The ROE objective is relevant for the corporation as a whole. However, to make it operational, banks are setting corporate goals for profit centres, such as economic value added or economic profit.
Economic profit = (profit allocated) – (allocated equity × cost of equity) > 0
Three technical issues arise in the calculation:
Fund transfer price for deposits and loans: matched-maturity market rate. The bank must send the relevant signal to the managers collecting deposits or granting loans.
Equity allocation: regulatory capital vs. economic (risk-based) capital. As a manager, you will prefer to receive a low equity allocation, as your performance will look better. Banks are increasingly shifting away from the use of regulatory ...