Keeping banks competitive: a foundation for robust performance management

Shawn Convery

Abstract Life is becoming tougher and tougher for banks. The author shows how a series of fundamental techniques, like funds transfer pricing, can make life simpler when used under an economic value management framework and can provide banks with the extra competitive edge that they need. Keywords Banking, Risk management, Transfer pricing
Shawn Convery is Chairman and Co-Founder of Almonde. He is currently a board member of the French ALM Association. Shawn holds a BA in Business Administration, Finance from North Eastern University. Before co-founding Almonde, Shawn worked at CIC-Banque CIN as Head of Asset-Liability Management for over eight years. Prior to this experience, Shawn worked in trading for Merrill Lynch in London.

Introduction
Banks are facing immense challenges to achieve sustainable protability. Historically low interest rates are compressing margins and forcing banks to enhance their performance management capabilities, while regulations such as Basle II and IAS 39 are providing the impetus for banks to establish a foundation for robust performance management. To respond to these challenges, institutions need to be able to adopt an economic value management (EVM) framework. At its simplest, an EVM framework enables banks to quantify any dimension of their performance, such as business unit, product or customer. They achieve this by breaking out all expected losses and embedded costs to determine the net commercial margin for the enterprise at all levels. In addition, they determine the amount of capital required to support the risk associated with that activity, i.e. the unexpected loss. This ensures that the analysis is consistent and comprehensive across all dimensions. By adjusting expected average returns by the likelihood that they will materialize (i.e. their volatility), or RAROC, banks are able to assess and improve their true performance. The lower the volatility of an average return, the more it is attractive to a bank because less economic capital will need to be set-aside for it. Also, they can identify every risk and cost component for allocation to that area of the organization that's most competent to deal with them. An example may be to transfer the credit risk on a loan away from the branch that sold it to the central credit risk department. These units can then be monitored and incentivized to achieve the best possible results against predetermined benchmarks. Thanks to its ability to break out and separate commercial (i.e. customer, product and business unit referred to as the commercial margin) and nancial (i.e. funding center and hedging referred to as the term margin) performance from overall organizational protability, funds transfer pricing (FTP) is both a critical rst step and the cornerstone of an EVM framework.

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VOL. 11 NO. 3 2003, pp. 38-41, MCB UP Limited, ISSN 0965-7967

DOI 10.1108/09657960310491181

`` Institutions are focused on the margins achieved. ''

What are the benets of an EVM framework?
In the banking environment, institutions are focused on the margins achieved, the inherent risks involved and all associated costs. In order to analyze and manage these effectively, they require the ability to quantify these issues, to reveal the underlying minimum performance required for break-even. This enables them to devise strategies to improve performance through superior understanding of the underlying economics of the organization. In applying an economic value management (EVM) framework banks are able to take an accurate, evidence-based strategic vision of every aspect of the organization's performance and how they interrelate. This enables them to achieve many benets, which include: J the ability to identify in real time the departments, investments and initiatives that are performing well, enabling additional resources to be deployed for maximum return and the lessons of success to be applied to other business areas; J the opportunity to identify under-performing areas of the bank's business, enabling them to be reassigned to more appropriate functional departments, reengineered or suspended; J the knowledge that strategic decisions are based on rm, factual evidence and not prejudice, hunch or guesswork; J a clear perspective on the overall impact of decisions on the organization's business, in both a micro and macro context; J simplied testing of decision's outcome prior to implementation; J the creation of a level playing eld that enables investments and other initiatives to be directly compared on a like-for-like basis; and J the opportunity to save management cost and time through an acceleration of the decisionmaking process and eliminating low-value initiatives and investments.

What is FTP, and why is it central to EVM?

At the time a nancial contract is entered into, FTP is the rate at which banks can obtain funds to nance an identical term asset or the rate at which banks can invest funds received through an identical term liability. For a xed rate loan, for example, the commercial margin is the positive difference between the xed rate payable by an asset and the cost of the FTP. This makes it a vital component in calculating the true protability or cost of any nancial contract within the context of the bank's overall business, additionally revealing any underlying strengths and weaknesses within the portfolio. FTP may also be modeled to accurately assess the impact of future interest rate changes on specic customer types, so facilitating product pricing for optimum business acquisition, retention and return. It therefore enables managers to make their decisions in the knowledge of business imperatives and market conditions. On a practical basis, it simplies the process of allocating internal charges to the appropriate business units. In short, FTP enables effective risk management, performance measurement and business understanding that can be drilled down to specic product and customer types in markets across the institution. It is therefore the critical component of an EVM framework, revealing true commercial and nancial performance at the customer, product and business unit level and so highlighting the contribution (or otherwise) that each transaction makes to corporate protability. Figure 1 shows how the funds transfer price enables institutions to move from an accounting based approach, where there is no knowledge of the underlying performance, to an EVM

