoint, the sum of dividends and share price appreciation—which is the definition of TSR—is ultimately a function of increasing EVA and, along with it, a company's “aggregate NPV.” He further shows that if stock prices are determined by discounting expected cash flows, corporate NPV will equal the discounted value of EVA, and increasing NPV will come down to increasing EVA. In developing his argument, the author demonstrates that TSR is actually a leveraged version of a measure he calls “TIR,” or total investor return, which is the blended return that an investor would earn from owning the entire capital structure of a company, bonds as well as stock. He then presents the findings of regression analysis showing that a company's TIR and TSR are both strongly positively correlated with its EVA performance plus the change in its aggregate NPV (with R²s equal to 1.0 and 0.94, respectively). In a final step, the author shows that the change in EVA provides a better statistical explanation than other financial measures for changes in aggregate NPV and, hence, actual TSR     

资本约束、金融脱媒、利率市场化与商业银行战略转型

当前国内商业银行内外部经营环境已发生深刻的变革,在资本约束、金融脱媒和利率市场化条件下,国内商业银行传统发展模式已难以为继,必须进行战略转型。我国商业银行战略转型的目标就是要实现股东价值的最大化。本文探讨了战略转型的主要途径,包括:一是要转变业务增长方式,即从外延粗放型增长到内涵集约型增长;二是要转变风险管理模式,即从风险管理理念、风险管理体制和风险管理技术等方面重构商业银行全面风险管理模式;三是要转变绩效评价体系,即从传统的以当期账面利润和不良资产率为核心的绩效考核体系,转变为以RAROC和EVA为核心的绩效评价体系。     

Risk Management,Corporate Governance,and the Search for Long-Term Investors

This discussion explores a number of ways that more effective risk management, corporate governance, and communication with investors can help companies increase their effciency and long-run value. According to one of the panelists, recent surveys of corporate directors suggest that companies should devote more time and attention to three issues—strategy, risk management, and succession planning—and that strategy and risk are the “flipsides of the same coin.” As the panelist argues, “You can't talk about strategy without talking about what risks you're going to take—and what risks you decide to take has to depend on the core competencies that drive the corporate strategy.” In addition to making risk management a critical part of corporate strategy, another notable recommendation is to communicate a company's strategy and business plan as clearly as possible to investors, with the aim of attracting more sophisticated, long-term shareholders. Contrary to popular belief, such a group may well include some hedge funds and other activist shareholders. According to a newly released report on shareholder activism (produced and cited by another panelist), corporate boards should work harder to identify and engage the “largest 10 shareholders in the organization,” with the ultimate goal of cultivating a shareholder base that buys into the company's strategy.     

EVOLUTION OR EXTINCTION: WHERE ARE BANKS HEADED?

The banking industry represents an interesting and important case study of how changes in technology and regulation influence business strategy and organizational design. A narrow focus on traditional bank products and performance measures would lead one to conclude that banking is a declining industry. Such a focus, however, would miss most of the innovations in banking–most notably, the move to “off-balance-sheet” activities–that have been taking place in recent years. A broader perspective shows banks evolving in ways that are enabling them to provide the same basic functions as before, but in new, more efficient ways. In the past, most banks thought of themselves as delivering a set of specific, largely unrelated products to different sets of customers. Today many banks are pursuing strategies that aim to strengthen their ability to perform various functions–for example, financial planning for retail clients, or raising capital for middle market companies–that tend to cut across the old product boundaries. As a result, and in contrast to most industrial firms, many banks are offering a more diversified range of products and services than ever before with the aim of exploiting potential synergies among those products. Such major changes in banks' strategies are in turn leading to fundamental changes in their “organizational architecture.” Some banking activities that were once controlled by a rigid management hierarchy are now being decentralized, whereas other functions that were largely decentralized are being subjected to more central coordination to help realize potential economies of scale and scope. Along with these changes in decision-making authority, banks are also being forced to rethink their internal performance evaluation and incentive compensation systems. As an ever larger portion of their activities continues to move off balance sheet, more and more banks are deciding that conventional accounting measures of bank operating performance such as ROA and ROE are inadequate, and that economic measures of performance like RAROC and EVA are needed to reflect the new reality of where banks are putting their capital at risk, and whether the rates of return they are earning on their different activities are high enough to reward their shareholders.     

关于商业银行分支机构提高经济增加值(EVA)的探讨

最大限度地提高商业银行分支机构的经济增加值,是一个涉及经营理念、管理方式、资金集中配置下的经营策略、资产负债结构调整、经济资本配置等诸多方面的复杂问题。当前分支机构应当紧紧围绕上级行以经济增加值为核心的绩效考评办法,以价值增值和资本节约为原则,以全面预算管理体系的建立健全为平台,以内部资金转移价格和经济资本配置系数、配置限额为导向,确定经营策略。具体包括:逐步增强主动负债的能力;按价值增长、资本节约的方向经营信贷资产业务;努力降低内部无息资产占用和低效资金占用:探索建立健全所得税申报工作机制等。     

