Journal of Applied Corporate Finance

S U M M E R 1 9 9 6 V O L U M E 9. 2

EVA® for Banks: Value Creation, Risk Management,

and Profitability Measurement
by Dennis G. Uyemura, Charles C. Kantor, and Justin M. Pettit,
Stern Stewart & Co.
EVA® FOR BANKS:
VALUE CREATION,
RISK MANAGEMENT,
AND PROFITABILITY
MEASUREMENT
ne of the classic challenges of corporate
O governance has been to define and imple-
ment an unambiguous measure of per-
formance that correlates well with share-
holder wealth creation. Economic Value Added has
been broadly accepted over the past 15 years as the
measure of financial performance that is most highly
correlated with increases in market value. Industrial
companies that have incorporated EVA as the pri-
mary measure of performance and the basis for
incentive compensation have achieved noteworthy
success by aligning the interests of management and
shareholders.
EVA is an operational measure that differs from
conventional earnings measures in two ways:
It explicitly charges for the use of capital and, for
this reason, is sometimes referred to as a “residual
income” measure; and
It adjusts reported earnings to minimize account-
ing distortions and to better match the timing of
revenue and expense recognition.
While the general concepts necessary for de-
veloping a complete EVA financial management
system for industrial companies have been well
known for over ten years, it is only recently that the
methods have been formalized for financial institu-
tions in a manner that facilitates analyses down to
EVA® is a registered trademark of Stern Stewart & Co.
94
BANK OF AMERICA
JOURNAL OF
JOURNAL
APPLIEDOF
CORPORATE
by Dennis G. Uyemura,
Charles C. Kantor, and
Justin M. Pettit,
Stern Stewart & Co.
the level of individual products, account officers,
and customer relationships. It is the purpose of this
paper to provide an overview of the aspects of the
measurements and analyses necessary to use EVA at
all levels of banking organizations. While this paper
focuses on commercial banks, the principles articu-
lated here can be applied with minor modification
to finance companies, insurance companies, bro-
kerage houses, mutual funds, and other financial
services companies.
The first section of this paper discusses the
concept of shareholder wealth and summarizes the
results of Stern Stewart & Co.’s newly-released
ranking of the 100 largest bank holding companies.
The second section defines the EVA measurement as
it pertains to banks, and presents evidence of EVA’s
stronger correlation with bank market values than
traditional financial measures. The third section
discusses how the EVA concept can be applied
within the organization to specific products, organi-
zational units, or customers. It also discusses the
major components of profitability measurement:
funds transfer pricing, indirect cost allocations, and
economic capital allocations. Finally, it shows how
EVA can be used as the basis for all financial
management activities, including the design of in-
centive compensation programs.
APPLIED CORPORATE
FINANCE FINANCE
MVA: SHAREHOLDER WEALTH CREATION
IN BANKING
Bank executives, analysts, and investors have
traditionally focused on a variety of performance
measures to assess how well banks and bank
holding companies are performing for their share-
holders. Among the most popular measures are
earnings per share growth, return on equity, balance
sheet growth, market capitalization, and the effi-
ciency ratio. None of these measures, however,
provides a direct answer to the most fundamental
question about the success of the management team:
Has the value of the shareholders’ investment in-
creased? And, if so, by how much?
Maximizing shareholders’ wealth, however, is
not the same as maximizing the total market value of
a company. The reason is that market value can be
increased either by increasing the market value of
each invested dollar (which is always good for inves-
tors) or by increasing the number of dollars invested
(which can be bad for investors if the market value
of the incremental investment ends up worth less
than the original amount invested). If the goal is to
increase shareholder wealth, then the candidate
method should measure not market value per se, but
the value added to shareholders’ investment.
A measure of shareholder wealth creation that
attempts to capture this value added is called Market
Value Added, or MVA.1 It is defined as the difference
between the current market value of all capital
elements and the historic dollar amount of capital
invested in the company. That is,
MVA = Market Capital – Invested Capital
A comparison between Norwest and Chase
Manhattan (prior to its merger with Chemical Bank)
illustrates this difference. At the end of 1994, Chase
had a market value of $11.3 billion, while Norwest
had a market value of $8.4 billion. Which had
performed better for its shareholders? Without know-
ing how much capital each bank had invested to
create their respective market values, it is impossible
to tell.
Our MVA analysis revealed that Norwest had
invested only $5.4 billion of investors’ capital to
achieve a value of $8.4 billion, whereas Chase had
1. See Irwin Ross, “The Stern Stewart Perfomance 1,000,” Journal of Applied
Corporate Finance, Vol. 8 No. 4 (Winter 1996).
95
VOLUME 9 NUMBER 2
invested $13.4 billion in creating an operation val-
ued at $11.3 billion. Thus, Norwest had created $3.0
billion of MVA ($8.4 – $5.4) while Chase had
destroyed $2.1 billion ($11.3 – $13.4) of shareholder
value.
When managers succeed in widening the spread
between the market value of capital and the amount
of capital invested, they increase the wealth of their
shareholders. Indeed, MVA is synonymous with the
Net Present Value (NPV) of the firm. By increasing
MVA, managers are in fact increasing the NPV of
forecasted cash flows for their shareholders. That is,
they are realizing returns in excess of the cost of the
capital being invested.
Stern Stewart has calculated the MVA of a
sample of the largest 100 bank holding companies
(in total assets as of December 31, 1995) and has
ranked them according to both MVA and MVA as a
percentage of capital. This is the first MVA ranking
for the banking industry.
As of the end of 1995, Citibank was first in the
industry in shareholder wealth creation. It had
generated $8.6 billion in MVA, a vast improvement
from its 1994 MVA of –$349 million, which had
placed them a lowly 92nd among the 100 largest
banks. Norwest finished second with MVA of $6.3
billion, followed by NationsBank $6.3bn, First Inter-
state $6.1bn and Wells Fargo $5.7bn. (The complete
rankings are presented in the Appendices.)
In reviewing the MVA rankings, larger compa-
nies may expect to rank higher in a dollar-based
ranking (such as we present in Appendix I). There
are two ways to “normalize” the ranking for size. One
is to compare the dollar MVA rank with the company
asset size rank. Citicorp is first both in MVA and in
asset size. In this sense, its performance may not be
extraordinary. In contrast, among the top 10 in MVA
rank, Norwest, First Interstate, Wells Fargo, Wachovia,
and Mellon all have asset positions significantly
smaller than their MVA ranks. That is, for their size,
these banks have created unusually large share-
holder values added.
Another way to normalize for size is to rank
banks according to MVA as a percent of capital,
which we call “standardized MVA” (see Appendix
II). A bank’s standardized MVA is analogous to its
market-to-book ratio. As such, it is not directly
proportional to wealth creation; nor is maximizing
SUMMER 1996
standardized MVA a wealth-maximizing corporate
objective. That is, a bank can improve its standard-
ized MVA by making decisions that reduce its dollar
MVA—for example, by forgoing positive-NPV growth
opportunities that will reduce its average rate of
return. Maximizing wealth creation requires balanc-
ing high returns per dollar of capital with deploying
as much capital as can be expected to provide
returns in excess of the cost of capital, such that the
product of these two factors (MVA in dollar terms)
is maximized. (We will return to this critical point in
the next section.)
Especially noteworthy are those banks that are
in the top quintile in both MVA rankings. They are
Fifth Third, First Bank System, First Interstate, Norwest,
THE WINNERS PURSUE DIFFERENT STRATEGIES
..............................................
THE HIGHLY RATED BANKS ACHIEVED THEIR ENVI-
able status by applying very different strategies. A
close examination reveals that the stock market recog-
nizes that there is more than one winning formula.
Citicorp, the top MVA performer, is building a brand
name recognized by consumers worldwide. They are
making their presence felt particularly in the emerging
markets of Latin America, Eastern Europe, and the
Middle East. Citibank is reaching its retail customers
through a global network of branches. In the more
developed markets of North America, Europe, and
Japan, Citibank offers its corporate customers, with
their international brand names and franchises, a
world-wide banking reach.
Wells Fargo provides a full range of consumer
banking on the West Coast and is achieving strong
growth in fee-based income from personal trust ac-
counts and mutual funds. The bank’s reputation for
effectively managing capital through aggressive share
repurchases and ability to generate savings through
speedy integration of acquisitions is highly valued by
the market. Wells is focused on cash earnings and not
traditional reported earnings as its primary measure of
financial performance—a focus that was reflected in its
decision to use the “purchase” method for the acqui-
sition of First Interstate.2 Although the amortization of
goodwill from this transaction (approximately $6.4
billion)3 will reduce reported earnings going forward
2. Wells Fargo 1995 Annual Report, Letter to the Shareholders. See also in this
issue Joel Houston and Michael Ryngaert, “The Value Added by Bank Mergers:
Lessons From Wells Fargo’s Acquisition of First Interstate.”
96
JOURNAL OF APPLIED CORPORATE FINANCE
and Wells Fargo. These organizations rank at the top
of the industry in both capital deployed and MVA
generated per dollar of capital. Two companies
deserve special congratulations. Fifth Third and
Norwest have ranked in the top quintile in both
rankings every year from 1990 through 1995.
THE CASE FOR EVA AS A PERFORMANCE
MEASURE
While MVA is the ultimate measure of share-
holder wealth creation, it is not practical as an
internal performance measure for several reasons:
Operating units do not usually have share prices
or market-determined valuations;
(by $300-$400 million a year), it will not affect Wells’s
operating cash flow, thus leaving the future MVA of the
company unaffected.
Norwest has been the most consistent MVA creator
among the largest 25 banks. This performance builds
market credibility and reputation. Norwest has a
somewhat unique philosophy in its declared belief
that banking is like retailing. Its branches are called
“stores” and are viewed as sales centers with explicit
goals for customer retention and cross-selling. (While
the banking industry on average sells 2.7 products per
customer, Norwest sells each customer 3.8 products.)4
Besides being the largest mortgage originator and
servicer in the country, Norwest also concentrates on
retail and small business clients, leaving large corpo-
rate relationships to the money centers.
NationsBank, sometimes referred to as the U.S.
universal bank, generates interest and fee income
through comprehensive corporate banking, corporate
finance, and investment banking services. Over the
past three years, NationsBank has diversified away
from commercial banking operations into consumer
finance, merchant banking, and trading operations.
The market is expecting the bank’s corporate finance
group to achieve growth through its dealings in
government securities and foreign exchange. Growth
in brokerage income is also expected from its exten-
sive branch network.
3. Wells Fargo 1995 Annual Report.
4. Charles B. Wendel, The New Financiers.
 Traditional performance measures (net income, ROA, ROE, and earnings per share)
do not properly reflect risk and therefore reinforce behavior that is either too
aggressive (that is, aims to maximize earnings) or too conservative (aims to prevent
dilution of returns).
Not all companies are publicly traded; and
Market values are subject to significant market
volatility that may be unrelated to the operating
decisions of management.
If MVA is not appropriate, then the question
remains: Which operational performance measure
should banks select? The following criteria should be
considered:
It should show a strong correlation with changes
in MVA;
It should be robust enough to be used for all
financial management activities;
It should be measurable at all levels of the organi-
zation, and in all dimensions—line of business,
functional department, product, and customer;
It should be practical and effective as the basis for
a value-based incentive compensation program.
The candidates that will be considered are:
1. Net income
2. Earnings per share
3. Return on assets
4. Return on equity
5. Economic Value Added (EVA)
The first four are traditional performance measures.
The last has been well-developed for industrial
companies, but has only recently been applied to
financial institutions. It will be described in the next
section.
EVA Defined
Economic Value Added (EVA) is a measure of
a firm’s profit after subtracting the cost of all capital
employed.5 It is defined as the current-period,
after-tax economic earnings net of a charge for the
use of capital. It can be developed in formulas as
follows:
EVA = (Return on Capital – Cost of Capital) * Capital
= (Capital * Return on Capital – Capital * Cost of Capital)
= NOPAT – (Capital * Cost of Capital)
= NOPAT – Capital Charge
where NOPAT represents “net operating profits,
after-tax” and the “capital charge” is the amount of
capital multiplied by the cost of capital. EVA differs
from conventional earnings in two important ways:
5. See Bennett Stewart, The Quest for Value (HarperCollins, 1992).
6. Adapted from D. Uyemura and D. van Deventer, Financial Risk Manage-
ment in Banking (Irwin, 1993).
97
VOLUME 9 NUMBER 2
1. NOPAT reflects operational profits adjusted to
minimize accounting conventions that misrepre-
sent economic flows (for example, misclassifications
of capital investments as operating expenses), or
that distort the proper matching of revenues and
expenses.
2. EVA assumes that management must generate
sufficient revenues not only to cover operating
expenses and the interest charges on debt, but also
to provide the return that shareholders require to
compensate them for the riskiness of their equity
investment in the company. Hence, a charge for all
debt and equity is subtracted from NOPAT.
While not permitted under GAAP accounting,
charging for the use of capital ensures that manage-
ment is at all times conscious of its obligation to
shareholders. It also provides an explicit mechanism
to formalize and quantify the overall risk structure of
the business, both in the amount of capital allocated
(which reflects the volatility, or “total risk,” of the
business) and in the cost of capital (which is based
on “systematic risk,” or the correlation of returns with
the market).
EVA versus Traditional Measures of
Performance
Using EVA as a measure of economic perfor-
mance can lead to management decisions that are
fundamentally different from those based on tradi-
tional measures. To illustrate this, consider the
following situation.6
A lending unit of a bank has six new loan
opportunities. All loans will have a one-year term. All
will have balances outstanding of $1 million, and all
have identical overall risk characteristics such that
they all receive the same capital allocations. Each of
the six loans, however, has a different profitability
estimate. A summary of each of the six incremental
opportunities with their expected profitability esti-
mates is summarized in Table 1.
The net income values shown in Table 1 are
assumed to be fully burdened in the sense that they
are net of funds transfer pricing (including an
earnings credit on allocated capital) and indirect
expense allocations. For simplicity, NOPAT is as-
sumed to be equal to net income. ROA and ROE are
SUMMER 1996
TABLE 1 Loan Opportunities: #1 #2 #3 #4 #5 #6
INCREMENTAL LOAN
OPPORTUNITIES* Balance 1,000 1,000 1,000 1,000 1,000 1,000
Capital Allocation 50 50 50 50 50 50
Net Income/NOPAT 40 20 10 5.0 2.0 1.0
Return on Assets (ROA) 4.0% 2.0% 1.0% 0.5% 0.2% 0.1%
Return on Equity (ROE) 80% 40% 20% 10% 4% 2%
Capital Charge (12%) 6.0 6.0 6.0 6.0 6.0 6.0
EVA 34 14 4.0 (1.0) (4.0) (5.0)

