Why is it so difficult to implement a good measure of Riskadjusted Performance

1
Why is it so difficult to implement a good
measure of Risk-adjusted Performance?

• Ed Bosworth
• February 2003

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Contents

• Why would you want to measure risk-adjusted
  performance?
• What makes a good measure of performance?
• Completeness
• Relevance
• Ubiquity
• Making RAPM a sustainable process

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What does it mean to measure risk-adjusted
performance in a financial institution

• Adjust accounting profit to allow for
  differential risk
• Transparent translation of shareholder
  expectations to business unit targets
• Where measurement of loss volatility hits the
  road (and the hip pocket nerve)

4
Examples of risk-adjusted performance measures

• EP / EVA
• profit minus cost of allocated capital
• RARORAC
• profit divided by allocated capital
• EP / EVA Growth
• MVA / SVA
• difference between market and book value of equity

EVA is a registered trademark of Stern Stewart
5
Why do risk managers think implementing RAPM a
good idea?

• Better comparative measurement implies better
  business decisions
• Helps avoid adverse selection in a competitive
  environment
• Exploits best practice in risk measurement
• Embeds risk management culture

Price
Simple system cannot compete on price
Risk
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Why does the Board think implementing RAPM is a
good idea?

• RAPM is sold as being value-accretive
• RAPM can be a tool for cultural change
• The link between RAPM and performance pay is
  often seen as crucial

Source Stern Stewart EVA is a registered
trademark of Stern Stewart
7
Is it any wonder that RAPM implementation is
difficult?

• Treads a fine line between complexity and panacea
• Changes the remuneration system
• Tools are often imprecise
• Context is all-important
• Carries the expectations of change agents
  throughout the firm
• What is the measure of successful implementation?
• Absence of argument?
• What does a good performance measure look like
  anyway?

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What are the characteristics of a good
performance measure?

• A measure of performance should be
• Complete (Shareholders)
• Relevant (Executive)
• Ubiquitous (Staff)
• For RAPM implementation to succeed, it must
  improve on traditional measures of performance
  (profit, sales, cost control) in all three
  dimensions
• There is a trade-off between simplicity and
  completeness / relevance
• There is a trade-off between management cost and
  ubiquity

Future RAPM
NPAT
EP
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A complete measure is a perfect reflection of
business risks

• Completeness refers to the level of comfort that
  a RAPM encompasses all risks in its measurement
  framework
• Incomplete measures may lead to imperfect
  decisions
• Traditional measures are not as complete as RAPM
  because they do not reflect the differential
  risks of different businesses
• But how many organisations include liquidity risk
  in their RAPM framework?
• How many include drivers for strategic risk?

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The quantification of strategic risk is a new
frontier for performance measurement

• Consider the assertion that outsourcing reduces
  strategic risk
• Outsourcing may protect against direct loss,
  reducing operational risk in the same way
  Securitisation reduces credit risk
• But what about indirect financial loss from
  damage to reputation or disruption to customer
  service?
• These problems are not insurmountable
• Customer satisfaction can be linked to future
  performance
• New mathematical techniques may need to be
  applied (eg, choice modelling for franchise risk)

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A relevant measure rewards staff for delivering
strategic objectives

• Relevance refers to the strength of the
  relationship between performance measurement and
  strategic direction
• Traditional measures are not as relevant as RAPM
  because they lack the risk dimension
• EP / RARORAC may not be aligned to the firms
  strategic direction
• For example, there may be EP-maximising decisions
  that the organisation is unwilling to make
• The design of a risk-adjusted performance measure
  may itself be a source of strategic risk!

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Portfolio optimisation cannot just be mathematical
Understanding the Strategic Optimum
The Strategic optimum is defined by the Board and
communicated to stakeholders (shareholders,
business units, customers) Products like KMV or
CreditMetrics help banks develop portfolio models
that determine a mathematical optimum (based on
portfolio theory). The strategic optimum will be
influenced by (although differ from) the
portfolio models mathematical optimum
Risk
Non-strategic exposures
Tenor
Exposure
Unused appetite
Industry
Geography
Demand-driven balance sheet
Strategic Optimum
(customer responsive)
(itself dynamic)
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Does relevance herald the return of Balanced
Scorecards?

• The relationship between a Balanced Scorecard and
  shareholder value is often too tenuous to allow
  management to understand the implications of
  their decisions
• A relevant RAPM should let managers choose
  between the following
• Cutting expenses by 1 million
• Spending 1 million on hedging risk
• Spending 1 million to improve customer
  satisfaction
• Balanced Scorecards may be useful in the interim

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Translating relevance from theory to practice is
not easy

• Little or no literature on key sources of
  strategic risk
• measuring the cost of customer dissatisfaction
• measuring the impact of staff turnover
• quantifying outsourcing risk
• How much of the quantification process does the
  Board need to understand?
• Operational issues arise even in areas where the
  quantification process is strong
• How do you price a risk that optimises
  mathematically but not strategically?

15
A ubiquitous measure is present and measured
consistently throughout the organisation

• Ubiquity refers to the strength of the
  relationship between a performance measure and
  business decisions
• Ubiquitous measures also support a strong
  relationship between performance measurement and
  staff incentives
• Traditional measures are normally much more
  ubiquitous than RAPM
• They are easier to understand
• Staff have a history of dealing with them, dating
  back to high school in many cases
• They are better regarded by external stakeholders

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The 4 Ps of Ubiquity
RAPM

• Primacy
• Pricing
• Project Assessment
• Planning

RAPM
RAPM
RAPM
RAPM
RAPM
RAPM
RAPM
RAPM
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Using risk-adjusted transfer pricing to make RAPM
ubiquitous

• Need to set a enterprise-wide risk appetite first
• Building a risk map of the organisation
• Credit risk in assets
• Liquidity risk in liabilities
• Market risk in cash-flows
• Operational risk in processes
• Strategic risk in new businesses?
• There is an uneasy relationship between risk
  location and management accounting

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Transfer pricing in an EWRM environment

• Extend the existing ALM transfer pricing system
  to cover all risks by linking it to the cost
  allocation process
• This implies profitable cost centres!!
• Potential for centralised balance sheet ownership
• Subject to an agreed transfer price for credit
  risk
• Requirement for better balance sheet planning
• RAPM must be linked to the planning cycle

Profit Centre 1
Allocated Costs and OpRisk Charges
Cost Centre
Profit Centre 2
Allocated Costs and OpRisk Charges
Allocated Costs and OpRisk Charges
Profit Centre 3
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Performance measurement sits between Risk
Management and Finance

• Performance Measurement is typically part of
  peoples jobs
• Potential for confusion exists when people
  responsible for measuring performance are also
  responsible for planning to make money (Finance)
  or not lose money (Risk Management)
• Centralising the performance measurement function
  allows for benefits of specialisation
• But what are the implications of centralisation
  for the rest of Finance and Risk Management?
• Does a centralised performance measurement
  function facilitate a centralised balance sheet
  management function?

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A Performance Measurement department might have
responsibility for

• Pricing models
• Value driver models
• Project assessment methodology
• Accounting policy
• Capital allocation methodology

• Dynamic provisioning methodology
• Risk quantification
• Cost of capital and internal hurdle rates
• Internal cost allocation methodology
• Balance Sheet and Capital Planning