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Economic profit and performance measurement in banking

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  • Ralph C. Kimball

Abstract

Successful bank operation requires managers to weigh complex trade-offs between growth, return, and risk. In recent years banks increasingly have adopted innovative performance metrics based on the concept of economic profit, rather than accounting earnings to assist managers in making such difficult and complex decisions. Banks hope in this way to elicit better decision-making by managers and also too align managerial behavior more closely with the interests of shareholders. This article analyzes the use of economic profit for measuring the performance of banks, focusing on the allocation of equity capital to products, customers, and businesses. The author reviews the use of economic profit to evaluate performance, to price transactions, and to reward managers. He describes in detail one performance measurement and incentive system and then goes on to discuss the shortcomings of performance metrics founded on economic profit, which may distort banks' investment and operating decision-making. He concludes that banks need to recognize the ambiguities of such calculations and be prepared to create and apply multiple specialized performance measures.

Suggested Citation

  • Ralph C. Kimball, 1998. "Economic profit and performance measurement in banking," New England Economic Review, Federal Reserve Bank of Boston, issue Jul, pages 35-53.
  • Handle: RePEc:fip:fedbne:y:1998:i:jul:p:35-53
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    References listed on IDEAS

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    1. Jerold L. Zimmerman, 1997. "Eva And Divisional Performance Measurement: Capturing Synergies And Other Issues," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(2), pages 98-109.
    2. Wruck, Karen Hopper & Jensen, Michael C., 1994. "Science, specific knowledge, and total quality management," Journal of Accounting and Economics, Elsevier, vol. 18(3), pages 247-287, November.
    3. James A. Brickley & Clifford W. Smith & Jerold L. Zimmerman, 1997. "Management Fads And Organizational Architecture," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(2), pages 24-39.
    4. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
    5. Jeffrey M. Bacidore & John A. Boquist & Todd T. Milbourn & Anjan V. Thakor, 1997. "Eva And Total Quality Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(2), pages 81-89.
    6. Hannan, Timothy H & Hanweck, Gerald A, 1988. "Bank Insolvency Risk and the Market for Large Certificates of Deposit," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(2), pages 203-211, May.
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    Citations

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    Cited by:

    1. Simon Feeny, 2000. "Determinants of Profitability: An Empirical Investigation Using Australian Tax Entities," Melbourne Institute Working Paper Series wp2000n01, Melbourne Institute of Applied Economic and Social Research, The University of Melbourne.
    2. Sinha, Pankaj & Taneja, Varundeep Singh & Gothi, Vineet, 2009. "Evaluation of riskiness of Indian Banks and probability of book value insolvency," MPRA Paper 15251, University Library of Munich, Germany.
    3. Sam Hakim & Simon Neaime, 2001. "Performance and Credit Rating in Banking: A Comparative Study for Egypt and Lebanon," Working Papers 0137, Economic Research Forum, revised 12 Jun 2001.
    4. Victoria Geyfman, 2005. "Risk-adjusted performance measures at bank holding companies with section 20 subsidiaries," Working Papers 05-26, Federal Reserve Bank of Philadelphia.
    5. POPA Gabriela & MIHAILESCU Laurentiu & CARAGEA Codin, 2009. "EVA – Advanced method for performance evaluation in banks," Economia. Seria Management, Faculty of Management, Academy of Economic Studies, Bucharest, Romania, vol. 12(1 Special), pages 168-173, July.
    6. Yoram Landskroner & David Ruthenberg & David Zaken, 2005. "Diversification and Performance in Banking: The Israeli Case," Journal of Financial Services Research, Springer;Western Finance Association, vol. 27(1), pages 27-49, February.
    7. Brian Bratten & Monika Causholli & Urooj Khan, 2016. "Usefulness of fair values for predicting banks’ future earnings: evidence from other comprehensive income and its components," Review of Accounting Studies, Springer, vol. 21(1), pages 280-315, March.
    8. Andrew Worthington & Tracey West, 2000. "A Review and Synthesis of the Economic Value-Added Literature," School of Economics and Finance Discussion Papers and Working Papers Series 075, School of Economics and Finance, Queensland University of Technology.
    9. repec:rss:jnljfm:v2i3p2 is not listed on IDEAS
    10. Homburg, Carsten & Scherpereel, Peter, 2008. "How should the cost of joint risk capital be allocated for performance measurement?," European Journal of Operational Research, Elsevier, vol. 187(1), pages 208-227, May.
    11. Bystrova, Y. & Shirokova, G., 2015. "Organizational changes and firm performance: Evidence from Russian new ventures," Working Papers 6417, Graduate School of Management, St. Petersburg State University.
    12. Peter Miu & Bogie Ozdemir & Evren Cubukgil & Michael Giesinger, 2016. "Determining Hurdle Rate and Capital Allocation in Credit Portfolio Management," Journal of Financial Services Research, Springer;Western Finance Association, vol. 50(2), pages 243-273, October.
    13. repec:eee:ejores:v:261:y:2017:i:3:p:1170-1188 is not listed on IDEAS

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    Keywords

    Bank management;

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