Modern banking, Shareholders´ requirements in a competitive and regulation environment, Strategic bank management, Balance Scorecard management method
Back to chapterModern banking is based on the ability of the management to meet shareholders’ requirements in a competitive market environment, in compliance with all the applicable regulatory measures. This task is not easy, and it requires coordinated management of the bank. What are the typical requirements of the shareholders? How do banking regulations develop? How should a successful bank operate in modern times?
In a market environment a shareholder strives to achieve a fair return on his investment. The shareholder’s investment represents the capital of the bank, which usually consists of the originally invested money and retained earnings, or other forms of capital, such as subordinated debt. Income, measured on an annual basis in proportion to the capital of shareholders then forms the basic indicator of the profitability of a bank — return on capital (Return on Equity)
\(\displaystyle \text {ROE =} \frac {\text {NI }} { \text {E}}\)
where: ROE = Return on Equity; NI = Net Income; E = Equity
To determine what a "reasonable" return is, one can, for example, compare it to other investments. Here, however, risk also plays a significant role, as not all investments carry the same risk. As the ROE ratio does not take into account any risk, its usage received some criticism (particularly after the financial crisis in 2008/2009). Therefore, in addition to ROE, other indicators are being used to evaluate the performance of a bank, e.g. RORAC (Return on Risk Adjusted Capital)
If the management wants to take advantage of ROE, it should establish a target value, preferably based on a suitable benchmark. In the banking sector, government bonds are usually considered as relatively low-risk investments, and they can serve as a comparative basis - benchmark - for other investments. On the other hand, shareholders with a higher risk bearing capacity may consider shares of the industries in which they are active as a suitable benchmark. If, for example, the bank's shareholder is an investment fund with average earnings of 15%, it can be assumed that it will require similar income also from the investments of capital embedded in the bank.
Another possible comparative basis are the average results of the other companies on the market. This procedure is often used for counting the economic profit, known under the name of EVA (= Economic Value Added). The EVA indicator is calculated as the difference of the profit after tax and the average weighted cost of capital.
\(\displaystyle \text {EVA = NOPAT – (WACC ×TIC)}\)
where: NOPAT = Net Operating Income After Tax, WACC = Weighted Average Cost of Capital, TIC = Total Invested Capital
NOPAT and TIC is usually calculated by bank´s controlling, WACC (in %) usually determine the shareholders, for example by using specific models reflecting volatility (i.e. specific risk, e.g. beta coefficient) of the given industry (in this case banking). EVA ratio has been used in banking since the 90s of 20th century. It is built on "the principle of opportunity" and measures, whether the bank is able to generate higher returns than the costs on invested capital, i.e. if the bank is able to increase the market value of its shares.
The "appropriate" level of the indicators ROE, RORAC and EVA varies, and depends on shareholders and the type of the bank they own. More details about bank performance indicators are in the chapter „Controlling“.
The most common banks are:
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