EVA and RAROC in banking performance metrics
For efficient business strategy and to improve performance, many financial institutions, such as banks, use banking performance metrics. These metrics help measure the profitability of business units, manage the risks associated with capital allocation, and evaluate the performance of each business unit.
The increasing prevalence of technology and the complexity of the market drive many institutions to improve their performance. In a world full of competition, survival is a goal of many businesses, both new and progressive, while those at the top also have the aspiration to maintain their glory.
Success in a competitive environment has become a challenge for companies. To achieve this, companies, such as banks, must measure their performance in order to find solutions once the result of the measure seems unfavorable. Banking performance metrics can be used to help managers make complex decisions.
Among the performance metrics used by many banks and other companies to generate financial information for decision-making and evaluation are economic value added and risk-adjusted return on capital, or RAROC.
Economic Value Added, simply known by its acronym version, is an estimate of an entity’s actual economic profit after making corrective adjustments to generally accepted accounting principles or GAAP accounting, including deducting the opportunity cost of equity capital. . It is estimated that the use of GAAP in corporations ignores some value of opportunity costs for shareholders.
The EVA of a company can be measured by deducting the monetary cost of capital from the net operating profit after taxes. The monetary cost of equity in EVA refers to the amount of money rather than the pro rata cost of equity.
Stern Stewart & Co. develops its trademark, Economic Value Added Performance Metrics.
Meanwhile, the RAROC, or risk-adjusted return on capital, is used to analyze the risk-adjusted financial performance of a company and to provide insight into profitability. It is a risk-based framework for measuring profitability.
RAROC, a relationship between risk-adjusted return and economic capital, is used to determine the economic benefit of a company. This system is used to allocate capital for risk management and performance evaluation.
Banks and other financial institutions use risk-adjusted return on capital. As a risk management tool, RAROC is used to determine the bank’s optimal capital structure by allocating capital to individual business units.
In addition, RAROC is used as a banking performance metric to allow banks to allocate capital to companies and business units, as determined based on the economic value added or EVA of each unit. Capital utilization as determined by risk improves banks’ capital allocation. The capital that is put at risk is expected to provide a return beyond risk-free.
EVA and RAROC are among the banking performance metrics used by banking business units to determine profitability in an economic sense. Economic value added is used in corporate finance to determine the value that is created beyond the required return. On the other hand, risk-adjusted return on capital is determined for capital allocation for risk management and performance evaluation purposes.