January 2012

Financial Services

Performance measurement in the banking industry post-crisis trends

by John Karr
After the financial crisis that began in 2008, banks are taking steps to improve their performance measurement capabilities in light of changed economic and market conditions and new management needs. For example, new regulatory strictures are affecting the underlying economics of such businesses as payment-card issuing and processing. Capital requirements are increasing for most banking businesses. New channels like mobile phones are becoming more important. Revenue growth continues to be difficult to achieve due to weak economic conditions, low interest rates and regulatory restrictions. Banks are trying to manage costs better, deepen relations with customers and enhance product mix and pricing decisions. These and other factors are causing banks to re-examine and improve the ways in which they measure and report business performance. Some major areas of emphasis and trends are emerging across the industry: Reviewing and enhancing organizational management profitability-reporting methodologies Emphasizing the use of business-unit key performance indicators (KPIs) Refining customer- and channel-profitability measurement and analytics Improving alignment of the components of the performance management process Improving systems support and automation of the performance management process Improving data quality and consistency Banks have their own performance measurement improvement agendas tied to their unique needs and strategies. For some banks, these are continuations of prior efforts while for others, they are new initiatives.

Banks are reviewing and enhancing key organizational management profitability-reporting methodologies to reflect changes in business models and their underlying economics. One focus is harmonization with risk management methods and definitions
Cost allocation. Allocation methodologies are being changed to provide more transparency to recipients and to support better decisions about the use of resources. More attention is being paid to understanding fixed and variable cost structures and cost and volume variances. Deeper analyses of channel costs are being developed. For certain categories of costs, such as overhead or administrative functions, allocations are being simplified to streamline budgeting and profitability-reporting processes.

Funds transfer pricing. FTP curves are being changed. The use of the swaps curve as opposed to LIBOR for maturities between three months and one year is becoming more common. Liquidity premiums are being added to reflect the banks specific funding costs at each point in the curve. More analysis is being performed on the core deposit book to determine its stickiness. Credit charges. Approaches to assigning provision for credit losses are being modified. The use of Basel-driven expected losses versus GAAP provision is being considered. Further, the implications of mark-to-market loan valuation under accounting pronouncements such as SOP 03-3 and FAS 141-R on monthly line-of-business results are being analyzed. Capital allocation. Banks that attribute equity to lines of business for organizational-profitability reporting are revising their methodologies for doing so. Because regulatory capital requirements are being raised, banks are not using economic capital calculations as the sole bases for line-of-business (LOB) capital attribution. Instead, combinations of economic capital, regulatory capital and goodwill attributions are being used. Despite the new capital attribution methodologies, considerable shareholder equity continues to be held at the top of the house. Inter-LOB revenue and expense-sharing arrangements. Banks are reviewing the methods by which revenues and expenses are shared among LOBs. They want to promote cross-selling, as well as to understand the true stand-alone economic value of each business line. In some cases, flat amounts or percentages of revenue are being put in place for cross-sales or referrals between LOBs.

evolve as well. Some typical KPIs used for retail banking LOBs include new accounts opened; account attrition; balance growth; products per household or customer; delinquencies; net promoter score; and headcount. KPIs can be developed for subsets of the retail LOB, including product lines such as mortgages, credit cards and insurance

Banks are refining customer- and channel-profitability reporting and analytics to support new strategies
Most banks have adopted customer-centric strategies. These strategies involve customer segmentation, needs and behavior analysis, product features, sales and service process design and pricing strategies, among other attributes. To develop and implement customer-centric strategies, banks need a deep understanding of customer profitability and economics on annual- and lifetime-value bases. As a result, banks are enhancing their customer-profitability calculation and analysis capabilities. Capturing accurate and comprehensive data on customers overall relationships with the bank in terms of accounts, products and sales and service interaction has been a major focus, as has refining profitability-calculation methodologies. Understanding which customers or groups of customers are profitable or unprofitable and why provides banks with information upon which to make marketing and pricing decisions. More channels, such as online and mobile ones, are being added to traditional channels like branches and call centers. Investments in them must be optimized. Consequently, banks are improving their analyses of channel economics, which involves developing models of channel costs, usage patterns and impacts on sales and customer retention. Even traditional metrics, such as branch profitability, are being challenged. Most banks measure monthly branch profitability using a common framework. Essentially, they create an income statement for the branch, which includes revenues (based on spreads and fees), credit costs, operating costs and allocated expenses. The asset and liability balances attributed to the branch are based on the accounts booked to it when a customer originates the account. Fees are also largely based on activities related to customer accounts booked to a branch although some branch P&Ls also include other line items, such as usage fees for ATMs located in the branch. Under this traditional profitability construct, it can take years for branches to be deemed profitable. That is, customer numbers and associated balances attributed to the branch need to accumulate over time before spread and fee revenues exceed direct and allocated costs. Bankers undergo an anguished waiting game hoping that their branch placement bets will pay off. Such a manner of measuring branch profitability is clearly inadequate, and certainly not one that any modern retailer would use. It credits the branch at which the customer first originated his or her account with the balances of the account, even if the customer has never again set foot in that branch. It offers no incentive for the provision of high-quality service in the time period it is most needed

Banks are emphasizing the use of line-of-business key performance indicators to supplement monthly organizational profitability reporting
At most large US banks, monthly organizational profitability reporting is sophisticated and well-accepted. However, bank executives are looking for measures that will assist them in understanding potential future performance, as well as in analyzing historical financial performance. The use of enterprise and LOB-specific KPIs in management reporting is growing. Banks are determining which KPIs will allow them to gain insights into the underlying performance of the business beyond a purely financial view. Reporting on KPIs that truly drive value provides more information upon which to make decisions and engage in strategic discussions about the business. Determining the KPIs that will be used requires developing a model of the business and analyzing the levers that have the greatest impact on its performance. It also calls for defining the levels in the LOB hierarchy at which the KPIs will be reported. Each bank has its own ideas about which KPIs are appropriate to LOBs based on its strategy and views of the business. For the most part, KPIs currently in use are fairly simple and intuitive. However, as driver-based models become more precise and complex, LOB KPIs are likely to

