PDF File: 

CFO2_wp_warren.pdf

Accenture

Risk-adjusted return on capital enhances traditional value-based measurement approaches to drive risk-based decision-making to all levels of the organization.

Maximizing return on investment has always been the primary objective of privately and publicly held companies. True shareholder value is realized when earnings on capital invested is greater than the minimum required by investors to compensate them for taking an underlying risk, measured over a reasonable time horizon. Traditional value-based measurement approaches such as economic value added (EVA) have effectively captured earnings and time dimensions. They have not, however, incorporated risk into the value-measurement equation.

Limits of Current Approaches

In the past, financial accounting results have been used to measure return on equity (ROE), calculating the rate of return based on earnings over the capital invested. While providing a consistent methodology to support standard measurement and comparability across organizations, ROE falls short on providing meaningful insight into value measurement. Its point-in-time accrual-based earnings measurement, rooted in financial accounting principles, distorts the true earnings of an organization. Its top-of-the-house-only view of invested capital limits ROE measurement to the business-unit level.

The introduction of shareholder value added (SVA) or EVA provides new insight into the measurement of value. SVA/EVA addresses some of the limitations of traditional ROE by applying discounted cash-flow techniques to value measurement. Focus on cash flow eliminates traditional earning distortions. Net present value calculations of cash flow over a business cycle, and discounted at a business’s cost of capital or hurdle rate, is a better measure of shareholder value. It does not provide, however, the ability to reasonably allocate capital to the business units employing the organization’s equity supports value measurement at the business line level. The limiting factor of SVA/EVA, however, is that it only provides a high level view of value creation.

True value-based management needs to provide analytics to drive proactive and actionable decision-making at all levels within the organization. To support sustainable value, it must identify where to invest capital across business and product lines, customer transactions, and distribution channels; and it must identify how to efficiently manage capital investments while protecting against risk.

Risk-Adjusted Measurement

Risk-adjusted performance measurement (RAPM) expands upon the SVA/EVA concept through its use of risk-adjusted return on risk-adjusted (economic) capital (RAROC). Economic profit and loss (P&L) is measured by calculating the difference between an organization’s economic return and its economic charge. The ability to drive RAROC down to the lowest reporting level within an organization gives decision-makers the capability to manage critical business dimensions — product, customer, channel, line of business, and geography — as it creates a level playing field to compare business activity on an apples-to-apples basis. The key differentiator between RAROC and other performance measurements is the inclusion of risk within the profit and loss and capital charge (see Figure 1).

Why Risk Matters

Risk is defined as deviations in earnings due to volatility and uncertainty. RAROC brings economic reality to performance measurement by incorporating risk into both earnings and capital measurement. Cash flows are adjusted for anticipated, predictable events based on the underlying risk of a transaction, captured through market valuations (e.g., mark-to-market and mark-to-model) and RAROC expected losses to measure economic return. Economic capital is allocated based on the need to protect against insolvency. Its measurement is driven by an organization’s appetite for risk and desire to influence its cost of capital through its external credit rating (see Figure 2).

Historically, RAROC has focused on financial services organizations, providing a comprehensive measurement of the inherent risks associated with transacting in financial instruments (credit, market, life, property and casualty, business specific and operational risk). Increasingly, however, RAROC methodology is becoming applicable across industries as organizations use sophisticated financial contracts to manage their costs of goods sold (energy and other commodity brokers), as nontraditional competitors are selling financial services (retail credit cards), and as globalization increases the risk of currency and interest-rate exposures. Recent events have made corporate governance and risk management a high priority for all industry groups, making the measurement of business and operational risk mandatory (see Figure 3).

A RAROC Framework

RAROC provides decision-makers with a frame-work that integrates the competing objectives of an organization’s stakeholders to optimize capital management while balancing risk.

RAROC Drives Strategic Decision-Making

RAROC provides a basis for strategic planning by identifying where to grow, divest, or fine-tune business activity by business and product lines, customer, and channels.