*All dollar values in thousands.

TABLE 2 # of Loans Accepted: 1 2 3 4 5 6

CASE STUDY PORTFOLIO
RESULTS Balance 1,000 2,000 3,000 4,000 5,000 6,000
Capital Allocation 50 100 150 200 250 300
Net Income/NOPAT 40 60 70 75 77 78
Return on Assets (ROA) 4.0% 3.0% 2.3% 1.9% 1.5% 1.3%
Return on Equity (ROE) 80% 60% 47% 38% 31% 26%
Capital Charge (12%) 6.0 12 18 24 30 36
EVA 34 48 52 51 47 42

defined as net income divided by assets and equity,
respectively. EVA is NOPAT less the capital charge
of $6,000, which is the $50,000 capital allocation
multiplied by the assumed cost of equity of 12%.
The pivotal question is: How many loans should
the lending unit accept? An ancillary question is:
Which of the four performance measures best cor-
relates with shareholder value creation?
Before proceeding, it is necessary to recast the
incremental financials shown in Table 1 into portfo-
lios of loans based on the number of loans ac-
cepted. This is essential because performance as-
sessment is virtually never conducted on a loan-by-
loan basis, but rather on portfolios of loans. The
results from grouping the loans into portfolios are
shown in Table 2.
Notice that if two loans were accepted, we
assume that incremental opportunities #1 and #2,
being the most profitable, would be selected. The
resulting portfolio would show $2 million in
outstandings, have $100,000 in allocated capital, and
$60,000 in expected net income.
In considering performance measurement, it is
portfolio results, not the profitability of incremental
transactions, that is the deciding factor. Once again,
the question is raised: How many loans should the
lending unit accept? The rational answer to this
question is not trite: The number of loans that should
be accepted is a direct function of the incentive
compensation goal of the lending unit.
For example, if the unit is evaluated and bo-
nuses are based on its earnings performance, then it
is perfectly rational for the unit to accept all six loans
to maximize its prospective earnings and bonuses. In
contrast, if it is evaluated on its ROA or ROE, it will
stop after accepting only the first loan. To accept any
more would “dilute” the high return of the best loan.
Neither result maximizes shareholder value
creation. Recall from Table 1 that loans #1, #2, and
#3 all provide returns in excess of the cost of capital
(12%). Therefore, the value-maximizing decision is
to accept the first three loans and reject the rest. The
only performance measure that is consistent with
value maximization is EVA maximization. That is, if
the lending unit were evaluated on its EVA, the unit
would indeed accept the first three loans and reject
the last three.
Traditional performance measures (net income,
ROA, ROE, and earnings per share) do not properly
reflect risk and therefore reinforce behavior that is
either too aggressive (that is, aims to maximize
earnings) or too conservative (aims to prevent
dilution of returns). While the incremental ROE of
each individual loan can be used as a clear economic

98
JOURNAL OF APPLIED CORPORATE FINANCE
 Among all of the performance measures, EVA has the strongest correlation
with MVA.