Performance measurement in the banking industry post-crisis trends

(when the branch is being opened) because direct compensation expense is charged to the P&L while balances are low. It muddies the contribution of other sales and service channels to overall customer satisfaction and profitability. Finally, it can delay decision-making about whether the branch is truly contributing value to the bank. To counter this, a more accurate picture of branch-level profit performance needs to be constructed. Such a picture should be more sensitive to actual performance during the reporting period as opposed to prior periods. It should reflect the effectiveness of the branch as a sales and service channel. Finally, it should be more sensitive to the operational levers that management can push or pull to influence the performance of the branch. One approach would be to change the items driving the monthly branch P&L. Rather than holding assets and liabilities accreted over time on its own balance sheet, the branch would be credited only for loans or deposits generated during the month. The bank would purchase the deposits or loans from the branch at their economic net present value. (One analogy is the mortgage-banking business, in which loan production offices sell the loans downstream rather than holding them on their own books.) The branch would also be credited for the customer service transactions it performs during the month. Monthly operating expenses, direct and allocated, would be deducted to arrive at a true monthly P&L amount. This would provide managers with a better understanding of branch performance.

in Figure 1. For example, forecasts are being presented using the same line-of-business and P&L constructs as for monthly reporting. Stress testing is becoming a repeatable process performed in parallel with forecasting. Also, consistent capital attribution methodologies are being used for strategic planning, capital budgeting, reporting and forecasting. Driver-based planning is now widely used, and the drivers are employed in forecasting as well. As previously noted, banks are also harmonizing financial views of the business and associated reporting with risk views and reports. This involves standardizing definitions (e.g., product types) and hierarchies and roll-up structures. Where regulatory methods and reporting, such as for Basel III, vary from GAAP accounting principles for balance sheet and income statement items (e.g., for credit exposures), institutions are attempting to explicitly reconcile and explain the differences.

Improving systems support and automation of the performance management process are critical elements in most banks plans
Banks are undertaking a variety of systems initiatives to streamline and automate components of their performance management process. These include implementing new financial planning and budgeting systems, developing new forecasting and stress testing systems and further automating standard monthly reporting processes such as cost allocation. Some banks are improving enterprise, LOB and functional reporting and analytic capabilities through the use of dashboards and data visualization software. The rationales for such performance management systems and automation investments vary and can include the following: Reducing operational costs. Automation can reduce or eliminate such manual activities as data entry, re-keying, reconciliation and so forth. Also, if there are multiple systems supporting the same process (e.g., budgeting) across the enterprise, moving to a single system can reduce licensing costs.

Because of the increased importance of forward-looking activities such as forecasting and stress testing, banks are better aligning the components of the performance management process
Banks are taking steps to see that the key components of the performance management process involve consistent definitions, hierarchies and methodologies. A schematic representation of the major components of the performance management process is shown

Figure 1: Illustrative performance management process

Strategic planning

Budgeting/ capital planning

Reporting/ analytics

Forecasting

Monitoring

Acting

Feedback Related processes

Risk management Internal/external communications Compensation, incentives and rewards Integrated technology Change management

Reducing production-cycle times. Automating certain processes can speed up information reporting and provision. Financial planning and budget automation can reduce the number of iterations required and the time between iterations. Improving controls. Many banks performance management processes are still heavily dependent on spreadsheets and local databases. Besides the costs associated with manual intervention, this can also create control weaknesses. Information reporting quality can suffer. Vendor support. In some cases, vendors have stopped supporting certain application software packages or older versions of such applications. This requires banks to select and implement replacements.

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Banks are investing heavily in improving data availability, quality and consistency, and performance management data is no exception
During the crisis, banks struggled to pull together complete and accurate reports of their positions, exposures and counterparties. Performing stress tests was an onerous exercise due to data gaps and inconsistencies. Regulators, boards and management all concluded that significant improvements in data quality were necessary to run banks effectively in the post-crisis era. As a result, virtually every large US bank is undertaking efforts to improve data quality across the enterprise. Data used in performance management processes is no exception. In fact, it is a focal point. The key data improvement activities in the banking industry that will enhance performance management and reporting include: Data governance. Banks are putting in place improved data governance approaches. Among these are specifying organizational responsibilities and processes for data definitions, ownership, validation and change control. Data sourcing. Multiple data sources are being rationalized. Golden sources are being defined for specific data sets and uses. Enterprise data warehouses are being built and implemented to serve multiple purposes, including performance measurement and reporting. The creation of data marts for unique users and user groups is still taking place, but under much more disciplined and rigorous governance. Data quality. In parallel with the actions described above, significant efforts are underway to improve data quality. This involves cleansing data in source systems and making sure that required data attributes are complete and accurate. Data quality maintenance processes are being enhanced so that data does not go stale or become corrupted over time.

Conclusion
Of course, individual banks face their own performance measurement circumstances and needs, such as integrating acquisitions into existing profitability measurement, budgeting and forecasting systems and tools. However, large US banks will eventually take steps to address the performance management issues described above. Bank finance, information technology, treasury, risk, operations and business unit managers will need to work together to improve performance management processes and systems at their institutions.

John Karr is a Principal in the Financial Services Office of Ernst & Young LLP. He is based in New York.