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The revenues include the interest margin plus fees. The operating costs allocated to a transaction or portfolios include direct costs and overheads. In addition revenues, costs and risk should relate to the same perimeter. If risk is client-based, there is a case for consolidating all revenues and costs over the client portfolios.

Revenues and Operating Costs

For credit risk, revenues include the interest margin, plus any upfront and recurring fees. The total is the overall revenue generated by a transaction. It is an AIS because it includes all revenues. The upfront fee increases the margin during the early life of the transaction. This makes the AIS higher in the early stages and lower in the later stages. To avoid such distortion, a simple solution is to calculate the average AIS over the life of the transaction to obtain an annualized AIS in value or as a percentage of exposure. For market risk, revenues are the P&L of the period.

To analyse the profitability of a given transaction, or of a product line, it is necessary to allocate costs. The minimum required return depends on which cost allocations are feasible. Revenues should contribute to absorbing direct and fixed operating costs, before obtaining the net required return on capital.

Allocating Costs and Hurdle Rate

If the hurdle rate after operating cost allocation is k% = 20%, and if the cost allocation to a transaction is 100:

Revenues > cost allocation + k% x capital = 100 + 20% x capital

The minimum return based on interest revenues and costs plus fees is higher than 25% in order to absorb the 100 operating cost. If allocating direct costs only is feasible, the minimum required rate remains above 20%, but by a lower amount. For instance, if 50, out of the 100, are direct costs, the minimum profitability should be such that:

Revenues — direct costs — fixed costs allocation > 20% x capital

Revenues — direct costs > 50 + 20% x capital

Revenues can be pre- or post-operating costs, depending on whether costs can be allocated without too much distortion because of indirect costs. The minimum benchmark of the ratio differs, to make it consistent with a post-operating cost income target. Finding this benchmark is easy since the capital base is defined. Lets assume that the capital base is

40, so that the pre-tax income is 20% x 40 = 8. Under no allocation of operating costs, it does not make sense to set the target revenues at 8 because there is still a 100 operating cost to absorb. The target revenue should be 100 + 8 = 108. If this revenue results from a 1000 loan, the required yield, or ROA%, is 108/1000 = 10.8%. Therefore, it is easy to adjust the benchmark rate as long as we know the capital base and the unallocated costs.

Client versus Transaction Revenues

Some revenues are independent of exposure or usage of individual credit lines by borrowers. They include the revenues from services and money transfers, which relate to the number of transactions for instance. This is an important consideration for risk-adjusting profitability. Relevant perimeters for calculating the risk adjustment are the client portfolio or other aggregates such as the business unit portfolios. For consistency, the same perimeter should apply to revenues.

The reason for using clients as a reference for consolidating revenues is that individual facility spreads often do not generate a RaRoC in line with target bank risk-adjusted profitability. Market spreads of large corporates do not compensate the banks risk, although that depends on country and geographic areas. In Europe, typical spreads to large and low risk corporates in the bond market are in the 10 to 20 basis point range, and substantially higher for small businesses. With such values, it is impossible to get a significant RaRoC.

For example, the market spread on a 1000 loan is 0.2%, while the required capital is 4% x 1000 = 40. The capital-based income should be 20% x 40 = 8, or 0.8% of the book value. It is much higher than the market spread over the risk-free rate, that is 0.2%. There is an implied capital in the market spread that would earn the target return. It is equal to the ratio of the given spread, 0.2% x 1000 = 2, to 20%, or 2/20% = 10. This technique allows us to tabulate, by spread level and risk class, the implied capital in market spreads and to measure the gap between the implied and the economic capital.

The example illustrates the discrepancy between market price of risk and internal price of risk. It also suggests having client-based revenues as well as transaction-based revenues for reporting purposes to make the risk-adjusted measures meaningful. The picture changes drastically when aggregating all revenues, fees and spreads, over all facilities and services to single customers. Fees increase substantially the profitability and represent an increasing fraction of revenues. Client RaRoC or client SVA probably provide a more relevant image than single facility spreads, RaRoC or SVA.