by Ralph C. Kimball
July/August 1998

Successful bank operation requires managers to weigh complex trade-offs between growth, return, and risk. In recent years banks increasingly have adopted innovative performance metrics based on the concept of economic profit, rather than accounting earnings, to assist managers in making such difficult and complex decisions. Banks hope in this way to elicit better decision-making by managers and also to align managerial behavior more closely with the interests of shareholders.

This article analyzes the use of economic profit for measuring the performance of banks, focusing on the allocation of equity capital to products, customers, and businesses. The author reviews the use of economic profit to evaluate performance, to price transactions, and to reward managers. He describes in detail one performance measurement and incentive system and then goes on to discuss the shortcomings of performance metrics founded on economic profit, which may distort banks' investment and operating decision-making. He concludes that banks need to recognize the ambiguities of such calculations and be prepared to create and apply multiple specialized performance measures.

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