It is a fact that a competitive marketplace does not treat all customers equally. Companies in different industries have set various criteria to distinguish the “important” customers from the others so that the important ones can be motivated differently to produce more profit. From this aspect, the banking industry is not different from the others.
In order to compete against large commercial banks, small-to-medium-sized banks have emphasized on providing personalized services to selected groups of customers. As a result of these special services and relationships, it becomes more complicated and difficult to distinguish the more profitable ones from the others. Without a clear, fair, uniform and accurate guideline, bank managers and officers may easily make wrong decisions, and may not actually be able to meet the performance requirements of the bank when they negotiate with those customers who “appear” to be important.
When a loan officer negotiates a deal that will produce $5,000 per month in interest income, is that a good deal to the bank or not? To answer this question correctly, an experienced banker needs to consider many other factors such as interest rate, principal amount, cost of fund, fees, terms, service overhead, credit risks, capital requirement, other potential income, etc. Realistically, can a bank expect its loan officers, who are also the sales/marketing arm of the bank, to do a complicated financial analysis to answer this question on the spot during the negotiation? If a loan officer cannot answer this question precisely, will he/she be able to negotiate effectively with the customer to secure the best result for the bank?
In today’s highly competitive banking industry, a banker needs a precise and dependable performance navigator that can analyze various options and help the banker to compete successfully against the others.
Risk-Adjusted Return on Capital (RAROC) is a well-defined principle in identifying the optimal path to outstanding performance. Based on the RAROC principle, FinmannaTM has applied several patent-pending technologies to condense the applicable financial concepts, risk management principles, and banking regulations into an easy-to-use Performance NavigatorTM (U.S. patent pending) so that bankers can make an optimal decision quickly and precisely with peace of mind.
| Description |
As regulatory agencies require banks to implement risk management, bankers are eager to measure their performance based on RAROC instead of ROC (Return on Capital). The RAROC ratio adjusts the Expected Profit by the Expected Loss and uses Capital at Risk (CAR) as the basis to measure performance. The conceptual formula is listed below:
To empower a banker to negotiate a deal effectively, the Expected Profit of that specific deal must be extracted out from the balance of the relationships for an independent evaluation. To reach that purpose, a transfer price must be established as the interest expense of the transaction. In addition, the non-interest expense of the transaction must be calculated based on the operating cost of the bank. To manage the interest rate risk dynamically, the Federal Fund Target Rate (the marginal rate) or related index serves as an excellent transfer price in performance evaluation because most banks sell their excess resources as federal funds at the end of the business day. Since some banks may use their own internal approaches to determine the transfer price, Performance NavigatorTM is designed to accept any transfer price adopted by the bank.
The Expected Loss includes the credit risk and the maturity risk of the subject deal. Since different banks may focus on particular market sectors with diverse products of various maturity lengths based on distinct business principles, the Expected Loss is different from bank to bank. Nevertheless, Performance NavigatorTM can derive such information based on the current maturity risk and the historical records of the bank.
Capital at Risk (CAR) is a risk-based economic measure of capital. It also serves the purpose of allocating capital to business deals in proportion to their risks. Since small-to-medium-sized banks are dealing with customers who are not rated by Moody or Standard & Poor, the available information is very limited in determining the term structure of credit risk of these customers. The unexpected loss of a deal is difficult to define. Therefore, the common practice in defining CAR is to use regulatory capital. The Basle Committee on Banking Supervision developed the International Convergence of Capital Measurement and Capital Standards in July 1988 (referred to as the “Accord”). The Accord was later endorsed by the central bank governors of the Group of Ten (G-10) countries and was amended several times. It the US regulatory agencies in July 1995 to manage solvency risk, and became mandatory to all financial institutions as of January 1, 1998. Performance NavigatorTM complies with the Accord and its amendments in meeting the regulatory requirement.
| Conclusion |
AROC is a forward-looking economic measure, rather than a backward-looking accounting measure. It is based on risk and profit projections and has been widely adopted in the financial industry. According to the RAROC measure, the Performance NavigatorTM leads bankers to achieve superb performance.
Some banks use “customer profitability systems” to calculate the backward-looking profitability of a customer. By using this approach, bankers have to make a bold assumption that a profitable customer in the past will also be a profitable one in the future. Obviously, this may not be the case. In today’s complicated and volatile global economy, many economic factors (e.g., interest rate) can change quickly and severely affect the profitability of a customer. Without the risk management provisions, a customer profitability figure may mislead bankers to a devastating result.
By comparison, Performance NavigatorTM provides an insight into the future based on up-to-date economic projections. The pertinent financial figures, risk factors and regulatory requirements are all taken into consideration in order to identify the optimal path to outstanding performance. More importantly, Performance NavigatorTM provides reliable, precise and unified bank-wide guidance that empowers bankers to proactively manage their performance with great confidence.