FIGURE 1
CORRELATIONS OF
VARIOUS PERFORMANCE
MEASURES WITH MVA

TABLE 3 Variable R squared alpha beta Std Error

RESULTS OF REGRESSING
MVA AGAINST VARIOUS EVA 40% 186 3.40 757
PERFORMANCE MEASURES (26) (0.14)
FOR TOP 100 BANK
HOLDING COMPANIES (AS Return on Assets 13% –435 62,018 912
OF DEC. 31, 1995) DURING (59) (5,429)
YEARS 1986 - 1995
Return on Equity 10% –309 3,581 928
(56) (367)
Net Income 8% 19 0.75 938
(35) (0.09)
Earnings per Share 6% –79 76 950
(45) (11)

signal for decision-making as well as the EVA, it is not
realistic to expect that the incremental ROE for each
loan can be calculated and used for ex post perfor-
mance measurement.
Most important, the portfolio ROE results shown
in Table 2 bear no direct relationship to value
creation or the cost of capital “hurdle rate.” Notice
that the portfolio ROEs for the various numbers of
loans range from a high of 80% down to 26%, all of
which are well above the hurdle rate of 12%.
Furthermore, it is not possible to know which of the
values correlates with value maximization. In par-
ticular, it appears perverse that a 47% ROE is
“superior” (in a value creation sense) to the 80% ROE
of the first loan.
The conclusion is that no “return” or “ratio”
measure can accurately assess shareholder value
creation for a portfolio of activities. Ratios and
returns indicate only average profitability. The ad-
vantage of EVA is that it is dollar-based. As such,
wealth maximization correlates with EVA maximiza-
tion. Any negative EVA transaction on the margin
will lower both the incremental and the overall
portfolio EVAs. It can therefore serve as a clear and
accurate beacon to all, both on the margin and for
a portfolio, to guide decision-making and perfor-
mance evaluation toward the common goal of
shareholder wealth maximization.
Statistical Correlation between EVA and MVA
The case study example suggests that the per-
formance measure that best correlates with share-
holder wealth maximization is EVA. To test this
hypothesis, the performance results for the largest
100 bank holding companies (as of December 31,
1995) were analyzed for the ten-year period 1986
through 1995. The statistical correlations between
MVA and a variety of performance measures were
evaluated. The results are summarized in Figure 1
and Table 3.
Among all of the performance measures, EVA
has the strongest correlation with MVA. The results
shown here relate to MVA as a dollar measure. An
alternative approach involves regressing changes in
the various performance measures against stan-
dardized MVA. The results of this analysis are
summarized in Figure 2 and Table 4.

99
VOLUME 9 NUMBER 2 SUMMER 1996
FIGURE 2
CORRELATIONS OF
VARIOUS PERFORMANCE
MEASURES WITH CHANGES
IN MVA

TABLE 4 Variable R squared alpha beta Std Error

RESULTS OF REGRESSING
CHANGES IN Standardized EVA 40% 0.09 3.58 0.31
STANDARDIZED MVA (0.02) (0.22)
AGAINST VARIOUS
PERFORMANCE MEASURES Return on Assets 25% 0.09 26.06 0.34
FOR TOP 100 BANK (0.02) (2.27)
HOLDING COMPANIES (AS
OF DEC. 31, 1995) DURING Return on Equity 21% 0.13 1.42 0.35
YEARS 1986 - 1995 (0.02) (0.14)
Net Income ($Bn) 3% 0.14 0.15 0.39
(0.02) (0.05)
Earnings per Share 6% 0.14 0.024 0.38
(0.02) (0.005)

In this analysis, the changes in standardized
MVA were calculated for every five-year interval
during 1986 through 1995. These changes were
regressed against the five-year changes in standard-
ized EVA (defined as EVA divided by capital) and the
other listed performance measures. Once again, EVA
provides the strongest correlation with MVA.
This conclusion was also reached in a similar
analysis of the Stern Stewart 1000 sample of industrial
companies. Therefore, the empirical data strongly
support the concept that EVA provides the best
operational performance measure.
Figure 3 shows the aggregate MVA, EVA, and
net income for the largest 100 bank holding com-
panies from 1986 through 1995. Notice that the
profile for the aggregate MVA correlates better with
the EVA pattern than with the net income profile.
In particular, the deteriorating trend from 1986
through 1991 is reflected in both the MVA and EVA
lines. Then, from 1991 through 1995, there was a
pattern of significant improvement in both, with
the exception of 1994 when a sharp increase in
interest rates depressed the performance of this
group of banks.
Figure 4 shows the aggregate standardized
MVA, standardized EVA, and aggregate ROE for
the same group of banks. (The aggregate ROA
profile is similar to that shown for ROE.) Here
again, there is a much stronger correspondence
between the MVA and EVA lines. As reflected in
the ROE measure, the volatility in large bank earn-
ings due to the large LDC provisions taken in 1987
is apparent. In 1988, there was a “rebound” as
provisions were significantly lower. The striking
changes in earnings and ROEs reported in 1987
and 1988 were virtually ignored by the market-
place (as judged by the MVA line). This provides
empirical evidence that markets are less concerned
about provision levels (and, hence, current earn-
ings) than other factors that are reflected in EVA.
This point will be discussed further in the next
section.
EVA Measurement for Commercial Banks
This section will present the concepts neces-
sary to calculate EVA for consolidated banks. A
subsequent section will consider the issues related

100
JOURNAL OF APPLIED CORPORATE FINANCE
 Loan loss provisions tend to “smooth” earnings in a manner that is
counterproductive for economic performance measurement. For internal
performance evaluation, risks should be recognized on a “real time” basis, not on a
subjective, anticipated basis.

FIGURE 3
AGGREGATE MVA, EVA,
AND NET INCOME FOR
THE 100 LARGEST
BANKING COMPANIES,
1986 THROUGH 1995
(BILLIONS OF DOLLARS)

FIGURE 4
AGGREGATE
STANDARDIZED MVA,
STANDARDIZED EVA, AND
ROE FOR THE 100 LARGEST
BANKING COMPANIES,
1986 THROUGH 1995

to undertaking the EVA measurement for lines of
businesses, products, and customer relationships.
To calculate EVA, it is necessary to determine
NOPAT and the capital charge. NOPAT, or net op-
erating profits after-tax, represents the operational
profits of the company restated in such a way that
conventional accounting profit (“net income”) is
adjusted to better reflect the current economics of the
business.
To date, over 160 potential accounting adjust-
ments have been identified and catalogued.7 For any
single company, however, it is rare to make more
than 10 adjustments of GAAP accounting. The filter
criteria applied to determine the necessary adjust-
ments are as follows:
Materiality: The adjustment should be significant
enough to be material to performance measurement.
Effect on behavior: It should drive value increasing
behavior. It should not cause distortions or promote
manipulation.
Ease of understanding: It should be clearly under-
stood by management.
Data availability: The data needed to make the
adjustment should be accessible and available for
reporting.
There are four major adjustments that are com-
mon in customizing EVA for banks:
1. Loan loss provision;
2. Taxes;
3. Non-recurring events (such as restructuring
charges); and
4. Securities accounting.
We discuss each below.
Loan Loss Provision and Loan Loss Reserve.
The single largest adjustment for most banks relates
to the loan loss provision and loan loss reserve. In
theory, the loan loss reserve should be sufficient to
absorb the present value of all future loan losses. In
any single reporting period, net chargeoffs reduce
the reserve and the loan loss provision replenishes
it. The provision should include any adjustments to
the loss estimates for pre-existing loans, as well as an
estimate of the future loan losses related to newly
originated loans.

