EVA and RAROC in banking performance indicators

EVA and RAROC in banking performance indicators

For an effective business strategy and to improve efficiency, many financial institutions, such as banks, use bank performance indicators. These metrics help in measuring the profitability of business units, managing the risks that come with capital allocation, and evaluating the performance of each business unit.

The increasing spread of technology and the complexity of the market are forcing many institutions to improve their work. In a competitive world, survival is the goal of many businesses, both new and progressive, while those at the top also strive to maintain their glory.

Success in a competitive environment then became a business challenge. To eventually achieve this, businesses such as banks need to measure their performance so that they can come up with solutions once the outcome of the measure appears unfavorable. Bank performance indicators can be used to assist managers in making complex decisions.

Among the performance measures used by many banks and other firms in providing financial information for decision making and evaluation are economic value added and risk-adjusted return on capital, or RAROC.

Economic value added, known simply as the shorthand version, is an estimate of an entity’s real economic profit after making corrective adjustments to generally accepted accounting principles, or GAAP accounting, including deducting the opportunity cost of equity capital. Based on estimates, the use of GAAP in corporations ignores a certain value of the opportunity cost of shareholders.

The EVA of a business can be measured by subtracting the cash cost of capital from the net operating profit after taxes. The cash cost of capital in EVA refers to the amount of money instead of the cost of capital in a proportional rate.

Stern Stewart & Co. develops its registered trademark, performance indicators with added economic value.

Meanwhile, RAROC or risk-adjusted return on capital is used to analyze a company’s risk-adjusted financial performance and provide insight into profitability. It is a risk-based framework for measuring 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 to manage risk and evaluate performance.

Risk-adjusted return on capital is used by banks and other financial institutions. As a risk management tool, RAROC is used to determine the optimal capital structure of a bank by allocating capital to individual business units.

In addition, RAROC is used as a metric of banking efficiency to allow banks to allocate capital to companies and business units as determined based on the economic value added or EVA of each unit. Using risk-adjusted capital improves banks’ capital allocation. Capital that is exposed to risk is expected to provide a return above the risk-free.

EVA and RAROC are among the banking performance indicators used by banking business units to determine profitability in an economic sense. Economic value added is used in corporate finance to define the value that is created beyond the required return. On the other hand, the risk-adjusted return on capital is determined for the allocation of capital for risk management and performance evaluation.

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