Ri$k Minds 2007 Geneva, 10-14 December 2007

Market Consistent Economic Profit (MCEP)* Linking , Value and Strategy

PricewaterhouseCoopers Conor O’Dowd and Mark Young

* Please note that the basic concept in this outline and its associated algorithms are PwC intellectual property called MCEP Agenda

1. Introduction 2. The need for a better measure of Economic Profit 3. Market Consistent Economic Profit (MCEP) 4. Industry case study and benefits 5. Appendix Introduction Context • The current risk-adjusted profitability approaches available to financial institutions have limitations.

• A principal limitation (common to all) is the inability to simply allocate and reconcile risk adjusted profit across differing dimensions within a Firm.

• PwC’s Market Consistent Economic Profit (MCEP) approach overcomes this key limitation by simply expressing lower level risk adjusted profit as additive and reconcilable and maintains the benefits common to all other approaches.

Purpose • Explore the common taxonomy of risk adjusted profitability approaches, highlighting the benefits and limitations.

• Demonstrate how MCEP provides the breakthrough that brings risk adjusted profitability measures alive, providing real competitive difference.

• A case study of a residential mortgage portfolio and the insights that MCEP provides over and above other approaches.

* Please note that the basic concept in this outline and its associated algorithms are PwC intellectual property called MCEP The risk journey – a taxonomy of risk and risk culture

“Risk is a strategic enabler” “Risk is an opportunity cost”

“Risk is a cost to be reduced” “Risk must be removed; it’s Integrated view a cost” Risk-adjusted of risk and value “All risk must be removed” Risk performance Regulatory Risk measure measurement Risk measure Integrated, Risk Economic capital value-based measure recognition Risk measure Profit-at-risk Risk measure Value-at-risk Drivers Risk measure Solvency and Drivers Key internal and Earnings-at-risk resilience based NPAT, EC and external forces Drivers internally focused Drivers NPAT, costs and Culture limits Drivers NPAT, costs, Culture Risk-aware NPAT, costs regulatory Risk seen as a and compliance performance driver Goal driven Culture Risk integral part of Risk-averse and Culture Goal business practices policy Risk-averse Culture Report and control EC Risk-averse policy driven Current benchmark Goal and Goal practice Risk minimisation compliance driven Limit driven Tradition Goal al EP Primary focus is to remove all risk limits Limit driven Risk is seen as a cost to be driven down LevelLevel ofof RiskRisk AwarenessAwareness integrati MovingMoving fromfrom riskrisk aversionaversion toto valuevalue on Risk is to be optimised with profit The need for a better measure of Economic Profit Performance measures need to be linked to the investor’s (market valuation) perspective

Key issues: Risk 1. The problems with current approaches to Economic Profit .

2. The need to look at performance from a valuation perspective Capital Profit The current orthodoxy is not justified economically

Risk

1. 3. Y In proportion to C In proportion to N E risk you need V risk you need L capital O profit S

PERFORMANCE Capital Profit

2. In proportion to capital you need profit The traditional measure of Economic Profit presents a problematic situation In the traditional view, profit is charged for risk via:

Economic profit = profit minus a capital charge of risk based capital times cost of capital Key problems with this definition are: • Risk based capital and cost of capital are inter-related through gearing, so that for example as capital reduces, the cost of capital increases

• The cost of capital should vary by business unit due to mix of risk (but how?)

• Capital charges made against individual business units do not add up to the Group capital charge unless a problematic and contentious “diversification benefit” is addressed (but how?) A market-consistent valuation perspective on risk and reward

The solvency The investor perspective perspective Risk Risk-adjusted performance, Economic (risk-based) investment decision, capital view pricing and value view Resilience to all types of Reward for risk that that require capital affect value support

Capital Profit Optimisation subject to capital constraints Market Consistent Economic Profit (MCEP) PwC’s MCEP is a breakthrough concept, allowing a proper separation of value into its risk-free and risk components

Key issues: Value 1. Building blocks of MCEP

2. The theoretical break through underpinning the approach. Risk-freeRisk-free RiskRisk componentcomponent componentcomponent This leads to consideration of the properties of a sound Economic Profit measure

EP can be added together across any dimension of a Additive business to produce Group EP.