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Figure 1 Funds transfer pricing enables organizations to move from an organizational centric view of performance to one that breaks down performance into its different components

approach where the funds transfer price enables institutions to break down performance between the commercial margin and term margin and then further into the underlying elements of performance. In the past, the technological hardware and software used within banks were not of sufcient power or exibility to handle the data volumes involved or provide the analytical capabilities demanded by an EVM framework. Today, however, such technology is available, enabling the appropriate levels of contract-level detail handling and providing the ability to analyze data across any number of dimensions in an ad-hoc fashion. For example, a bank has a variety of different performance management requirements. They need a solution to help them comply with Basle II, which relies heavily on accurate risk pricing. This in turn gives the banks the opportunity to improve performance management. The same bank's marketing department is under pressure to improve customer segmentation and deliver the right product mix to achieve higher margins. The heads of commercial and retail banking are under pressure to achieve their margin targets. And the Treasury group is looking for better ways to analyze their nancial margins. These types of projects in the past would have been done separately with different databases and solutions put in place all based on highly aggregated data. However, today these solutions are available on an integrated platform with the ability to handle contract level detail. This enables an institution to satisfy these individual needs while establishing the foundation of an economic value management framework. The bank is able to calculate and report on their exposures to regulators more accurately, marketing managers can tailor products to particular customer segments, heads of commercial and retail banking can track performance of individual branches and personnel, and treasury managers are able to identify and track the components to their nancial margins. The follow on effects are powerful as this type of analysis can be easily extended to other areas within the bank. This allows senior managers and the board to identify and track performance across the institution. Enabling all departments to analyze product, customer and business unit data, allowing them to build a far more accurate and detailed picture of the institution's holistic performance, driving better decision-making and paving the way to increased protability.

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To better understand how this works, Figure 2 illustrates an example of how the breakdown of the margins and losses, both expected and unexpected, can be used to calculate a risk adjusted return on capital (RAROC) gure. In Figure 2, we begin with the commercial margin, and subtract the total expected loss, comprised of a variety of spreads such as embedded option and credit spreads, to arrive at the expected net commercial margin (0.50% (0.44%)) = 0.06%. Subsequently, we calculate the total unexpected loss, comprised of spreads such as the unexpected credit loss spread, and from the two calculate RAROC. RAROC is the expected net commercial margin divided by the Total Unexpected Loss ((0.06% / 0.35%) = 17.14%).

How to use EVM

EVM is a mechanism that enables the calculation of margins associated with a bank's performance. There are three reasons for this: (1) It can establish the minimum performance needed for break-even in any transaction, and factor in expected elements that may reduce the value of an asset or liability to the bank. This reveals the net commercial margin the value that the bank expects to derive from the asset or liability, excluding unexpected losses that may require capital reserves. (2) It can generate a customer focused and risk adjusted performance driven culture within the bank by attributing prot & loss to the business units within the organization responsible for generating risk. (3) Equally, it can enable the allocation of risk on each transaction to the area of the bank that is most capable of managing the risk (i.e. the central credit risk department rather than the branch that sold the contract). This creates a dynamic, efcient environment that leads to greater efciency across the enterprise and focuses task-resolution on the most appropriate centers of expertise for additional control.

Conclusion
FTP is both a cornerstone and a critical rst step in establishing a true EVM framework, going beyond the nance and accounting functions to enable an institution the effective management of all the margins, risks and costs associated in accurately dening its performance. This is why FTP is increasingly being recognized as a vital competitive and functional tool in banking and wider nancial services in the twenty-rst century.

Figure 2 Calculating RAROC from the commercial margin, the total expected loss, and total unexpected loss
Commercial Margin Embedded Option EL Spread Credit EL Spread Operational EL Spread Overhead Cost Spread Bank R ating Spread Total Expected Loss Expected Net Commercial Margin Embedded Option UL Spread Credit UL Operations UL Total Unexpected Loss RAROC - ENCM / UL 0.50% 0.07% 0.19% 0.12% 0.04% 0.02% 0.44%

Expected Loss

0.06% ==> Commercial Margin - Total Expected Loss 0.15% 0.11% 0.09% 0.35%

Unexpected Loss

17.14% ==> Expected Net Commercial Margin / Total Unxexpected Loss

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