Recent project work led me to have several conversations about the allocation of capital, the establishment of price (rate-setting) 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, it’s important to say, although I find this stuff fascinating, I am not speaking as a qualified financial professional. What I do have, however, is 35 years’-plus experience with pricing and a point of view.
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Most operators will 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%. But that number is made of two parts: the profit and the capital over which it is expressed. I want to look mainly at the capital part.
As most of you will know, 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 past few years, and thereby avoiding a repeat of the failures.
It requires the organisation to hold an amount of capital derived by certain defined methodologies against the levels of risk it is undertaking in its activities. But the principal measure of a business is its ability to make profits as a return on the investment placed in the business by the shareholders – its capital.
So for a given spread of risks, such as auto lending, 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.
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By GlobalDataIn 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 such as we see in the 10% example or the 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 since we said the balance sheet capital can be influenced by corporate decisions then the pricing view, which tends to be reflected also in business planning, is often the yardstick.
Going back to our 10% example, this raises several questions. Is our 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