Scaleable EP can be measured at any level across a business.

EP can be related to a meaningful concept of value, Integrated for example a market consistent economic value.

EP is underpinned by a pricing framework that is Rigorous based on the market price of risk and capital. PwC’s MCEP is a breakthrough concept, allowing a proper separation of value into its risk-free and risk components

Value

Risk-freeRisk-free RiskRisk componentcomponent componentcomponent

Risk-free component is the The risk charge isolates the payoff discounted at the risk- effect of risk on investment free rate value Market Consistent Economic Profit

MCEP = less

a Risk charge Risk Charge less

a Funding charge equal to the risk-free

Funding Capital Profit rate times capital. Charge MCEP Technical Details - The concept of a stochastic discount factor…

Modern asset pricing theory is cast in terms of stochastic discount factors. These are marginal rates of substitution between consumption at the start and end of a period and they allow assets (such as a business unit) to be priced as follows: p = E (m x) *

where p is economic value of the asset

x is the payoff of the asset (a random variable),

m is the stochastic discount factor applying given the state of consumption at the time (another random variable).

* E (m x) denotes the expected value of the product of m and x.

31 MCEP Technical Details - Stochastic discount factors differentiate the price of risk

The discount factor m co-varies negatively with consumption, so that adverse payoffs when consumption is depressed are given greater weight than favourable payoffs when consumption is buoyant. Payoff x is not cyclical Payoff x is strongly (eg. ) – negatively cyclical equates to discounting (eg. ) at the risk free rate r

m

x 0 p p MCEP Technical Details – Economic Profit measures the change in the market consistent economic value of the payoff

MCEP is a fully risk-adjusted multi-period measure of economic profit. It can be discounted at the risk-free rate, unlike traditional economic profit.

MCEP = p1 / (1 + r) – p0

MCEP

m x 0 p0 p1 MCEP Technical Details - MCEP

Market Consistent Economic Profit MCEP = profit = P less the risk charge* + (1 + r ) covar (m, x) less the funding charge – p r (equal to the risk-free rate times the opening value**)

MCEP is additive: the sum of the results across all Additive business units adds to the Group result

* the covariance of m and x is typically negative ** in practice funding charges are often based on net assets MCEP Technical Details - The concept of a value driver… Value Drivers are key significant random variables on which the payoff x (in this context profit) depends. • The randomness in the value drivers are often correlated because of – particularly risks related to the economy. New Business Customer Retention • To apply the SDF to a particular asset, the Acquisition correlations of the value drivers to growth in consumption needs to be determined.

• Value Drivers can be calibrated using a simple financial model of the business eg. budgeting models

• For example, the most important random variable may be Revenue, which depends on the value drivers New Business Acquisition m and Customer Retention. x 0 p MCEP Technical Details - the PWC Risk Charge formula

PwC has developed a closed-form solution for the Risk Charge in both a single-period and multi-period setting, under the following simplifying assumptions: • Constant Relative Risk Aversion utility to specify m. • Value drivers are expressed as growth rates in the payoff x (growth in profit) • Value driver growth rates are lognormal and independently and identically distributed from period to period, and the weights (effect on profit) attaching to the value drivers are constant. • The business cash flows continue indefinitely in a multi-period setting, which is suitable for practical purposes because the calculation is re-based each year using parameters that are suitable at the time.

This formula-based approach* makes MCEP very straightforward to put into practice.

* The formula and the details of its derivation are made available on a commercial-in-confidence basis to clients who use MCEP Industry case study and benefits Drilling down on MCEP and the insights it provides to a residential mortgage portfolio.

