Capital Allocation

Traditional measures of profitability like return on assets (ROA) do not provide insight into the deposit-gathering side of the business, let alone non-fund products such as insurance sales and brokerage services. Risk-Adjusted Return on Capital (RAROC) has become the industry standard for evaluating an institution with a diverse set of services.

While the allocation of capital in a profitability model should complement a risk management and capital adequacy framework, it remains a different animal. Regulatory frameworks, such as those provided by the OCC and Federal Reserve, are primarily developed in order to measure the safety and soundness of an institution. While they are an excellent starting point, they might not fully reflect the economic value created (or destroyed).

Clients have the flexibility of performing their own risk assessment or of using guidelines developed by The Kafafian Group. We have performed a number of these assessments and can offer constructive suggestions to an institution just beginning the capital allocation process. In many cases, institutions have not previously considered allocating capital to lines of business such as deposit gathering. Given the need to evaluate business units independently, and of the very real risks associated with those activities, this becomes necessary.