Economic Profit and Performance Measurement in Banking
Kimball, Ralph C., New England Economic Review
Successful bank operation requires managers to weigh complex trade-offs between growth, return, and risk. In recent years banks increasingly have adopted innovative performance metrics such as risk-adjusted return on capital (RAROC) and economic value added [[(EVA.sup.SM]).sup.1], which assist managers in making such difficult and complex decisions. These innovative measures all share as a basis the concept of economic profit, rather than accounting earnings. By forcing line managers to include the opportunity cost of equity when making investment and operating decisions, banks expect to elicit better decision-making by managers. By implementing performance measurement and incentive systems driven by economic profit and allocated equity capital, senior managers also hope to align managerial behavior more closely with the interests of shareholders.
This article analyzes the use of economic profit for measuring the performance of banks. In particular, since economic profit cannot be calculated without some imputation of equity, the article focuses on the allocation of equity capital to products, customers, and businesses. The first section of the article describes the use of economic profit to evaluate performance, to price transactions, and to reward managers. The second section describes in detail one performance measurement and incentive system, known as [EVA.sup.SM], which has been adopted by a considerable number of both banks and other companies. The third and fourth sections discuss the shortcomings of performance metrics founded on economic profit, which may distort banks' investment and operating decisionmaking. These metrics assume that it is possible to allocate earnings and equity capital to lines of business, products, and customers in a way that isolates the economic revenues and costs of each activity. However, if lines of business are related, either in the production of output or in their use of capital, then this isolation may not be possible, and these methods of measuring performance may mislead managers. The conclusion argues that banks need to recognize the ambiguities inherent in the calculation of economic profit and be prepared to create and apply multiple specialized performance metrics.
I. Economic Profit and Performance Measurement in Banks
Economists and accountants differ on the proper definition of profit. To the accountant, profit is the excess of revenues over expenses and taxes and is best measured by earnings. To the economist, earnings fails to include an important expense item, the opportunity cost of the equity capital contributed by the shareholders of the firm. A firm earns economic profits only to the extent that its earnings exceed the returns it might earn on other investments. Thus, earnings will always exceed economic profits, and a firm can be profitable in an accounting sense yet unprofitable in an economic sense.(1)
This conceptual difference has important practical implications. If managers attempt to maximize earnings (or growth of earnings) rather than economic profit, they will invest additional units of equity capital so long as the marginal contribution to earnings is positive. But if they do so, the marginal contribution of the last unit of equity capital will be zero and less than its opportunity cost, and the average return to equity capital may be greater or less than its opportunity cost depending upon how much equity is used. In contrast, a manager who maximizes economic profits will add units of equity capital only until the marginal contribution of capital is equal to its opportunity cost, and the average return to equity capital will equal or exceed its opportunity cost.
As a result, firms that make business decisions without explicitly incorporating the opportunity cost of equity will be inefficient users of equity capital, engaging in investment projects that generate low returns to shareholders.(2) In 1995, a year of robust earnings, one study estimated that fewer than half of the 1,000 largest industrial and nonfinancial firms earned sufficient returns to cover their opportunity cost of capital (see Ross 1997). …