7. See The Quest for Value, cited earlier.

101
VOLUME 9 NUMBER 2 SUMMER 1996
 While this convention is certainly conservative,
it distorts performance measurement. In essence, all
loan losses must be “pre-funded” out of current
earnings. While diligent monitoring of loan loss
exposures is laudable from a management perspec-
tive, the result is that provisions are often “opportu-
nistic”—larger than necessary when the bank has
strong operating earnings, and smaller when earn-
ings are “under pressure.” That is, provisions tend to
“smooth” earnings in a manner that is counterpro-
ductive for economic performance measurement. In
reality, economic performance is risky. Risk mani-
fests itself as volatility in economic profits, i.e.,
NOPAT. At least for purposes of internal perfor-
mance evaluation, risks should be recognized on a
“real time” basis, not on a subjective, anticipated
basis. Therefore, a bank’s measure of operating
profits, NOPAT, should not include loan loss provi-
sions, but instead should contain net chargeoffs as
the current period estimate of losses due to credit
risk. (As will be discussed in a later section, the
volatility patterns associated with risk-taking provide
critical information in allocating capital and estimat-
ing the cost of capital.)
Does this adjustment imply that the loan loss
provision and reserve should be ignored altogether?
No. The loss reserve (on an after-tax basis) repre-
sents an estimate of the present value of expected
future loan losses. As such, it should be viewed as
a component of the economic capital of the com-
pany. Economic capital, or “risk capital” as it will
be described in a subsequent section, is composed
of estimates of “expected” and “unexpected” loss
exposures.
The loan loss reserve should not be included in
capital on a pre-tax basis. The reason is that the loan
loss provision is not an allowable expense for tax
purposes, and therefore does not shelter the com-
pany from taxes. Therefore, the reserve should be
included in capital net of its corresponding deferred
tax debit.
Taxes. Most corporations show characteristic
and persistent differences between their “book tax
provisions” and their cash tax payments that give rise
to deferred tax balances. Banks are no exception. To
the extent that such differences are quasi-permanent
for going concerns, deferred taxes should be consid-
ered a permanent funding source, i.e., capital.
This treatment is quite analogous to the discus-
sion of the loan loss provision and reserve. In
calculating NOPAT, exclude the book tax provision
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JOURNAL OF APPLIED CORPORATE FINANCE
and include cash operating taxes. For capital, in-
clude any net deferred tax credits. (Net deferred tax
debits would reduce the capital accounts.)
Non-recurring Events. Non-recurring events
must be considered on a case-by-case basis. A com-
mon non-recurring event in banking in recent years
is the restructuring charge. To the extent that such a
charge represents a disinvestment, the charge should
not be considered a reduction of operating profits,
but as an adjustment to capital. Again, this adjust-
ment should be conducted on an after-tax basis.
Securities Accounting. The accounting for in-
vestment securities has been changed such that “avail-
able for sale” securities are marked-to-market through
the capital accounts. Such adjustments have little or
no economic meaning if the liabilities funding the
securities are not also marked to market. That is, the
balance sheet may contain natural hedges through
matched-maturity funding that would make such
adjustments irrelevant, if not misleading. Also, under
MVA and EVA, it is conventional to treat capital on
a historic basis, not on a current market basis. The
rationale is that it would be impractical to attempt to
adjust all activities to their current market value. This
would add unwarranted volatility to the EVA calcu-
lation and negate its effectiveness as the basis for risk
assessment or incentive compensation programs.
Therefore, any adjustments conducted under FAS
115 are removed from all EVA calculations.
Securities gains and losses have historically been
viewed skeptically as an earnings management de-
vice. From an economic perspective, selling an “un-
der-water” security (i.e., a security with a coupon
below the current market yield) and using the pro-
ceeds to replace it with a current market yield secu-
rity is a zero-NPV transaction (before taxes). Hence,
securities transactions should not be rewarded or
penalized. Presumably, they occur as a natural con-
sequence of bank investment, liquidity, and interest
rate risk management activities. To remove the ef-
fects of gains and losses, such amounts should be
excluded from NOPAT when incurred, but amor-
tized against NOPAT over the remaining lives of the
securities that were sold. In this way, EVA is unaf-
fected by the decision to hold or sell the security.
The Definition of Capital. Capital for consoli-
dated banks can now be summarized from the
various adjustments discussed above for NOPAT.
Briefly, capital is composed of:
Shareholders’ equity, excluding FAS 115 adjustments;
Loan loss reserves (net of deferred tax debits);
 EVA is normally applied as a “top-down” process. This means that all analysis begins
at the highest level of the organization and is “drilled-down” to lower levels only as
warranted by the need and benefit of such additional detail.
Other net deferred tax credits;
Non-recurring events, such as restructuring charges
(after taxes); and,
Unamortized securities gains and losses (after
taxes).
Notice that whenever an item is removed from
earnings, such as the loan loss provision, it is
included in capital. This ensures that if an item is not
considered a component of current operations, it
will be capitalized and will be assessed a capital
charge. In this way, the net present value of any
activity is not changed due to whatever final battery
of accounting adjustments is necessary.
THE EVA FINANCIAL MANAGEMENT SYSTEM
FOR BANKS
The previous discussion has focused on the
application of EVA and MVA to consolidated bank
holding companies. While this is important for an
overall assessment of the economic performance of
an organization from a shareholder perspective, the
use of EVA for the financial management of banks
and other financial institutions requires dealing with
more detailed levels of risk assessment and profit-
ability measurement. This section and those that
follow will discuss how EVA can be used to “drill-
down” to lower levels of the organization to deter-
mine the performance characteristics and “EVA
drivers” of specific activities. The advantage of such
a “top-down” process is that it can provide manage-
ment and the Board of Directors with valuable
comparative risk-and-return metrics for each of the
major lines of businesses, product lines, and cus-
tomer segments within the consolidated company.
The EVA Financial Management System encom-
passes the calculation and use of EVA for all aspects
of financial measurement and decision-making at all
levels of the organization. These activities include,
but are not limited to, budgeting, strategic planning,
product pricing, financial reporting, internal and
external communications, and acquisition pricing. It
also entails calculating EVA at various hierarchical
levels and in various dimensions, including lines of
businesses, functional departments, products, cus-
tomer segments, and customer relationships.
Such detail allows management to discern which
businesses, products, and customer relationships
are creating value and which are not. Once under-
performing units, products, or relationships are
identified, it is then possible to formulate a plan to
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VOLUME 9 NUMBER 2
correct the situation. Management can consider
such options as:
Improving the profitability of the activity through
repricing or resetting terms and conditions;
Growing the activity, perhaps via more aggressive
pricing, to realize improved economies of scale or
cost efficiencies; or
Shrinking the activity to redeploy the capital to
superior opportunities, even if that includes return-
ing the capital to shareholders.
Moreover, it is possible to discern which aspects
of each detailed activity are most important in the
EVA outcome of the analysis. This type of analysis is
referred to as an “EVA drivers” analysis in that it
identifies the specific aspects and parameters of any
product or service that are key to realizing a sustain-
able, positive EVA.
EVA and Profitability Measurement
Such comprehensive profitability measurement
may appear to be a daunting undertaking. But that
need not be the case, especially when three prin-
ciples are observed:
The 80/20 Rule is the empirical observation that
one can obtain 80% of the information sought by
analyzing the most significant 20% of the data. For
example, it is often observed that about 80% of the
profitability dynamics of a portfolio can usually be
explained by analyzing the largest 20% of all ac-
counts. For most situations, such a degree of under-
standing is more than sufficient.
EVA is normally applied as a “top-down” process.
This means that all analysis begins at the highest level
of the organization and is “drilled-down” to lower
levels only as warranted by the need and benefit of
such additional detail. The major advantages of this
and the 80/20 Rule are that analyses can be con-
ducted on entire product categories or portfolios
rather than on individual accounts.
Line managers should be held accountable only
for the risk-types they are allowed and expected to
manage. For example, lending unit managers are
responsible for credit risk and loan pricing, but are
not in control of interest rate or liquidity risk
management. Hence, their EVA should be affected
by credit risk dynamics, but should not be subjected
to interest rate movements. This accountability con-
cept simplifies the EVA analysis of the major line
units by limiting the risk dimensions and cost
allocation types that should be undertaken.
SUMMER 1996
 With these principles, the cost and feasibility of
EVA profitability analysis become quite tractable.
The major components of EVA profitability
measurement are:
Funds Transfer Pricing (FTP)
Indirect Expense Allocations (or Cost Accounting)
Economic Capital Allocations.
Funds Transfer Pricing. Funds transfer pric-
ing is a procedure that creates a matched-maturity
cost of funds for all loans and investments and an
appropriate matched-maturity earnings credit for
all funding sources, such as deposits and borrow-
ings. In this way, the net interest margins calcu-
lated for all line units are only minimally exposed
to unexpected shifts in market interest rates or to
changes in the price of liquidity. Again, line
managers should not be held accountable for
interest rate risk if they are not empowered or
expected to manage that risk.
When undertaken, funds transfer pricing is
often conducted at an account level of detail. That is,
each loan account is transfer-priced individually, as
is each deposit account. This necessarily involves
building extremely large and costly FTP systems. In
the experience of the authors, such detailed and
costly systems are rarely needed for management
purposes. It is usually more than sufficient to transfer
price product portfolios using regression techniques
rather than account-by-account analyses. Such tech-
niques can easily be conducted in spreadsheets on
a single personal computer, rather than in much
larger “data warehouse”-type systems. In dealing
with portfolios rather than accounts, the amount of
analysis required can be lowered by three to six
orders of magnitude!
A proper funds transfer pricing system will
“sweep” all of the balance sheet repricing mis-
matches into a central “ALCO” (Asset and Liability
Committee) or Treasury unit. (The proper approach
to calculating the EVA of the Treasury unit will be
discussed in a later section.) As an illustration,
consider a simple bank that has two line units: a
lending unit and a branch unit. The lending unit
makes a single one-year, fixed rate $1 million loan
yielding 7%. The branch unit issues a $1 million
three-month CD costing 4%. The bank in consoli-
dation has a net interest margin of 3%. How should
this margin be apportioned between the two line
