For efficient business strategy and to improve performance, many financial institutions, such as banks, utilize banking performance metrics. These metrics help in measuring the profitability of the business units, to manage the risks that come with the allocation of capital, and to evaluate 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 filled with competition, survival is an objective of many businesses, both the new ones and even progressive ones, while those at the top also have the aspiration to sustain their glory.
Success in a competitive environment has then become a challenge among businesses. To possibly attain this, businesses, such as banks, must measure their performance to be able to come up with solutions once the result of the measure seems unfavourable. Banking performance metrics can be used to aid managers in coming up with complex decisions.
Among the performance metrics used by many banks and other businesses in coming up with financial information for decision-making and evaluation are economic value added and risk-adjusted return of capital or RAROC.
Economic value added, simply known to its acronym version, is an estimate of real economic profit of an entity after performing corrective adjustments to generally-accepted accounting principles or GAAP accounting including the deduction of the equity capital's opportunity cost. Based on estimates, the utilization of GAAP in corporations ignores a certain worth in shareholder opportunity costs.
The EVA of a business can be measured by deducting the money cost of capital to the Net Operating Profit After Taxes. The money cost of capital in EVA refers to the amount of money instead of the cost of capital in proportional rate.
Stern Stewart & Co. develops its registered trademark, Economic Value Added performance metrics.
Meanwhile, the RAROC or risk adjusted return of capital, is used to analyse the risk-adjusted financial performance of an enterprise and to provide a view of profitability. It is a risk-based framework to measure profitability.
A ratio of risk-adjusted return to economic capital, RAROC is used to determine the economic profit of an enterprise. This system is used to allocate capital for risk management and performance evaluation.
The risk-adjusted return of capital is utilized by banks and other financial institutions. As a risk management tool, RAROC is used to determine the optimal capital structure of the bank through the allocation of capital to individual business units.
Moreover, RAROC is used as a banking performance metric to let banks assign capital to companies and business units, as determined on the economic value added or EVA of each unit. The utilization of capital as determined on risk enhances the capital allocation of banks. The capital that is placed at risk is expected to provide return beyond the risk-free.
EVA and RAROC are among the banking performance metrics used by banking business units to determine profitability in economic sense. The economic value added is utilized in corporate finance to determine the value being created beyond the required return. On the other hand, the risk-adjusted return of capital is determined for the allocation of capital for risk management and performance evaluation purposes.