Key issues:

55 65 75 85 95 105115125135145155165 1.Establishing the conditions for understanding Payoff Distribution Current strategy Base the benefits of MCEP. and outlook

Economic downturn, 1 with no change in strategy

2.Examining the outcomes for a residential 55 65 75 85 95 105115125135145155165 Payoff Distribution mortgage portfolio. Economic downturn 2 with change in strategy

55 65 75Payoff 85 95 Distribution 105 115 125 135 145 155 165 Establishing the conditions for realising the benefits Approach Steps required

The method requires the following steps: We illustrate the method with an example of a stand-alone mortgage business with a small set of key value drivers. Identify the key value drivers in each business unit, and the risk factors they are subject to. The specific choices of drivers and inputs in the example are illustrative but drawn from Australian banking experience. For each key value driver, forecast the: • expected total return The method can accommodate any choice of drivers and • variability of the return inputs and the example is designed to demonstrate its simplicity. • contribution to the overall return • correlations between the - driver returns - driver returns and the market return Calculate MCEP™

Value Drivers of the Mortgage Business

For the stand-alone mortgage business we focus on the value of the business at the end of a one-year investment horizon and work with the following key value drivers:

New Business Volume Funding Customer Retention Credit Quality Modelling the outcomes of different scenarios and outcomes on MCEP

Key inputs and assumptions Scenarios Outcomes

Overall conditions Current strategy Base and outlook MCEP = $1.08 Risk Free Rate 5% Economic value of the investment is 55 65 75 85 95 105115125135145155165 $100 Payoff Distribution Investment $100 Expected profit for payoff of $107.10 Zero or positive MCEP denotes Profit 107.14 - 100 = $7.14 Time horizon 1 year an appropriate level of reward less risk charge $1.06 Driver forecasts less funding charge $5.00 for time and risk

Expected Standard Weights Growth Rate Deviation Economic downturn, 1 MCEP = ($10.39) New Business Volume 1.15 0.20 0.25 with no change in strategy Economic value is $90, a loss of Expected Standard Weights Fundi ng 1.05 0.10 0.30 Growth RateDeviation $10 on the initial investment 55 65 75 85 95 105115125135145155165 New Business 1.00 0.20 0.25 Payoff Distribution Customer retention 1.10 0.10 0.30 Volume Funding 0.90 0.10 0.30

Credit Quality 0.98 0.10 0.15 Customer Need to change strategy 1.00 0.10 0.30 retention

Credit Quality 0.95 0.10 0.15 Correlations

New Customer Credit Market Business Funding retention Quality Portfolio 2 Volume Economic downturn MCEP = ($3.87) with change in strategy New Business Volume 100% 20% 0% -40% 30% Economic value is $96, an Expected Standard Weights Growth RateDeviation Funding 20% 100% 30% 30% 20% improvement of $6 compared to 55 65 75 85 95 105 115 125 135 145 155 165 New Business 0.13 0.00 0.00 Volume Payoff Distribution Customer retention 0% 30% 100% -20% -20% no change in strategy Funding 3.07 0.00 0.00 Credit Quality -40% 30% -20% 100% 60% Customer 0.00 0.00 0.00 retention Need to change operations 30% 20% -20% 60% 100% Credit Quality 0.00 0.00 0.00 Modelling the outcomes of different scenarios and outcomes on MCEP

Key inputs and assumptions Scenarios Outcomes

Overall conditions Current strategy Base and outlook MCEP = $1.08 Risk Free Rate 5% Economic value of the investment is Driver forecasts 55 65 75 85 95 105115125135145155165 $100 Payoff Distribution Investment $100 Expected profit for payoff of $107.10 Zero or positive MCEP denotes Profit 107.14 - 100 = $7.14 Time horizon 1 year an appropriate level of reward less risk charge Expected Sta$1.06ndard Driver forecasts less funding charge $5.00 Weightsfor time and risk GrowthRate Deviation Expected Standard Weights Growth Rate Deviation Economic downturn, 1 MCEP = ($10.39) New Business Volume 1.15 0.20 0.25 with no change in strategy Economic value is $90, a loss of NewBusinessVolume Expected Standard1 .15 0.20 0.25 Weights Fundi ng 1.05 0.10 0.30 Growth RateDeviation $10 on the initial investment 55 65 75 85 95 105115125135145155165 New Business 1.00 0.20 0.25 Payoff Distribution Customer retention 1.10 0.10 0.30 Volume Funding 0.90 0.10 0.30