units?
The starting situation may be illustrated using a
“T”-account format as follows:
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JOURNAL OF APPLIED CORPORATE FINANCE
Lending Unit:
$1MM Loan, 1-yr, 7%
Branch Unit:
$1MM CD, 3-month, 4%
Under FTP, the correct procedure would entail
determining the appropriate transfer rates for three-
month and one-year maturities. Suppose that the
appropriate transfer rates are:
Three-month transfer rate: 5.0%
One-year transfer rate: 5.5%
One then assigns a one-year $1 million transfer
liability at 5.5% to the lending unit with an offsetting
one-year $1 million transfer asset at 5.5% to the
Treasury unit, which acts as a funding “clearing-
house” for the bank. A three-month $1 million
transfer asset at 5.0% is assigned to the branch unit
as an “earnings credit” for the deposit. The offsetting
transfer liability is booked in the Treasury unit. The
final books would be:
Lending Unit:
$1MM Loan, 1-year, 7.0% $1MM Trans. Liab.,
1-year, 5.5%
Branch Unit:
$1MM Trans. Asset, $1MM CD, 3-month, 4.0%
3-month, 5.0%
Treasury Unit:
$1MM Trans. Asset, $1MM Trans. Liab.,
1-year, 5.5% 3-month, 5.0%
Notice that it is only after FTP that the correct net
interest margins for each unit can be determined.
The Lending Unit has a matched-maturity margin of
1.5%, the Branch Unit shows 1.0%, and the Treasury
Unit 0.5%. The Treasury Unit’s margin is an appro-
priate spread determined by the transfer yield curve.
It represents the consensus margin necessary to
compensate the Treasury unit for the interest rate
mismatch it “owns.”
Of course, the manager of the Treasury unit may
opt to reduce the mismatch using on- or off-balance-
sheet hedging strategies. If it were to rid the bank of
the mismatch completely, it would presumably also
lower the bank’s overall net interest margin from
3.0% to 2.5% because it would eliminate the mis-
match risk by giving up the 0.5% spread. This could
be accomplished by borrowing $1 million for one
year at 5.5% and investing the proceeds for three
months at a yield of 5.0%.
Indirect Expense Allocations. As with FTP,
indirect expense allocations can be conducted at a
detailed account-level of detail or using portfolio
characteristics. The latter approach not only simpli-
fies the system and resource requirements, it has the
added benefit that it lowers the potential conten-
tiousness of the cost allocation process itself. Indeed,
while portfolio activity statistics such as routine
transaction counts, special handling counts, credit
quality ratings, telephone inquiry counts, and so
forth may provide the basis for “activity-based”
allocations, a procedure as simple as an informal
survey form where each support manager allocates
his or her unit’s time by product type or by line unit
can suffice.
In considering the design of a cost allocation
process, it is recommended that a product-based set
of “standard unit costs” be used for analyses in all
dimensions. A product-based approach has the
considerable advantage that it establishes a practical
basis for the EVA calculation in all dimensions:
products, lines of businesses, line units, or customer
relationships. To handle situations where transac-
tions counts have material effects on account prof-
itability calculations, such as with demand deposit
accounts (“DDA”), it is a straightforward matter
either to create several classes of DDA correspond-
ing to degrees of transaction activity or to assign costs
based in whole or in part on transactions counts at
a portfolio level (as opposed to an account level) for
each line unit.
Treasury Unit EVA Calculation
The Treasury unit is normally responsible for
several major activities:
Management of the investment portfolio;
Management of incremental short-term funds bor-
rowings or placements as a component of liquidity
management;
Execution of wholesale borrowing, debt and eq-
uity issuances;
Management of interest rate risk mismatches; and
Trading activities.
105
VOLUME 9 NUMBER 2
Virtually every large financial institution has an
active Treasury unit that engages in these activities
to some extent. It is surprising, then, how little is
understood about the proper criteria to use to assess
the economic performance of the Treasury unit.
It is recommended that three different EVA
calculations be performed:
1. Unmanaged Mismatch EVA: An EVA calculation
should be conducted on the bank’s inherent mis-
matches before consideration of any of Treasury’s
transactions. These mismatch positions are the
transfer pricing offsets generated by the FTP system
that were developed in the Funds Transfer Pricing
section above. Over full interest rate and economic
cycles, the unmanaged mismatch EVA will tend to be
somewhat negative.
2. Treasury Unit EVA: This calculation should
include the transfer pricing offsets along with all
other Treasury positions, including investments,
borrowings, and off-balance-sheet hedges—but
excluding any trading activities.
3. Trading Portfolio EVA: This analysis should
isolate all speculative or risk-taking strategies as
distinguished from more conventional risk-reduc-
tion and funding activities.
The EVA contribution of the Treasury unit is the
incremental EVA improvement between the first two
calculations. That is, if the Treasury did not exist, the
organization would generally show negative EVA
due to the natural balance sheet mismatches gener-
ated in the course of normal business activities.
However, due to the Treasury and ALCO activities,
the negative EVA can usually be substantially re-
duced to quite tolerable levels through the Treasury’s
risk reduction and risk management activities. Re-
ducing a negative EVA to a value closer to zero can
be as valuable to the shareholder as any other
wealth-creating activity. Using this approach, the risk
management activities of the Treasury can be prop-
erly recognized and rewarded.
It is strongly recommended that the risk reduction
activities of the Treasury be evaluated separately from
the trading or other risk-taking activities. In the frame-
work presented here, this can be accommodated by
creating the third Treasury unit to calculate the NOPAT
attributable to trading and speculative positions.
Support Unit EVA Calculation
Support units such as credit administration,
data processing, operations, and marketing play
SUMMER 1996
critical roles in facilitating the origination, servic-
ing, and risk management priorities of the organi-
zation. Often such units do not have EVAs per se
because, in most organizations, they do not for-
mally charge market prices for their services.
(Under cost allocations, they allocate their actual
or budgeted expenses with no profit margin.) In
such circumstances, it is common to tie the
incentive compensation of support units either to
the EVA performance of the consolidated com-
pany or to the EVA performance of the specific
line units supported. For example, credit admin-
istration may have its bonuses tied to the EVA of
the lending units in the bank.
However, with the advent of outsourcing of
data processing, operations, internal audit, and
credit administration, market pricing is becom-
ing available. Therefore, if the organization
wishes, it is possible to create formal market
transfer prices for many support activities and to
calculate support unit EVAs as if they were stand-
alone “profit centers.”
EVA and Overhead Cost Allocations
The issue of overhead allocation revolves
around the issue of whether line unit EVAs will be
calculated on a “fully burdened” basis or not.
Those that argue in favor of such allocations
observe that overhead and other fixed costs must
be covered and that to ignore such costs leads to
overstated line unit EVAs. Those who argue
against allocated overhead assert that line units
have no management control or accountability for
corporate overhead; hence, they should not be
burdened with it. The accountability principle
described above is consistent with this latter
perspective.
Whether or not overhead expenses are allo-
cated, there should be no instance in which a cost
overrun in an overhead unit keeps a line unit from
achieving its EVA goal. To prevent such a circum-
stance, it is a simple matter to allocate budgeted
overhead expenses, and not actual overhead
expenses. In this way, overhead departments
cannot cause adverse budget variances in line
units.
8. See in this issue “RAROC at Bank of America: From Theory to Practice.”
9. The concepts of cash capital and risk capital are formulated by Robert
Merton and Andre Perold, in “Theory of Risk Capital in Financial Firms,” Journal
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JOURNAL OF APPLIED CORPORATE FINANCE
Economic Capital Allocation: Cash Capital vs.
Risk Capital
While funds transfer pricing and support cost
allocations are well-known and fairly widely prac-
ticed in the industry, the concept of economic capital
allocations is another story altogether.
Due to the extreme influence of the regulatory
capital standards since the mid-1980s, far too many
bankers default their views on capital allocation to
the risk-based capital rules. This is most unfortunate,
because those standards were never intended for
such internal managerial applications.
The first breakthrough—and a critical step to-
ward an economic approach to capital—was “RAROC”
as developed by Bankers Trust.8 Recently, the use of
such “market value at risk” measures has broadened
considerably—indeed, to the point where they are
becoming de facto standards in the industry. The
following discussion is consistent with these con-
cepts in principle, but the “top-down” framework we
propose is considerably easier to implement than the
bottom-up approach now used by many banks.
For financial institutions, the role of capital can
be viewed as providing a reasonable margin of loss
absorption capacity to meet business uncertainties
and contingencies. This viewpoint leads to a funda-
mentally different perspective on capital for financial
versus industrial companies. Industrial companies
deploy capital in real assets that can be tallied
without severe difficulties. Financial institutions le-
verage their invested capital with financial risks that
can overwhelm the specific amount of capital histori-
cally invested in the company.
The potential discrepancy between the capital
on hand and the amount of capital at risk is crucial
to the proper calculation of EVA with any financial
institution. “Cash capital” refers to the historic amount
of capital invested in the business and available to
absorb losses. This is the classic amount of capital
that is normally associated with EVA calculations for
industrial companies. “Risk capital” is a probabilistic
concept that refers to the amount of market value that
can be lost with an adverse event that is often
quantified as two- to three-standard deviations of
market value volatility.9 These two concepts can
differ substantially.
of Applied Corporate Finance, Vol 6, No. 3 (Fall 1993). Our method of calculating
risk capital differs somewhat from that of Merton and Perold.
 The volatility characteristics of a NOPAT time series will reflect all of the business
risks of any line of business, product, or customer relationship. The significant
advantage of using NOPAT volatility is that it allows EVA analysis at any these levels
in a way that captures the volatility effects from all sources of risk (credit, interest
rates, liquidity, or operations).
Consider, for example, the purchase of $100
million of 90-day Treasury bills. The “cash capital”
amount would correspond to the full $100 million.
However, the amount of “risk capital” from an
economic perspective would be close to zero dol-
lars, regardless of one’s definition of “risk.” This is an
example where cash capital far exceeds risk capital.
Conversely, consider an indexed, amortizing
interest rate swap with a 5-year term and notional
principal of $100 million. The amount of conven-
tional cash capital deployed may well be $0, since in
many instances no cash is exchanged at the outset
of such transactions. However, many millions of
dollars of capital have been put at risk. In this case,
risk capital far exceeds cash capital.
For financial institutions, it is imperative to
analyze both cash capital and risk capital. For
internal profitability measurement, risk capital should
be the operative concept to establish a proper capital
charge to calculate EVA.
