An Analytic Approach for a Volatile Era
The banking industry is at a difficult crossroads as it struggles to meet the risk-based capital standards that the regulators have set.
Banks must approach the difficult choices required in today's environment with the appropriate analytical framework in place. Otherwise, they risk making poor decisions.
Unfortunately, the banks' traditional analysis technique, based on calculating returns on equity using average costs, is inadequate for today's harsher, more volatile environment.
The Better Way
Net-present-value analysis is vastly superior to the ROE approach when the bank is forced to choose from two or more mutually exclusive options, such as a decision on whether to maintain or lower the interest rates it pays on money market accounts.
These decisions are difficult, because if the bank offers a lower rate, the reduction could cause customers to close their accounts. And the ROE approach does not lend itself easily to evaluating whether a higher return on equity on a smaller block of business is more favorable.
Thus, the ROE framework does not lend itself to evaluating, for example, whether it is preferable to earn 20% on $50 million of equity or 30% on $20 million of equity.
It is also difficult to use the ROE framework to evaluate whether it is preferable to earn 30% on an investment that has a six-month life or 20% on an investment that has a two-year life, if only one of the two investments can be made.
For More Complex Situations
Net-present-value analysis is vastly superior in some of the more complex situations that confront banks today, such as a decision on whether to raise or lower interest rates on a money market fund.
For example, a client bank was trying to decide recently whether to lower credited rates on a highly profitable block of money market accounts.
The bank was achieving a return on equity of about 25% on the business, and the ROE would increase to about 30% if rates were lowered 25 basis points. However, the bank's management believed that many customers would terminate their accounts if rates were lowered.
This is a classic example of the deficiency in using the ROE approach, a case where it's necessary to appraise the benefit of a greater return on a smaller piece of business.
A Case History
In this situation, the analysis focused on the change in the net present value of profits at 18% that would occur if the bank lowered credited rates. (Given the scarcity of capital in the banking industry today, the bank had concluded that the appropriate minimum return on capital, or "hurdle" rate, was 18%.)
This calculation was performed by projecting the monthly profits that would emerge from the block of business over the next two years using two scenarios:
* If credited rates remained unchanged.
* If credited rates were reduced 25 basis points.
Based on this analysis, the bank concluded that its overall return would be improved relative to the 18% hurdle rate by reducing credited rates 25 basis points on this product.
The financial people would not have been able to answer the questions of what the impact of this change would be on the bank's bottom line using a return-on-assets approach.
However, using the net-present-value approach, the bank was able to calculate a breakeven termination rate.
A More Complete Picture
Banks are only beginning to realize the importance of the financial analysis frameworks. Historically, the ROE analysis was adequate for banking in a simpler, more regulated era.
The competitive pressures faced by U.S. financial institutions are forcing rapid change in an industry not known for responding quickly to change. The institutions that fail to adapt their analytical approaches will be left behind.
Mr. Deakins is a senior consultant with Milliman & Robertson Inc., a nationwide firm of actuaries and consultants that is based in Seattle.