Credit Quality 0.98 0.10 0.15 Customer Need to change strategy 1.00 0.10 0.30 Funding retention 1.05 0.10 0.30

Credit Quality 0.95 0.10 0.15 Correlations

New Customer Credit Market Business Funding CretentionustoQualitymPortfolioer retention 1.10 2 0.10 0.30 Volume Economic downturn MCEP = ($3.87) with change in strategy New Business Volume 100% 20% 0% -40% 30% Economic value is $96, an Expected Standard Weights Growth RateDeviation Funding 20% 100% 30% 30% 20% improvement of $6 compared to 55 65 75 85 95 105 115 125 135 145 155 165 New Business 0.13 0.00 0.00 Credit Quality Volume 0.98 Payoff Distribution0.10 0.15 Customer retention 0% 30% 100% -20% -20% no change in strategy Funding 3.07 0.00 0.00 Credit Quality -40% 30% -20% 100% 60% Customer 0.00 0.00 0.00 retention Need to change operations Market Portfolio 30% 20% -20% 60% 100% Credit Quality 0.00 0.00 0.00 Modelling the outcomes of different scenarios and outcomes on MCEP

Key inputs and assumptions Scenarios Outcomes

Overall conditions Current strategy Base and outlook MCEP = $1.08 Risk Free Rate 5% Economic value of the investment is 55 65 75 85 95 105115125135145155165 $100 Payoff Distribution Investment $100 Expected profit for payoff of $107.10 Zero or positive MCEP denotes Profit 107.14 - 100 = $7.14 Time horizon Current1 year strategy an appropriate level of reward less risk charge Base $1.06 Driver forecasts and outlookless funding charge $5.00 for time and risk

Expected Standard Weights Growth Rate Deviation Economic valuEconomice of thedownturn, investment 1 MCEP = ($10.39) New Business Volume 1.15 0.20 0.25 with no change in strategy Economic value is $90, a loss of Expected Standard Weights 55 65 75 85 95105115125135145155165 Fundi ng 1.05 0.10 0.30 Growth RateDeviation $10 on the initial investment is $100 55 65 75 85 95 105115125135145155165 New Business 1.00 0.20 0.25 Payoff DistributionPayoff Distribution Customer retention 1.10 0.10 0.30 Volume Expected profitFunding for payoff0.90 0.10 of 0.30 Credit Quality 0.98 0.10 0.15 Customer Need to change strategy 1.00 0.10 0.30 retention $107.10 Credit Quality 0.95 0.10 0.15 Correlations

New ProfitCustomer Credit Market 107.10 - 100 = $7.10 Business Funding retention Quality Portfolio 2 Volume Economic downturn MCEP = ($3.87) with change in strategy Economic value is $96, an New Business Volume 100% 20%less 0% -40%risk 30% charge $1.06 Expected Standard Weights Growth RateDeviation Funding 20% 100% 30% 30% 20% improvement of $6 compared to 55 65 75 85 95 105 115 125 135 145 155 165 New Business 0.13 0.00 0.00 Volume Payoff Distribution no change in strategy Customer retention 0% 30% less100% -20% funding -20% charge $5.00 Funding 3.07 0.00 0.00 Credit Quality -40% 30% -20% 100% 60% Customer 0.00 0.00 0.00 retention Need to change operations Market Portfolio 30% 20% -20% 60% 100% Credit QualityMCEP0.00 0.00 0.00 = $1.08 Modelling the outcomes of different scenarios and outcomes on MCEP