Capital Allocation Methodologies
To calculate EVA in all profitability dimensions,
it is essential that a robust economic capital alloca-
tion methodology be adopted. There are four meth-
ods that can be used:
1. Peer benchmarking
2. Market value volatility
3. Option pricing theory
4. NOPAT volatility
For EVA calculations related to lines of busi-
nesses, any of the four are potentially applicable.
However, for product EVA or customer relationship
EVA calculations, NOPAT volatility provides the
most straightforward and intuitive approach.
Choosing NOPAT volatility as a surrogate for
market value volatility may seem surprising at first
glace. However, the volatility characteristics of a
NOPAT time series will reflect all of the business risks
of any line of business, product or customer relation-
ship. The significant advantage of using NOPAT
volatility is that it allows EVA analysis in any dimen-
sion (units, products, or customers) in a way that
captures the volatility effects from all sources of risk
(credit, interest rates, liquidity, or operations). Fi-
nally, it quantifies the effects of business risk diver-
sification when the volatility characteristics at the
consolidated level are compared to the volatilities of
the individual lines of businesses, product types, or
customer segments.
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VOLUME 9 NUMBER 2
To use NOPAT volatility to estimate risk capital,
the standard deviation of NOPAT is capitalized to
create a proxy for market value volatility. There are
several questions that need to be addressed:
How many standard deviations of market value
volatility should be used?
Do all risk types require the same number of
standard deviations for equivalent risk coverage?
Over how long a time period should the standard
deviation be measured?
How should business cycle effects be incorporated
in the calculation?
Can historic volatilities be used as estimates of
current risk capital?
Which units should receive the benefit of risk
diversification?
How is the amount of risk capital reconciled to
regulatory and rating agency capital standards?
These questions will be discussed in sequence.
Number of Standard Deviations. Usually, from
two to three standard deviations of market value
volatility are used as the capital allocation. For a
normal distribution, the following percentage cover-
age of risk is implied for various numbers of standard
deviations:
Number of Std Dev % Coverage of Risk
1.00 84.1%
2.00 97.7%
2.33 99.0%
2.58 99.5%
3.00 99.9%
Standard Deviations by Risk Type. In practice,
risk distributions tend to show more skewness than
normal distributions. Empirically, it has been found
that three standard deviations are usually adequate
to cover about 99% of any risk distribution.
Length of Time Frame and Business Cycles.
The next two questions are related. That is, should
a time period long enough to cover a full economic
cycle be used, or is it better to focus on a shorter time
frame? Full economic cycles can run from four to
seven years. The problems with using a full cycle are
as follows:
A capital allocation based on full business cycle
periods will have the effect of “averaging out” the
risk parameters. Relying on shorter time periods has
the advantage that structural shifts and unprec-
edented risk episodes will be quickly reflected in the
capital allocation.
SUMMER 1996
 A longer-term capital allocation based on full
business cycles will be “sticky” in that efforts to lower
business volatility will not be reflected in signifi-
cantly lower capital allocations for several years.
Shorter-term allocations will be more responsive to
current trends in business risks, both rising and
falling. This issue can be very important in situations
where a unit experiences a “blow up” that results in
significant improvements in risk assessments and
controls. Using a five-year or longer volatility period
would imply that management will be burdened
with the effects of the old volatility for many years
before it can realize the benefit of its improved
standards through a lower capital allocation.
We recommend using shorter-term time frames,
but a large enough number of standard deviations to
compensate for adverse business cycle movements.
It is not unusual to use from 18 to 36 months of
volatility.
Historic vs. Forecasted Volatilities. For most
core operating activities, such as lending, deposit-
gathering, and fee-based services, historic volatilities
are often quite reliable. However, historic volatilities
cannot be expected to be accurate for the Treasury
unit regarding interest rate risk. There are two
reasons:
The Treasury unit can quickly and radically alter its
net mismatch positions. In some cases, it may need
to shift from a net long (liability sensitive) to a net
short (asset sensitive) posture within a month. Such
rapid changes in risk profile may not be reflected
properly in a historic volatility analysis.
If the historic time period being analyzed happens
not to have experienced significant yield curve
volatility, then the capital allocation will be artificially
low, regardless of the size of the balance sheet
mismatches.
For both reasons, it is essential that interest rate
risk be assessed on a “going forward” basis. To do
this, the theoretical market value change associated
with a hypothetical three-standard deviation rate
shift should be determined for the Treasury unit and
for the “unmanaged mismatch” book.
Business Risk Diversification. Diversification
effects can be extremely difficult to attribute unam-
biguously. One attempt would be to measure the
incremental volatility effect of each line unit rela-
tive to the consolidation of all remaining units.
Unfortunately, the results can be nonsensical and
can change significantly from time to time due to
subtle changes in circumstances. As will be dis-
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JOURNAL OF APPLIED CORPORATE FINANCE
cussed in the “risk management” section below, an
alternative is to incorporate the effects of risk diver-
sification in the cost of capital calculation, rather
than the amount of capital allocated. Alternatively,
diversification effects may be shared among all
units by multiplying all capital allocations by a
constant adjustment factor.
Reconciliation of Cash Capital and Risk Capi-
tal. Usually, the economic allocation of risk capi-
tal results in levels of capital quite a bit lower than
actually exist in the consolidated company. This
should not be surprising, as bank capital levels
are subject to regulatory and rating agency stan-
dards that tend to be higher than needed to
support the company on an economic basis. How
should the amounts of cash capital and risk
capital be reconciled?
A simple procedure is to proportionately gross
up the allocated risk capital values by a standard
multiplicative factor to achieve a desired “target
capital” level that in management’s opinion is suffi-
cient to meet regulatory and rating agency standards.
Furthermore, a contingency amount of capital may
be retained for discretionary activities at the parent
company level. Any cash capital in excess of such
“target” and “discretionary” amounts would be avail-
able for distribution to shareholders through share
repurchases or dividends. In calculating line of
business EVA, it is only the target capital amounts
that are allocated to the line units. Any discretionary
or excess capital would be unallocated and held at
the parent level.
EVA and Top-Down Risk Management
To assess the economic performance of any set
of financial transactions, it is necessary to analyze
three parameters: (1) returns, (2) volatilities of re-
turns, and (3) the correlation of returns with the
market. The EVA Financial Management System
described here formally recognizes these parameters
as follows:
Returns Volatilities Correlations
Measure: NOPAT Standard Deviation Covariances
EVA elements: NOPAT Risk Capital Cost of Capital
EVA equation:
EVA= NOPAT – (Risk Capital * Cost of Capital)
 The best performance measurement framework will have little behavioral effect on
an organization if the company is unwilling to establish clear incentive
compensation programs focused on the measure.
When applied systematically to lines of busi-
nesses or product categories, the EVA framework
provides a robust approach to economic perfor-
mance assessment that can be implemented at any
level of detail desired. The usual approach is to apply
the framework in a top-down process. That is, EVA
is calculated sequentially for:
The consolidated bank holding company;
The major legal entities or regions;
The lines of businesses; and
The product categories.
The capital allocation procedures described
above have another important application: a com-
prehensive assessment of business risk. Such a top-
down analysis of all business risks can be important
in that it can:
Facilitate a quantitative framework for determining
risk levels by type (credit, interest rate, liquidity, and
operations);
Serve as a high-level check on the detailed,
bottom-up risk management procedures and con-
trols that every organization endeavors to establish
by risk type;
Show trends in business risk dynamics through
economic cycles;
Illustrate the effects of business risk diversification.
It should be emphasized at this point that the
top-down EVA financial management system
should be viewed as a complement to, and not a
replacement of, any organization’s bottom-up risk
management activities. Bottom-up risk manage-
ment refers to all of the detailed credit administra-
tion, interest rate risk management, and opera-
tional controls that every organization must un-
dertake. Also, even if organizations have devel-
oped extensive funds transfer pricing, cost alloca-
tion, and/or RAROC-style capital allocation sys-
tems, the EVA financial management system can
either be integrated with those systems, or serve
as a high-level, independent economic assess-
ment of the organization’s business risks and
returns.
10. See the favorable reference to Centura Banks in “Clueless Bankers,”
Fortune, November 27, 1995, Vol. 132, No. 11.
DENNIS UYEMURA
is Senior Vice President of Stern Stewart & Co., in charge of Stern
Stewart’s bank advisory service. He was formerly CFO of Silicon
Valley Bank in Santa Clara, California.
109
VOLUME 9 NUMBER 2
IN CLOSING: EVA AND INCENTIVE
COMPENSATION
EVA is the best performance measure for finan-
cial institutions for several reasons:
It has the strongest correlation with MVA;
It offers a top-down, comprehensive evaluation of
the risk dynamics of the organization;
It provides a capital allocation methodology that is
intuitive, simple to measure, and manageable; and
It can unify all financial management activities.
The best performance measurement framework
will have little behavioral effect on an organization
if the company is unwilling to establish clear incen-
tive compensation programs focused on the mea-
sure. EVA is no exception. Fortunately, EVA is easily
incorporated as the centerpiece of incentive com-
pensation programs in all industries, including bank-
ing. To date, two domestic banks, Centura Banks10
and Silicon Valley Bancshares, have adopted orga-
nization-wide EVA incentive programs.
The advantages of the EVA incentive system are:
It bridges the disciplines of corporate finance and
human resources management;
It provides objective goal-setting (a “target” bonus is
earned only if total returns equal the cost of capital);
It integrates short-term and long-term incentive pro-
grams through a “bonus bank” deferral concept; and
It assures shareholders that aggregate incentive
award amounts will remain a very modest percent-
age of total wealth creation; that is, managers win
only when shareholders win.
The last point is critical. A common criticism of
conventional incentive programs is that senior man-
agement can receive large bonuses in years when
shareholder returns have been well below the cost
of capital. EVA provides a strong linkage between
shareholders and management. It ensures that man-
agers’ efforts will be measured according to the
wealth they are creating for their shareholders, and
that the total compensation they receive will be
tightly correlated with that performance.
CHARLES KANTOR AND JUSTIN PETTIT
are Vice Presidents of Stern Stewart & Co.
SUMMER 1996
APPENDIX I BANKS RANKED BY 1995 MARKET VALUE ADDED

