Managing the value of financial institutions: Part 2: aligning internal performance frameworks with market valuations

RMA Journal, The, April, 2005 by Beverly J. Foster

How do we think about value creation within our institutions? What specific performance metrics should we use to create a link to shareholder value? And how do we get those metrics to have an impact throughout the institution? Those are the questions tackled in Part 2 of a three-part series on managing the value of financial institutions.

Aligning Performance Measures and Market Valuation

Many banks and insurance companies are actively implementing an economic profit or return-based metric system, such as RAROC (risk-adjusted return on capital), suggested Tom Wilson of Mercer Oliver Wyman. Wilson's remarks opened the second of three sets of panel discussions on the topic of managing the value of financial institutions.

Within such a metric system, economic earnings are divided by some measure of the economic capital allocated to the business unit to yield a RAROC (or RARORAC--risk-adjusted return on risk-adjusted capital). That result is then compared with the firm's cost of capital, with the difference representing the economic profit generated by the firm during the year. Adding the present value of the firm's future economic profits to its net asset value gives the intrinsic value of the firm, or what the shareholder should be willing to pay for the firm.

There are different levels within which these performance and value metrics can be applied:

1. The tactical or transactional level, often directed at improving product pricing, customer relationship discipline, and risk capacity allocation.

2. The business-unit or operational level, where metrics--whether measured for capital or for returns--need to drive business behavior consistent with transaction economics as well as overall corporate strategy and objectives.

3. The strategic level, to guide the firm's overall corporate portfolio and growth strategy.

All too often, it is at the top of the house where hanks' and insurance companies' internal performance metrics fall short, Wilson said. More specifically, an institution quite proud of itself for using RAROC at the transaction and business-unit level may nonetheless find that RAROC has little or no influence on corporate strategy. All too often, senior management focuses on earnings and earnings growth, applying a price-to-earnings multiple to derive strategy--in effect, creating strategy "on the back of an envelope." However, shareholders care about more than just earnings--they also care about the sustainability of returns and how effectively capital is used. Unfortunately, this disconnect can cause the firm to select strategies that are not in the shareholders' best interests.

The failure of internal metrics to have strategic impact was illustrated by a survey conducted by Mercer Oliver Wyman. The CFOs of banks and insurance companies globally ranked the importance of measures used for developing corporate strategy as follows:

1. Earnings and earnings growth.

2. Revenue and revenue growth.

3. Cost and cost income ratios.

4. Return on book capital or equity.

5. Return on risk capital.

It's important to note that return on risk capital was a distant fifth. This data reinforces the perception that, unfortunately, earnings and revenue growth are more important for strategy development than the firm's internal performance metrics.

But why do internal metrics fail to have an impact? When asked, the CFOs ranked the disconnect between their internal metrics and shareholder value as the greatest reason. Not surprisingly, if the connection between shareholder value and such internal metrics as RAROC is not understood internally, the information will not be used externally. Asked the most important pieces of financial information an institution communicates externally, the ranking top to bottom further reinforces the problem: earnings and earnings growth, return on equity, line of business information, and--a distant ninth--internal metrics.

To align internal metrics with shareholder valuation, firms need to address three important challenges.

1. How do we measure economic returns? For example, how do we measure--at the point of sale--the contribution of a variable annuity life insurance product? The sales cost up front could be substantial and the actual economics flow out over a course of 30 years, subject to a lot of assumptions about consumer behavior as well as the behavior of investment function, crediting policies, and more. Similarly, should a bank measure period earnings on an economic basis by marking the banking credit book to market and then tracking the relative changes? How far to take this economic perspective in terms of recognizing earnings poses both philosophical and implementation challenges for many institutions.

2. How do we measure and allocate capital? Many institutions allocate capital to business units based on their contribution to the risk of the institution, following a debtholders' perspective. In other words, internal models based on some solvency or rating aspiration drive economic aggregate capital requirements and allocations to business units. However, if a business is measured on an economic capital basis and has grown through inorganic acquisition--for example, capital is being used to fund business expansion as well as for solvency purposes--is performance being measured fairly? In such a case, total invested capital can be quite a bit higher than required regulatory capital, which is substantially higher than the required economic capital. If capital is used as a funding element as well as for risk solvency, how are the two balanced in order for the institution to attribute capital? Many institutions with inorganically grown businesses look marvelous on a RAROC basis but less so on an invested capital basis: In terms of shareholder value creation, if they've never stepped back and extracted the synergies from those businesses, they have actually destroyed shareholder value.