RAROC provides a viewpoint to manage capital adequacy levels. Economic capital represents the capital an organization should maintain to achieve a targeted standard of risk-based solvency. The comparison of economic capital against invested (actual) and regulatory (required) capital identifies where an organization is over- or undercapitalized. Overcapitalized firms (economic capital is greater than invested and regulatory capital) can reduce equity holdings to increase return on equity or arbitrage their capital by reinvesting it in more profitable business activities to generate higher earnings. Undercapitalized firms need to either increase invested capital or reduce riskier activities to achieve solvency and credit rating targets. In financially regulated organizations such as banks, invested capital must meet minimum regulatory requirements. Emerging regulatory standards, known as Basel II, will allow financial institutions to align regulatory capital measurement to their internal RAROC methodologies, setting the stage for further capital rationalization and re-investment opportunities.

RAROC identifies reinvestment opportunities to redeploy capital into value-creating activities (see Figure 4).

RAROC Drives Tactical Decision-Making

RAROC’s ability to measure economic profit at the lowest reporting levels within an organization enables risk-based pricing to optimize returns by product line and by individual customer transaction or deal.

RAROC measurement can be used to define compensation and incentive programs to drive value-based management decision-making to the front lines.

RAROC quantifies reduction of risk due to reinsurance, asset securitization, and other risk-transfer transactions to third parties. A more meaningful cost-benefit analysis can be performed to support risk-management decision-making.

Challenges in Implementation

Rigorous RAROC and information system infrastructures are required to successfully deliver risk-adjusted performance results.

RAROC Methodology

Failure to capture risk diversification. The sum of combined risks is less than the sum of each stand-alone risk. Rigorous RAROC solutions need to capture all relevant risks for a given business and account for risk diversification/co-relation so as not to overstate economic capital. Failure to do so makes managing by RAROC self-defeating.

Use of accounting-based loss provisions as a substitute for RAROC P&L adjustments. Accounting loss provisions may fluctuate significantly year over year, distorting true earnings measurement. RAROC applies expected loss methodology to normalize or smooth expected losses to provide accurate earnings estimate based on risk, rather than point-in-time, historical trends.

Reliance on historical top-down data vs. current instrument-level data. The use of historical data measures business performance on prior business strategies, policies, and decisions. Businesses are not rewarded for what they are doing today. Top-down data does not provide sufficient detail to support a rigorous, meaningful RAROC methodology.

Use of standard deviation vs. confidence intervals to define risk tolerances. Risk tolerances based on standard deviations distort risk measurement if the risk is not evenly distributed (e.g., credit risk) and as a result will not support consistent risk targeting. The use of confidence intervals measures risk based on an organization’s target solvency levels and is directly related to targeted credit ratings.

Implementation Issues

Implementation requires close collaboration between finance and risk management. Functional silos, incompatible priorities, and disparate system infrastructures (core business, finance, and risk-management applications) provide challenges that need to be addressed to support an enterprise-wide implementation.

One-size-fits-all solutions delivery does not meet the needs of the business. RAROC needs to be tailored to meet the unique needs of individual business units.

Lack of integrated management reporting can be an obstacle. Risks are independently measured and reported, providing the business with an incomplete picture of true risk-adjusted performance measurement.

Value-Based Management Implementation Solutions

Accenture’s value-based management solution follows an evolutionary approach to implementing new processes, technology, and organizational models to ensure a successful implementation.

Process: Redesign operational processes to integrate value-based management into planning, measuring, and managing activities.

Technology: Develop a robust data model and system infrastructure to measure RAROC-based risks, P&L adjustments, and economic capital.

Organizational structure: Introduce a new business model centered on shareholder value creation; disseminate a culture that turns executives into shareholders, transforming their strategic and tactical decision-making; and disseminate job competencies and roles/responsibilities that promote and foster successful value-based management models.

Prototype and phased implementation: Develop a high-level prototype that validates the proof of concept before significant investments are made. The use of a prototype provides a benchmark for developing tailored solutions that satisfy the independent needs of an organization’s business units.

Figure 1: Factoring Risk Into Profit and Loss Calculations With the RAROC Framework

Figure 2: RAROC brings economic reality into internal and external capital measurements.

Figure 3: Balancing Risk and Capital Optimization Through RAROC

Figure 4: RAROC identifies opportunities to redeploy capital into value-creating activities.

About the Author

Title: 

Manager, Finance & Performance Management

Accenture

Todd Warren is a manager in the Accenture Finance & Performance Management service line in the Financial Services operating group – Northeast U.S. and Canada. He specializes in developing performance measurement solutions for global financial services firms.