Key inputs and assumptions ScenariosScenarios Outcomes

Overall conditions CurrentCurrent strategystrategy BaseBase andandEconomic outlookoutlook downturn, MCEP = $1.08 Risk Free Rate 5% EconomicEconomic valuevalue ofof thethe investmentinvestment isis $100 1 55 65 75 85 95 105115125135145155165 $100 55 65 75 85 95 105115125135145155165 Expectedwith profit no for changepayoff of $107.10 in strategyPayoffPayoff DistributionDistribution Investment $100 Expected profit for payoff of $107.10 Zero or positive MCEP denotes ProfitProfit 107.14107.14 -- 100 = $7.14$7.14 Time horizon 1 year an appropriate level of reward lessless riskrisk chargecharge $1.06$1.06 Expected Standard for time and risk Driver forecasts lessless fundingfunding chargecharge $5.00$5.00 Weights Growth Rate Deviation Expected Standard Weights Growth Rate Deviation EconomicEconomic downturn,downturn, 11 MCEP = ($10.39) New BusinessFunding Volume stress1.15 0.20 0.25 withNewwith noBuno changesichangeness Vo inin lu strategystrategyme 1.00 0.20Economic 0.25 value is $90, a loss of ExpectedExpected StandardStandard WeightsWeights Fundi ng 1.05 0.10 0.30 GrowthGrowth Rate RateDeviationDeviation $10 on the initial investment 5555 65 65 7575 85 85 9595 105115125135145155165 105115125135145155165 NewNew Business Business Funding 1.001.00 0.20 0.20 0.250.25 0.90PayoffPayoff DistributionDistribution 0.10 0.30 Customer retention 1.10 0.10 0.30 VolumeVolume

Restricted Volumes FundingFunding 0.900.90 0.10 0.10 0.300.30

Credit Quality 0.98 0.10 0.15 CustomerCustomer Need to change strategy 1.001.00 0.10 0.10 0.300.30 Curetentionretentionstomer retention 1.00 0.10 0.30 CreditCredit Quality Quality 0.950.95 0.10 0.10 0.150.15 PoorerCorrelations Credit Quality

New Credit Quality 0.95 0.10 0.15 Customer Credit Market Business Funding retention Quality Portfolio 22 Volume EconomicEconomic downturndownturn MCEP = ($3.87) withwith changechange inin strategystrategy New Business Volume 100% 20% 0% -40% 30% Economic value is $96, an ExpectedExpected StandardStandard MCEPWeightsWeights = ($10.39) GrowthGrowth Rate RateDeviationDeviation Funding 20% 100% 30% 30% 20% improvement of $6 compared to 55 65 75 85 95 105 115 125 135 145 155 165 NewNew Business Business 55 65 75 85 95 105 115 125 135 145 155 165 0.130.13 0.00 0.00 0.000.00 VolumeVolume PayoffPayoff DistributionDistribution Customer retention 0% 30% 100% -20% -20% Economic value is $90, a loss of $10no change on the in strategy FundingFunding 3.073.07 0.00 0.00 0.000.00 Credit Quality -40% 30% -20% 100% 60% CustomerCustomer initial economic value 0.000.00 0.00 0.00 0.000.00 retentionretention Need to change operations Market Portfolio 30% 20% -20% 60% 100% CreditCredit Quality Quality 0.000.00 0.00 0.00 0.000.00 Modelling the outcomes of different scenarios and outcomes on MCEP

Key inputs and assumptions Scenarios Outcomes

Overall conditions Current strategy Base and outlook MCEP = $1.08 Risk Free Rate 5% Economic value of the investment is EconomicEconomic value of the investment downturn is $10055 65 75 85 95 105115125135145155165 $100 55 65 75 85 95 105115125135145155165 2 PaPayoffyoff DistrDistributionibution Investment $100 Expected profit for payoff of $107.10 Expectedwith profit change for payoff of $107.10in strategy Zero or positive MCEP denotes Profit 107.14 - 100 = $7.14 Time horizon 1 year Profit 107.14 - 100 = $7.14 an appropriate level of reward less risk charge $1.06 less risk charge $1.06 for time and risk Driver forecasts lessless fundingfunding charge charge $5.0$5.000 Expected Standard Expected Standard Weights Weights Growth Rate Deviation Growth Rate Deviation Economic downturn, 11 MCEP = ($10.39) New BusinessFunding Volume 1.15stress 0.20 0.25 with no change in strategy Economic value is Rest$90ricte, a dloss Volum ofe but New BusineExpectedss Vol Standardum e fund on-balance sheet Expected Standard Weights 0.97 0.20 0.25 Fundi ng 1.05 0.10 0.30 Growth RateDeviation Weights Growth RateDeviation $10 on the initial investment 55 65 75 85 95 105115125135145155165 New Business 55 65 75 85 95 105115125135145155165 New Business 1.00 0.20 0.25 Volume 1.00 0.20 0.25 PaPayoffyoff DistribuDistributiontion Customer retention 1.10 0.10 0.30 Volume Restricted Volumes Funding 0.90 0.10 0.30 FundingFunding 0.90 0.10 0.30 1.05 0.10 0.30 Credit Quality 0.98 0.10 0.15 Customer Need to change strategy Customer 1.00 0.10 0.30 retention 1.00 0.10 0.30 Segmentation to pursue retention Credit Quality 0.95 0.10 0.15 higher quality customer CuCreditstomer Quality re0.95tention 0.10 0.15 1.07 0.10 0.30 PoorerCorrelations Credit Quality

