Introduction:
In the dynamic and complex landscape of financial services, strategic pricing of products emerges as a cornerstone for the long-term sustainability and growth of institutions. This white paper delves into the intricacies of determining the optimal pricing strategy using the Risk-Adjusted Return on Assets (RAROA) framework, a method acclaimed for its effectiveness in balancing profitability with risk management.
Central to this approach is the calculation of Return on Assets (ROA), a critical metric guiding institutions in setting prices that not only covers operational costs but also contributes to capital growth and maintenance. The paper explores the nuances of this baseline calculation for both banks and credit unions, considering unique factors like capital ratios, dividend expectations, and tax implications.
The inclusion of major risks such as Liquidity/Interest Rate Risk (LIRR) and Credit Risk in pricing strategies is a key focus. Despite its importance, LIRR has been historically overlooked by a significant number of institutions, a gap that becomes more pronounced in periods of high interest rate volatility. The paper discusses how methodologies like Funds Transfer Pricing (FTP) evolve to effectively address these challenges.
Operational costs, another crucial component, are scrutinized for their impact on pricing. The paper emphasizes the need for precise cost allocation based on employee activities, arguing that accuracy in determining these costs is crucial for the validity of the entire pricing process. The paper concludes with broader strategic considerations, underscoring the importance of centralized authority and alignment of incentives within the institution.
Determine Return on Assets (ROA):
The process begins with calculating the Return on Assets. This is an essential step to ensure that the pricing covers not only the operational costs but also generates enough return to maintain and/or grow the capital of the institution.
The Baseline: This starts with calculating the ROA needed to, at minimum, maintain the current capital ratio. That is simply the desired or current capital ratio times the institutional growth rate. The approach ensured that capital changes proportionally with assets so that it does not inadvertently decay due to poor pricing. This is the baseline for both banks and credit unions.
For Credit Unions: This baseline is the optimal ROA that directs any potential excess profits back to the membership. It keeps the credit union from overpricing or underpricing loans and deposits.
For Banks: The calculation for banks is a little more involved. They must make the same baseline calculation but add to it a provision for minimum target dividends. In addition, banks must consider taxes so that the two prior targets are on an after-tax basis.
One additional step for banks would be to divide the resulting ROA by capital. This is the basis for Risk-Adjusted Return on Capital (RAROC). It attempts to maximize the efficient use of capital. The downside is that, when applied to extremes, it decreases the margin of error if something goes wrong and thus increases risk to the institution.
Incorporation of Major Risks and Costs:
Liquidity/Interest Rate Risk (LIRR): This risk pertains to the potential loss that a financial institution might face due to changes in interest rates or issues with liquidity. Surprisingly, about 50% of institutions fail to include this risk in their pricing strategies.
For over 30 years, the most common approach to incorporating LIRR has been through Funds Transfer Pricing (FTP). Over the past 15 years the issue has faded because there was little to no interest rate volatility. Since the reappearance of highly volatile interest rates, those that have applied the FTP concept have found themselves in a much better position to manage LIRR, particularly liquidity.
Credit Risk: This is a more commonly understood risk and relates to the potential loss that might occur if borrowers fail to repay their loans. Credit risk assessment is a standard part of most financial institutions' pricing strategies.
Adding Operational Cost: The framework then requires the addition of all costs related to originating and servicing the products. This includes administrative expenses, costs related to underwriting and servicing loans, and any other operational expenses.
This is often the biggest challenge for institutions. Obtaining accurate origination and servicing costs can be a real struggle. The key to doing this is understanding what employees are doing since employees cause about 80% of all non-interest (operational) expenses. The ability to measure the time an employ spends doing specific activities leads to accurate cost assignment. Get this wrong and the entire process is highly questionable and pricing very suspect.
Product Pricing:
Loans: When all the pieces are added together, the RAROA framework helps in setting a minimum price for loans. This price should be high enough to cover the calculated ROA, the risks involved (both LIRR and credit risk), and the operational costs.
Deposits: Conversely, it helps in determining a maximum price for deposits, balancing the need to attract depositors while maintaining profitability.
Outcome - A Strategic Approach to Pricing:
The result of applying the RAROA framework is a more balanced and risk-adjusted pricing strategy. This ensures that the financial institution remains profitable while covering associated risks and costs. There are some management aspects that should be considered.
Centralized Authority: One key issue associated with this approach is that the CFO is the only entity with all the information needed to apply this concept, particularly LIRR. In addition, just like having the Chief Credit Officer not reporting to the Chief Lending Officer, the measurement of profitability should not be done by the lending or deposit groups. This is the entire reason why CFOs are separate entities, so they provide an unbiased assessment of profitability plus make sure that all risks and costs are accounted for.
Pricing Flexibility: Lending and deposit groups are free to offer prices that are either above the minimum rate for loans or below the maximum rate for deposits. They should not be allowed to go beyond these baseline parameters without the consent of executive management.
Incentives to Follow: Another good tactic is to have bonus compensation tied to obtaining the RAROA or RAROC number. This is particularly important for lending and deposit gathering people as it focuses them on creating “value” for the stakeholders and not simply chasing loan or deposit volume. If applied to the entire organization, it unites everyone in a common goal.
Summary:
This white paper explored the strategic application of the Risk-Adjusted Return on Assets (RAROA) framework in financial institutions, focusing on establishing a robust pricing strategy for products like loans and deposits. It began by highlighting the importance of calculating the Return on Assets (ROA), a crucial step for ensuring pricing covered operational costs and supported capital growth. The approach differed for banks and credit unions, with banks also considering dividends and taxes, and credit unions aiming to return excess profits to members.
The paper then delved into the integration of significant risks such as Liquidity/Interest Rate Risk (LIRR) and Credit Risk into the pricing model. It emphasized the historical oversight of LIRR in many institutions and the resurgence of its importance in periods of high interest rate volatility. Additionally, it discussed the challenge of accurately allocating operational costs, particularly those associated with employee activities, which were essential for the validity of the pricing process.
Finally, the white paper addressed the broader strategic implications of RAROA. It highlighted the necessity of centralized authority, especially the role of the CFO, in maintaining an unbiased overview of profitability, risks, and costs. The flexibility in pricing within defined parameters and the alignment of incentives, like bonus schemes tied to achieving RAROA or RAROC targets, were also discussed as vital for fostering a culture focused on creating value for stakeholders.