EVA IN THE E&P INDUSTRY: THE CASE OF NUEVO ENERGY

This article presents a case study illustrating some aspects of the new business model discussed in the roundtable above. Continuing a major theme in the roundtable, the authors begin by arguing that the long‐run failure of the E&P industry to create shareholder wealth stems to a large degree from weak or distorted incentives held out to the top executives and managers of most large, publicly traded companies. This article traces the incentive problem to the lack of an effective wealth creation metric to guide the financial management process. Although the industry employs a variety of accounting‐based performance measures, none is a reliable measure of wealth creation. In place of traditional financial metrics such as earnings, annual cash flow, and return on capital, this article recommends a performance evaluation and incentive compensation system that is tied to the use of a “reserve‐adjusted” EVA measure—one that exhibits a strong statistical correlation with changes in shareholder wealth in the E&P business. The greater explanatory power of this new measure reflects the reality that changes in the value of reserves in the ground can greatly outweigh changes in annual earnings or cash flows. As the focal point of a compensation plan, EVA has advantages over stock options in that it can be calculated at various levels in the organization, even at the level of a single well, whereas stock prices only exist for the company as a whole. For this reason, an EVA incentive system permits a clearer “line of sight” between pay packages and the performance of the part of the business for which managers are directly accountable. Perhaps even more important, EVA can be calculated (using an “internal hedging” mechanism) in a way that removes the impact of changes in oil prices on the incentive outcome. And, as demonstrated in the case study of Nuevo Energy, such internal hedging allows companies to give their employees a much greater share of wealth created with far less cost than by simply granting stock or stock options.     

Save the Buyback,Save Jobs

In response to a recent New York Times op‐ed by Senators Schumer and Sanders deploring the effects of stock buybacks on workers and the economy, the authors explain the role of buybacks in increasing corporate productivity and in recycling “excess capital” from mature companies with limited growth and employment opportunities to the next generation of Apples and Amazons. Some companies, as Schumer and Sanders charge, are guilty of repurchasing shares in the name of “shareholder value maximization” instead of pursuing job‐creating investments. But as the authors argue, well‐run companies increase shareholder value not by boosting EPS through buybacks, but mainly by earning competitive returns on capital and investing in their long‐run “earnings power.” And by paying out capital they have no productive uses for, such companies give their own shareholders the opportunity to reinvest in other companies with promising prospects for growth and jobs. But the authors go on to note the tendency of companies to buy back shares not when their stock prices are low, but instead when the companies are flush with cash and nearer the top than the bottom of the business cycle. The result of this tendency, as research by Fortuna Advisors (the authors' firm) shows, is that fully three quarters of companies doing large buybacks during the period 2013‐2017 failed to produce an adequate “Buyback ROI,” a metric developed by Fortuna that indicates management's effectiveness in “timing” its stock repurchases. Given the usefulness of buybacks in recycling capital, the authors conclude that the most reliable solution to the corporate short termism and underinvestment problem is for companies to adopt better financial performance measures—including Buyback ROI—to guide their capital allocation. And when management determines that it has significantly more capital than value‐adding investments, but wants to avoid committing to unsustainable dividend increases, it should consider buybacks—but only if management is convinced that its stock price has not outpaced performance.     

“Analysis of Incremental Returns of Canadian Mutual Funds”, J. F. Carrière; C. F. Hill,April 2001

Abstract

The determination and allocation of economic capital is important for pricing, risk management, and related insurer financial decision making. This paper considers the allocation of economic capital to lines of business in insurance. We show how to derive closed-form results for the complete markets, arbitrage-free allocation of the insurer default option value, or insolvency exchange option, to lines of business for an insurer balance sheet. We assume that individual lines of business and the surplus ratio are joint log-normal although the method we adopt allows other assumptions. The allocation of the default option value is required for fair pricing in the multiline insurer. We discuss and illustrate other methods of capital allocation, including Myers-Read, and give numerical examples for the capital allocation of the default option value based on explicit payoffs by line.     

CHOOSING THE RIGHT FINANCIAL SYSTEM FOR GROWTH

Well‐functioning financial systems promote economic growth by channeling funds from those who save to those who invest in the productive capacity of economies. What are the main features of a well functioning system? Are well developed capital markets essential to the process? Or are commercial banks and other “private” sources of capital capable of bringing about the same levels of growth and prosperity? In this article, the authors use information about the financial systems of a large number of both developed and developing countries to examine various relationships between a country's financial structure and its overall economic performance. Perhaps most important, the authors report a significantly positive correlation, using data for 34 countries, between the size of a country's financial system—measured by the total of commercial bank assets, equity market capitalization, and bonds outstanding—and economic development (as measured by GDP per capita). At the same time, the authors also provide evidence that banks (or loans) and capital markets (or securities) are complements, not substitutes, in promoting economic development, and that the presence of foreign‐owned banks (though not state‐owned banks) has a positive association with growth. In other words, both private banks and capital markets are likely to play important, though different roles in channeling funds from savers to investors.     

关于商业银行分支机构提高经济增加值（EVA）的探讨

最大限度地提高商业银行分支机构的经济增加值，是一个涉及经营理念、管理方式、资金集中配置下的经营策略、资产负债结构调整、经济资本配置等诸多方面的复杂问题。当前分支机构应当紧紧围绕上级行以经济增加值为核心的绩效考评办法，以价值增值和资本节约为原则，以全面预算管理体系的建立健全为平台，以内部资金转移价格和经济资本配置系数、配置限额为导向，确定经营策略。具体包括：逐步增强主动负债的能力；按价值增长、资本节约的方向经营信贷资产业务；努力降低内部无息资产占用和低效资金占用；探索建立健全所得税申报工作机制等。     

利率市场化背景下银行同业存款定价的模型设计

随着我国利率市场化进程的不断推进,同业存款已经实现了市场化定价。为了适应利率市场化的形势,进一步巩固客户关系,并为银行业务发展提供低成本的资金来源,需要积极研究完善同业存款定价方法。本文借鉴西方商业银行在存贷款等产品定价方面的研究,结合当前商业银行金融同业业务的具体情况,设计了基于客户综合贡献和银行目标利润的同业存款定价模型,并对此方法做进一步的讨论,提出要将定量分析与定性分析相结合,完善客户关系管理(CRM)系统,结合不同行业同业客户特点提高该模型适用性等建议。