EVA® FOR BANKS: VALUE CREATION, RISK MANAGEMENT, AND PROFITABILITY MEASUREMENT

Dennis G. Uyemura, Charles C. Kantor and Justin M. Pettit

Journal of Applied Corporate Finance, 1996, vol. 9, issue 2, 94-109

Abstract: This article presents a complete ranking of America's 100 largest bank holding companies according to their shareholder value added. This research, the first of its kind for the banking industry, defines an EVA measurement for banks and presents evidence of EVA's stronger correlation with bank market values than traditional accounting measures like ROA and ROE. Besides developing EVA and MVA as analytical tools for viewing the economic performance of the organization from a shareholder perspective, the authors also present a framework for calculating EVA at all levels of the organization, including lines of business, functional departments, products, customer segments, and customer relationships. The implementation of an EVA profitability measurement system at the business unit (or lower) level requires methods for three critical tasks: (1) transfer pricing of funds; (2) allocation of indirect expenses; and (3) allocation of economic capital. Although solutions to the first two are fairly straightforward, the allocation of capital to business units is a major challenge for banks today. In contrast to the complex, “bottom‐up” approach used by a number of large banks in implementing their RAROC systems, the authors propose a greatly simplified, “top‐down” approach that requires calculation of only the volatility of a business's operating profit (or NOPAT). The advantage of using NOPAT volatility is that it allows EVA analysis at any level of the organization in a way that captures the volatility effects from all sources of risk (credit, interest rates, liquidity, or operations). While such a top‐down approach is clearly not meant to take the place of a comprehensive, bottom‐up RAROC analysis, it is intended to provide a complement–a high‐level “check” on the detailed, bottom‐up risk management procedures and controls now in place at most banks. Moreover, for those banks that have developed extensive funds transfer pricing, cost allocation, and RAROCstyle capital allocation systems, the EVA financial management system can either be integrated with those systems or serve as an independent economic assessment of the bank's business risks and returns.

Date: 1996
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