In the second part of his analysis, Ian Dewsnap assesses rates, risks and returns.
Last month I posed some questions about the expression of return on capital in so far as business plans, forecast and pricing are concerned (Motor Finance 100, February 2013, Allocation of capital and establishing price).
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My recent project work raised several conversations on this subject and it was fascinating to hear divergent views on the topic.
Most 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. The expression pre-tax 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.
Then comes the more interesting question: the RoC calculation requires both the profits and the capital. But what capital level? In my
last article, we 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.
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By GlobalDataIf 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 are unique to these groups, such as losses, operating costs, balances and term of funding.
Maybe also the position on the ability to fund (securitisation qualification) will be different.
After all, if the organisation comes under Basel regulation then this type of difference drives 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 robustly the capital and alignment with the internal reporting of the organisation – how does this impact the expected business plan volumes?
The model itself usually sits in Excel (what doesn’t these days?) and can be as simple or as complex as the organisation wishes.
Most people take their business inputs for average amount financed, term, and so on.
Some do the same with funding rates blended by product. 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. But so far I don’t know of anyone
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? As it turns out, very. And don’t get me started on the treatment of funding costs!
Ian Dewsnap is director of UK operations at BenchMark Consulting International