MVA Rank EVA Rank Return On Cost Of

Asset 1995 MVA 1995 EVA Capital Capital
Name Rank 95 94 90 95 94 90 (MM’s) (MM’s) % %

Citicorp 1 1 92 100 1 1 100 8,550 1,167 12.8 8.9

Norwest Corp 12 2 2 6 5 3 3 6,326 330 16.2 10.5
NationsBank Corp 3 3 96 4 7 6,280 348 12.3 10.2
First Interstate Bancorp 13 4 6 90 6 4 90 6,123 312 16.9 10.9
Wells Fargo & Co. 15 5 1 80 3 2 1 5,682 401 16.0 9.8
Banc One Corp 9 6 3 2 7 97 2 5,556 284 12.7 10.0
J.P. Morgan & Co. 4 7 12 1 21 92 95 4,638 82 9.4 8.8
PNC Bank Corp 11 8 88 87 99 96 88 4,407 (338) 5.5 10.3
Wachovia Corp 18 9 4 13 10 3,759 139 12.2 9.4
Mellon Bank Corp 21 10 23 76 15 82 83 3,719 115 12.4 10.1
Fleet Financial Group 10 11 20 98 6 3,687 (132) 8.7 10.5
First Bank System 24 12 8 71 8 8 79 3,589 268 16.1 9.2
First Union Corp 8 13 9 85 9 5 61 3,345 265 11.9 9.0
SunTrust Banks 17 14 5 8 16 11 47 3,327 112 13.3 10.7
Fifth Third Bancorp 36 15 7 4 22 17 11 2,835 80 13.7 10.0
Bank of New York Co. 14 16 93 93 12 95 86 2,694 150 11.9 10.1
Chemical Banking Corp 5 17 98 97 2 100 97 2,669 440 13.3 10.7
CoreStates Financial Corp 27 18 10 11 11 61 81 2,542 164 14.7 9.8
Chase Manhattan Corp 6 19 99 99 24 33 99 2,244 68 9.5 9.0
U.S. Bancorp 26 20 39 62 25 98 5 2,138 66 12.1 10.0
Barnett Banks 20 21 21 77 14 15 73 2,129 121 13.8 10.8
BankAmerica Corp 2 22 100 95 17 30 93 2,095 102 10.4 10.0
Boatmen’s Bancshares 25 23 28 52 18 13 56 2,084 102 13.2 10.1
Bank of Boston Corp 16 24 94 92 10 83 94 1,938 239 14.1 9.8
State Street Boston Corp 28 25 15 3 33 27 7 1,846 43 13.7 11.3
National City Corp 22 26 11 15 19 16 60 1,779 100 11.8 9.3
Comerica 23 27 36 49 20 12 63 1,694 95 12.4 9.7
Northern Trust Corp 33 28 17 7 32 35 22 1,618 43 11.9 9.5
Synovus Financial Corp 57 29 16 28 28 1,437 51 17.8 10.3
Huntington Bancshares 32 30 18 65 30 18 35 1,381 50 11.8 9.4
Meridian Bancorp 40 31 40 69 80 72 39 1,249 4 9.9 9.7
Marshall & Ilsley Corp 42 32 14 30 26 48 25 1,119 63 14.2 9.8
First Tennessee National 45 33 19 34 23 20 17 1,075 69 16.8 9.9
Southern National Corp 31 34 38 19 34 24 20 999 39 13.5 10.4
Mercantile Bancorp 37 35 57 63 35 23 32 978 39 12.6 10.2
Star Banc Corp 54 36 35 29 26 958 50 14.9 9.7
Amsouth Bancorp 35 37 61 53 42 81 41 903 28 11.5 9.9
BayBanks 46 38 62 73 44 76 72 866 26 14.4 11.7
Integra Financial Corp 41 39 32 61 96 29 57 858 (22) 8.3 9.9
First of America Bank Corp 29 40 76 37 25 853 36 11.5 9.9
Old Kent Financial Corp 47 41 31 23 36 22 13 800 38 13.6 10.0
Zions Bancorp 65 42 52 21 45 49 19 734 25 15.5 10.0
Republic New York Corp 19 43 77 9 97 53 75 713 (71) 6.7 8.0
UJB Financial Corp 38 44 42 75 66 87 64 690 12 10.8 10.1
Crestar Financial Corp 34 45 58 72 39 46 54 645 28 11.5 9.9
First Security Corp 44 46 81 64 93 43 45 639 (14) 9.2 10.2
SouthTrust Corp 30 47 50 27 21 634 59 12.8 9.5
Summit Bancorp 64 48 67 38 49 90 48 534 21 13.2 9.5
First Virginia Banks 56 49 41 24 56 36 26 517 17 12.3 10.3
First Commerce Corp 55 50 65 40 75 77 29 513 8 11.6 10.3

110
JOURNAL OF APPLIED CORPORATE FINANCE
APPENDIX I (Continued)

MVA Rank EVA Rank Return On Cost Of

Asset 1995 MVA 1995 EVA Capital Capital
Name Rank 95 94 90 95 94 90 (MM’s) (MM’s) % %

First American Corp 52 51 79 70 55 62 69 499 17 12.2 10.2

Bankers Trust New York 7 52 95 13 100 99 89 492 (541) 2.9 9.5
Hibernia Corp 60 53 68 66 88 94 50 491 (4) 11.0 11.6
Commerce Bancshares 53 54 59 33 64 60 18 478 13 11.9 10.4
Mercantile Bankshares 61 55 53 14 53 47 9 471 19 13.0 10.6
Valley National Bancorp 72 56 25 38 32 468 29 16.8 9.0
Central Fidelity Banks 51 57 34 22 54 71 10 438 18 11.4 9.5
Signet Banking Corp 50 58 22 78 92 91 58 414 (11) 9.7 10.5
First Commercial Corp 66 59 43 65 51 380 13 13.4 10.2
CCB Financial Corp 68 60 73 50 55 378 20 14.7 9.6
First Empire State Corp 48 61 80 55 31 19 15 371 49 14.1 9.8
Union Planters Corp 49 62 91 47 41 89 43 365 28 12.1 9.6
Centura Banks 67 63 48 46 39 351 22 15.2 9.6
First National Bancorp 83 64 87 344 (4) 8.6 10.0
National Commerce Bancorp 79 65 30 47 41 337 22 16.7 9.3
Mark Twain Bancshares 86 66 44 51 40 329 20 17.2 10.0
Associated Banc-Corp 78 67 56 58 56 324 16 14.5 9.8
Deposit Guaranty Corp 63 68 72 57 50 308 16 13.2 10.1
Trustmark Corp 69 69 63 72 57 285 9 11.6 9.7
First Michigan Bank Corp 84 70 45 70 63 238 9 13.1 9.4
First Financial Bancorp 97 71 77 216 6 13.2 10.5
Provident Bancorp 62 72 55 40 34 212 28 12.8 8.6
Cullen/Frost Bankers 73 73 74 45 59 64 53 207 15 15.0 10.5
City National Corp 74 74 71 17 76 86 8 206 8 13.1 11.2
Trustco Bank Corp Ny 95 75 62 200 13 17.4 9.8
CNB Bancshares 80 76 47 68 65 196 10 12.7 9.2
Magna Group 70 77 66 81 69 190 3 10.4 9.8
Banponce Corp 39 78 86 43 37 188 27 11.9 9.7
Westamerica Bancorp 90 79 74 187 9 13.4 9.5
River Forest Bancorp 96 80 52 178 20 20.4 10.1
United Carolina Bancshares 76 81 70 60 70 173 15 14.8 10.1
One Valley Bancorp of WV 75 82 51 63 44 158 13 13.5 9.8
Bancorp Hawaii 43 83 90 25 94 66 4 154 (14) 9.3 10.3
National Bancorp of Alaska 91 84 48 153 21 18.7 9.2
First Hawaiian 58 85 78 10 67 78 6 139 11 10.8 9.5
Fort Wayne National Corp 94 86 84 134 1 10.2 9.8
Colonial Bancgroup 77 87 82 61 59 124 13 15.8 10.6
BancorpSouth 82 88 75 71 68 117 9 12.4 9.2
Citizens Banking Corp 81 89 64 78 75 112 4 10.7 9.4
Banknorth Group 100 90 79 96 4 12.6 10.4
Peoples Heritage Financial 85 91 84 86 79 90 (1) 11.0 11.5
Victoria Bankshares 99 92 90 87 (4) 7.5 9.9
Imperial Bancorp 87 93 85 32 91 88 14 79 (8) 8.0 11.0
Commerce Bancorp 92 94 69 78 10 15.3 9.4
Jefferson Bankshares 98 95 82 78 2 10.6 9.8
Riggs National Corp 71 96 83 59 95 85 66 74 (18) 7.0 10.0
Amcore Financial 93 97 89 72 (4) 7.6 9.7
Susquehanna Bancshares 88 98 83 68 1 9.9 9.5
Provident Bankshares Corp 89 99 85 44 (0) 10.1 10.2
First Citizens Bancshares 59 100 89 48 73 67 24 17 9 10.8 9.1

111
VOLUME 9 NUMBER 2 SUMMER 1996
APPENDIX II BANKS RANKED BY 1995 MVA AS A PERCENTAGE OF CAPITAL
MVA as % EVA as %
of Cap Rank of Cap Rank 1995 MVA 1995 EVA Return On Cost Of
Asset as % of as % of Capital Capital
Name Rank 95 94 90 95 94 90 Capital Capital % %

