In the second of two articles, Ian Dewsnap looks at the allocation of capital and its impact on pricing
Last month I posed some questions about the expression of return on capital when it comes to business plans, forecast and pricing.
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My recent work raised several conversations on this subject and it was fascinating to hear divergent views on the topic.
Most firms will express a return on capital (RoC or equity RoE) objective. Very few will define that as a calculation requiring profits being expressed as pre- or post-tax.
There are arguments both ways. A pre-tax expression means comparisons with a true operating performance between different operating units irrespective of their tax positions and tax regimes.
Those who prefer the after-tax expression are reflecting an ability to return money to their shareholder from the operating position of the company, assuming standard rates of taxation which apply are paid. Both are valid, but not comparable.
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By GlobalDataThen comes the more interesting question. The RoC calculation requires both the profits and the capital. But what capital level?
In my last article, I established this is not going to be either the actual capital in the company at any one time, or the regulatory required capital (although it could be the latter by choice).
The capital level for this purpose is usually decided at head office or director level.
If the purpose is to have a basis for setting pricing, then assumptions need to be made. Is the level of capital to be equal across all products?
Or will it be divided to be lower for, say, wholesale, government-related leases and higher for SMEs and retail?
There is logic to this. Other variables will be unique to each of these groups such as losses, operating costs, balances and term of funding. Possibly, also, the position on the ability to fund will be different.
After all, if the organisation comes under Basel regulation then these differences drive the risk weighting and thus the capital allocation to be held – why should this not be reflected in the pricing?
These decisions all reflect in the rate which ultimately will be charged for this product to the customer.
And if all this is to be done, then it requires a methodology to allocate the capital robustly and alignment with the internal reporting of the organisation – how does this impact the expected business plan volumes?
This raises the question of allocating capital to different risk customer groups.
At a simple level, rate for risk is already in the market – subprime rates are higher than prime, for instance.
But, so far, I don’t know of anyone in the UK allocating rates for each deal depending on the risk score of each customer such as we see in the US.
We don’t yet have the wide acceptance of credit rating that exists in that market and we see this as not marketable at present. Maybe it will come one day.
Pricing and capital – how hard can it be? Turns out, very…
Ian Dewsnap is director of UK operations at BenchMark Consulting International