New Customer Credit Market Business Funding retention Quality Portfolio 2 Volume CrEconomicedit Qual downturnity 2 1.00 0.10 0.15MCEP = ($3.87) with change in strategy Improved credit quality New Business Volume 100% 20% 0% -40% 30% Economic value is $96, an Expected Standard Expected Standard Weights Growth RateDeviation Weights Funding 20% 100% 30% 30% 20% Growth RateDeviation improvement of $6 compared to MCEP55 65= 75 85($3.87) 95 105 115 125 135 145 155 165 New Business 55 65 75 85 95 105 115 125 135 145 155 165 New Business 0.13 0.00 0.00 Volume 0.13 0.00 0.00 Payoff Distribution no change in strategy Customer retention 0% 30% 100% -20% -20% EconomicVolume value is $96, an improvementPayoff Distribution of $6 compared to Funding 3.07 0.00 0.00 Credit Quality -40% 30% -20% 100% 60% no change in strategy Customer 0.00 0.00 0.00 retentionretention Need to change operations Market Portfolio 30% 20% -20% 60% 100% Credit Quality 0.00 0.00 0.00 MCEP is a major advance in risk-based performance measurement & valuation The benefits flow from a decision-support framework which is sound and useable:

The risk charge, funding charge and MCEP are additive across business units (or other structural dimensions), resolving the confusion and contention around Additive “diversification benefit” when making decisions about reward for risk. • Adding a new business unit does not affect the MCEP or risk charge of existing business units

MCEP is scalable - based on fundamental value drivers and the risks thereto, enabling integrated risk & reward decision-making at both group and business unit level. Scaleable

An integrated model of all significant risks is employed – whereas the traditional approach only contemplates interactions between risks as an afterthought. Integrated • Regulator and shareholder perspectives are clearly separated, but with a common analysis of risk profile.

Rigorous is underpinned by a marginal utility pricing framework that produces market consistent risk adjusted values. MCEP focuses Risk, Value and Strategy into one complete view of a business’s performance

MCEP provides an objective and straightforward approach to risk-adjusted profitability underpinned by breakthrough thinking, at its core:

• Provides management with unique insights on value creation activity and strategies Risk Based Capital Risk Adjusted Profitability • Is granular enough to retain relevance at business (Regulatory and Economic) unit level while providing desirable properties at the top-level of the Firm Risk Appetite SVA • Takes a forward-looking view of the business and Value • Is underpinned by a strong technical foundation. Risk Most importantly the measurement is not an end in itself – management of value and risk is the key Integrated Budgeting and Portfolio MCEP Forecasting Management 4 key attributes underpin the 3 views of MCEP:

can be added together across any dimension of a Additive business. Risk Limits Strategy Company TSR Scaleable can measure at any level across a business.

encapsulates all material effects of risk and Distribution model Product innovation Integrated capital of a business. Sales effectiveness is underpinned by a marginal utility pricing Rigorous framework that adapts to business structure. Key contacts

Conor O’Dowd Mark Young Partner Director +61 2 8266 2625 +61 2 8266 5747 [email protected] [email protected]