Recently I’ve had several conversations about the allocation of capital, the establishment of price and the mechanisms used to do so by some players in the lending industry. It was interesting to learn the prioritisation and level of detail applied across companies and the differences which arise.
First off, although I find this stuff fascinating, I am not speaking as a qualified financial professional. What I do have, however, is more than 35 years’ experience with pricing and an opinion.
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Most lenders measure success in terms of a return-on-capital or return-on-equity percentage and they will have an objective to return, for instance, 10%.
That number is made of two parts: the profit and the capital over which it is expressed. I want to look at the capital part.
The Basel regulations deal with the amount of capital a business is required to hold, principally to lower the risk an organisation will be unable to weather the kind of events we have seen over the last few years.
It requires the organisation to hold an amount of capital derived by certain defined methodology against the levels of risk it is undertaking in its activities.
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By GlobalDataBut the principle measure of a business is its ability to make profits as a return on the investment placed by the shareholders – its capital. Therefore, for a given spread of risks, such as a leasing portfolio, to maintain the same return on the shareholder capital, when the capital increases because of the risk profile, so must the profit margin of the business.
In discussions, capital is used to describe several instances but principally refers to:
– Capital sitting in the balance sheet at any one time
– Capital defined for regulatory purposes such as Basel
– Capital used for the expression of the return-on-capital or rate setting processes (pricing, business plans and forecasts)
It is the latter which interests me most.
The balance sheet capital numbers will change over time as profits are made, capital increased, dividends declared or other transactions.
These things are influenced by corporate decisions and not stable for pricing or business planning. Regulation such as Basel will define capital more clearly than that, but this is not likely to be a capital level I wish to use for pricing purposes and applies only to the company as a whole. It does not provide any useable split between products, for example.
What is set in pricing models defines the expression of return-on-capital for many firms. Yes, the year-end balance sheet also shows a number, but, as the balance sheet capital can be influenced by corporate decisions, the pricing view, which tends to be reflected also in business planning, is often the yardstick.
This raises several questions. Is our hypothetical 10% to be net of tax, or pre-tax? Is our capital fixed for all products, or do we vary it by product or by customer as the principles of Basel would do? Do I have a methodology for calculating my return in order to set my pricing which reflects my capital view? How detailed does that have to be? I propose to explore these questions in next month’s article.
Ian Dewsnap is director of UK operations at BenchMark Consulting International
