Profit Analysis Crucial in Asset-Liability Management
Reich, Steven L., Shih, Andre, American Banker
Risk-adjusted return on capital measures are enjoying extensive and justly deserved popularity in asset-liability management.
Banks increasingly use risk-adjusted return on capital to shape and guide their most fundamental business decisions.
Such analysis may determine such critical issues as pricing products and relationships, entering or exiting major business lines, shrinking or expanding retail branch networks, and approving or rejecting proposed capital investments.
In view of the uses to which these measures are put, it is vital that banking executives and analysts understand that the numbers can be very misleading if not properly developed.
As every analyst of asset-liability management knows, measures of risk-adjusted return on capital (RAROC) are ratios developed from two independent factors: after-tax profit (the numerator) and capital (the denominator).
These ratios can be extremely sensitive to subtle changes in the profit or capital totals used to derive them. Such sensitivity can have major implications for the decisions to which a ratio is being applied.
Banks and banking consultants spend a great deal of time and money estimating the proper capital figures to use in developing their RAROC ratios, and it is important that they do. But they need to dedicate at least as much time and care on the methods they use to compute the seemingly straightforward profit term.
That's a serious challenge, because in actual banking practice RAROC ratios are far more sensitive to the profit term than to the capital term.
Computing the profit term is a fundamentally more complex task. Profit totals are generally the product of many incremental decisions about cost and revenue allocations, and they require the netting of many large numbers. Slight differences in allocating large components, along with minor variations in allocation methods, may produce very significant changes in the final risk-adjusted return on capital.
In some industries, variations in the numerator might not prove so important. There are, however, at least three distinct characteristics of the banking industry that can magnify the effect of the numerator in these ratios.
The lower the required capital, the greater the weight of the profit term.
In comparison with many other types of businesses, banks are highly leveraged institutions. The capital required to support a business line in banking is usually 10% or less. Deposit-taking may require as little as 1.5%.
The capital term in a risk-adjusted-return ratio is therefore quite small in relation to the revenues and costs used to compute profit. In mathematical terms, a ratio with a small denominator will be more sensitive to changes in the numerator.
The smaller the denominator (capital), the larger the impact of any change in value of the numerator (the estimated profit).
The more specific and targeted the decisions being addressed, the greater the weight of the profit term.
When bankers attempt to apply risk-adjusted-return ratios to specific operating decisions, such as closing branches or evaluating specific products, they must often deal with highly aggregated data.
As we have said, computing profit generally requires the application of various allocations and assumptions. The lower down in the data hierarchy we move, the more assumptions and allocations we must apply to break down the highly aggregated data.
Small inaccuracies and minor variations in the assumptions and allocations applied to the large components of the profit calculation (revenues and costs) will produce large swings in the profit totals computed, and these swings will distort subsequent risk-adjusted-return measures.
The thinner the profit margin, the greater the weight of the profit term.
Bank balance sheets and transaction volumes are very large, but profit margins are razor thin. As competition intensifies, margins are likely to grow even thinner. …