Synovus Financial Corp 57 1 4 5 5 187.5 7.5 17.8 10.3

Zions Bancorp 65 2 33 28 15 26 20 150.0 5.4 15.5 10.0
Fifth Third Bancorp 36 3 5 3 29 16 13 115.4 3.7 13.7 10.0
First Interstate Bancorp 13 4 29 58 11 19 78 111.1 6.0 16.9 10.9
Valley National Bancorp 72 5 2 3 1 110.2 7.7 16.8 9.0
Mark Twain Bancshares 86 6 8 7 2 109.6 7.2 17.2 10.0
First National Bancorp 83 7 92 108.3 -1.3 8.6 10.0
National Commerce Bancorp 79 8 3 6 4 107.0 7.4 16.7 9.3
Trustco Bank Corp NY 95 9 4 106.0 7.6 17.4 9.8
Norwest Corp 12 10 12 10 13 12 7 102.9 5.7 16.2 10.5
Star Banc Corp 54 11 39 16 17 99.0 5.2 14.9 9.7
State Street Boston Corp 28 12 22 2 52 38 8 97.4 2.5 13.7 11.3
First Tennessee National 45 13 9 30 9 6 17 97.0 6.9 16.8 9.9
Associated Banc-Corp. 78 14 20 20 22 91.9 4.8 14.5 9.8
Wells Fargo & Co. 15 15 13 26 10 15 1 90.6 6.2 16.0 9.8
Summit Bancorp 64 16 53 51 31 98 68 89.4 3.7 13.2 9.5
First Financial Bancorp 97 17 44 89.2 2.8 13.2 10.5
First Michigan Bank Corp 84 18 6 30 32 87.6 3.7 13.1 9.4
River Forest Bancorp 96 19 1 87.1 10.3 20.4 10.1
First Bank System 24 20 26 38 8 18 61 86.0 6.9 16.1 9.2
Centura Banks 67 21 21 14 8 83.1 5.6 15.2 9.6
First Commercial Corp 66 22 18 37 21 82.8 3.1 13.4 10.2
Northern Trust Corp 33 23 25 5 54 54 19 82.3 2.4 11.9 9.5
BayBanks 46 24 58 93 46 76 85 81.5 2.7 14.4 11.7
CCB Financial Corp 68 25 52 18 23 78.0 5.1 14.7 9.6
CoreStates Financial Corp 27 26 31 13 19 69 74 75.7 4.9 14.7 9.8
Marshall & Ilsley Corp 42 27 11 25 23 56 22 73.7 4.4 14.2 9.8
Mellon Bank Corp 21 28 71 39 58 79 69 73.4 2.2 12.4 10.1
Westamerica Bancorp 90 29 27 72.5 3.9 13.4 9.5
SunTrust Banks 17 30 14 14 49 42 25 71.4 2.6 13.3 10.7
Meridian Bancorp 40 31 64 59 84 75 32 70.1 0.2 9.9 9.7
Wachovia Corp 18 32 17 43 39 70.0 2.8 12.2 9.4
Old Kent Financial Corp 47 33 30 20 33 10 16 68.7 3.6 13.6 10.0
First Commerce Corp 55 34 46 64 75 86 39 66.5 1.2 11.6 10.3
Hibernia Corp 60 35 66 79 87 99 53 62.1 -0.5 11.0 11.6
Huntington Bancshares 32 36 36 45 56 31 30 62.0 2.3 11.8 9.4
CNB Bancshares 80 37 7 34 41 60.8 3.5 12.7 9.2
Integra Financial Corp 41 38 40 54 93 43 56 60.4 -1.6 8.3 9.9
Fort Wayne National Corp 94 39 82 59.6 0.4 10.2 9.8
Cullen/Frost Bankers 73 40 57 90 22 49 86 58.6 4.5 15.0 10.5
BankNorth Group 100 41 57 57.7 2.3 12.6 10.4
U.S. Bancorp 26 42 70 33 60 94 11 57.6 2.1 12.1 10.0
First Virginia Banks 56 43 44 24 62 28 26 57.3 2.0 12.3 10.3
Boatmen’s Bancshares 25 44 63 27 40 34 36 56.8 3.1 13.2 10.1
Mercantile Bankshares 61 45 48 9 55 50 5 56.1 2.4 13.0 10.6
Trustmark Corp 69 46 41 64 37 56.0 1.9 11.6 9.7
Southern National Corp 31 47 37 19 38 3 23 55.8 3.1 13.5 10.4
Deposit Guaranty Corp 63 48 62 39 35 54.8 3.1 13.2 10.1
PNC Bank Corp 11 49 83 48 99 84 75 54.5 -4.8 5.5 10.3
Mercantile Bancorp 37 50 69 57 53 25 33 54.2 2.4 12.6 10.2

112
JOURNAL OF APPLIED CORPORATE FINANCE
APPENDIX II (Continued)
MVA as % EVA as %
of Cap Rank of Cap Rank 1995 MVA 1995 EVA Return On Cost Of
Asset as % of as % of Capital Capital
Name Rank 95 94 90 95 94 90 Capital Capital % %

United Carolina Bancshares 76 51 42 21 63 53.1 4.7 14.8 10.1

Amsouth Bancorp 35 52 75 42 69 83 37 52.7 1.6 11.5 9.9
First American Corp 52 53 79 94 63 62 87 49.7 2.0 12.2 10.2
Barnett Banks 20 54 61 44 41 47 47 49.4 2.9 13.8 10.8
Commerce Bancshares 53 55 55 29 72 58 18 49.3 1.5 11.9 10.4
Banc One Corp 9 56 35 4 45 82 9 48.1 2.7 12.7 10.0
City National Corp 74 57 50 12 65 97 3 47.8 1.9 13.1 11.2
Comerica 23 58 74 31 47 30 49 45.4 2.7 12.4 9.7
Victoria Bankshares 99 59 96 44.1 -2.3 7.5 9.9
UJB Financial Corp 38 60 59 84 77 87 55 44.0 0.8 10.8 10.1
Central Fidelity Banks 51 61 32 23 66 73 6 43.7 1.9 11.4 9.5
First Security Corp 44 62 82 63 90 55 46 42.9 -1.0 9.2 10.2
Colonial Bancgroup 77 63 94 17 11 42.4 5.2 15.8 10.6
National Bancorp of Alaska 91 64 2 42.0 9.5 18.7 9.2
One Valley Bancorp of WV 75 65 24 32 9 42.0 3.6 13.5 9.8
Commerce Bancorp 92 66 12 41.3 5.9 15.3 9.4
National City Corp 22 67 38 16 51 45 38 40.8 2.5 11.8 9.3
Fleet Financial Group 10 68 67 94 33 39.3 -1.8 8.7 10.5
Magna Group 70 69 45 78 65 37.9 0.6 10.4 9.8
First of America Bank Corp 29 70 77 70 46 36.5 1.6 11.5 9.9
Bank of Boston Corp 16 71 91 85 24 78 94 36.2 4.3 14.1 9.8
NationsBank Corp 3 72 84 61 60 35.9 2.0 12.3 10.2
Citizens Banking Corp 81 73 27 73 72 35.6 1.3 10.7 9.4
BancorpSouth 82 74 56 35 51 35.2 3.2 12.4 9.2
First Union Corp 8 75 54 41 42 44 31 34.9 2.9 11.9 9.0
Jefferson Bankshares 98 76 76 33.9 0.8 10.6 9.8
Amcore Financial 93 77 95 33.7 -2.1 7.6 9.7
Crestar Financial Corp 34 78 72 61 71 61 40 33.6 1.6 11.5 9.9
Signet Banking Corp 50 79 34 80 88 89 41 33.3 -0.8 9.7 10.5
SouthTrust Corp 30 80 68 36 29 31.9 3.2 12.8 9.5
Peoples Heritage Financial 85 81 97 86 96 30.5 -0.5 11.0 11.5
Bank of New York Co. 14 82 85 72 67 80 54 30.2 1.8 11.9 10.1
J.P. Morgan & Co. 4 83 73 7 79 77 67 30.1 0.6 9.4 8.8
Imperial Bancorp 87 84 99 49 98 100 10 30.0 -3.0 8.0 11.0
First Empire State Corp 48 85 80 50 25 7 15 29.7 4.3 14.1 9.8
Provident Bancorp 62 86 43 26 14 29.5 4.2 12.8 8.6
Union Planters Corp 49 87 98 75 50 92 62 28.9 2.5 12.1 9.6
Citicorp 1 88 81 62 28 13 66 27.4 3.9 12.8 8.9
Provident Bankshares Corp 89 89 85 23.4 -0.1 10.1 10.2
Susquehanna Bancshares 88 90 81 20.8 0.5 9.9 9.5
Chase Manhattan Corp 6 91 95 76 80 71 89 15.7 0.5 9.5 9.0
First Hawaiian 58 92 76 6 74 85 2 15.5 1.2 10.8 9.5
Chemical Banking Corp 5 93 90 77 48 90 83 15.4 2.7 13.3 10.7
Banponce Corp 39 94 87 59 48 13.8 2.1 11.9 9.7
Republic New York Corp 19 95 78 15 91 70 48 12.4 -1.3 6.7 8.0
Riggs National Corp 71 96 88 55 97 93 76 11.7 -3.0 7.0 10.0
Bancorp Hawaii 43 97 93 21 89 66 4 10.5 -1.0 9.3 10.3
BankAmerica Corp 2 98 96 43 83 74 59 6.7 0.3 10.4 10.0
Bankers Trust New York 7 99 89 18 100 88 63 5.8 -6.5 2.9 9.5
First Citizens Bancshares 59 100 100 78 68 59 29 2.9 1.7 10.8 9.1

113
VOLUME 9 NUMBER 2 SUMMER 1996
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