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Enterprise Performance Management – Redefining Shareholder Value for BanksShareholder value is a key parameter with regard to the valuation of an enterprise; it assumes greater prominence in today's dynamic economic environment. This measure provides a clear, unambiguous quantification of an organization's value within the framework of current financial reporting standards and banking regulations. In spite of being criticized for having a narrow focus on financial goals, it helps the management gain an aggregated view of the value of a banking enterprise, and understand it in all its financial facets – profitability, capital, solvency or liquidity, and risks.

As markets become competitive and customers grow demanding, Chief Financial Officers (CFOs) across the banking world need to proactively participate in developing the organization's strategic roadmap, review business performance, as well as endorse its annual financial results. A CFO's responsibilities include decision-making related to the pricing of financial products, measurement and management of liquidity, solvency, interest rate risks, fund transfer pricing, and credit loss provisioning, among others.

This paper examines the planning and decision support systems that banking CFOs require to improve business output, thereby enhancing shareholder value.

Introduction

To avoid a financial debacle, lending firms should adopt a conservative approach in sanctioning credit, and dissuade customers from assuming highly leveraged positions with respect to their funding arrangements. However, over the last couple of decades, to make the most of a booming economy, banks had drifted from this guiding principle to ensure profitability. Competitive pressures therefore resulted in highly leveraged, low equity banking entities. Under the recessionary pressures of the recent past, such banks tried to de-leverage from tenuous positions by shedding assets or using methods such as securitization. Financial entities, globally, had been drawn into a web of transactions, for example, of mortgage-based securities and a host of related financial instruments. As regulations became stricter, lending institutions turned to short-term funding sources, rather than conventional deposits, for these transactions. Debt default and liquidity concerns resulted in panic sales all across, which further led to a downward spiral of asset prices, sinking profits, and the general erosion of equity valuations, across the globe.

Post the financial crisis, banks put in conscious efforts to move back toward better capitalization, in part, also due to stiffer regulatory demands. However, they continue to struggle with concerns around low profitability and their inability to sustain capital buffer to extend credit– a critical need for many growth-starved economies. This has also resulted in a shift to new business models for improved profitability and sustainable operations. The focus now is to minimize leveraging of equity and adopt strategies that promote investments with healthier RoIs, while increasing shareholder value. As a result, the role of the banking CFO has expanded to include the responsibility for making recommendations for organizational strategy and evaluating post-execution performance.

In light of these developments, banks need to have strong mechanisms for enterprise performance management (EPM). They need efficient EPM systems that provide holistic as well as granular views of the

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enterprise. CFOs can use such systems to gain a deeper understanding of the bank’s current and future financial valuations, profitability, and cash flows (both on and off balance sheet), for better transparency and improved capability to make future projections. By enabling CFOs to actively participate in the strategic planning and forecasting process, and allowing them to set target performance metrics and recommend course corrections as and when required, these systems help in ensuring the bank consistently creates shareholder value.

How Shareholder Value is measured

As per financial literature, entity valuations are done on the basis of financial reporting standards and frameworks, and the results are presented in financial statements. However, market volatilities over the last decade have changed the perception of value, engineered new business models, and developed complex financial instruments for risk management. These changes have in turn triggered a need for a reappraisal of standards and regulations to classify and measure the value of an enterprise. The mere valuation of an enterprise’s assets and liabilities at a given point of time does not quite suffice to capture the value of a going concern.

Industry analysts use several methods to measure and forecast shareholder value based on conventional market multiples. These include PE ratio, MBV approach, and other evolutionary models around cash flow discounting such as the dividend growth model. The banking industry is susceptible to credit cycles and loan defaults, therefore market anticipations based on ratios (like PE and MBV) have limitations and can lead to distortions in valuation forecasts. Shareholder Value Added is another measure calculated as the excess of an enterprise’s Return on Equity (RoE) over the shareholders expected Rate of Return (RoR); it reflects the company's efficiency in utilizing investor money.

A bank’s valuation is best gauged not only with respect to present intrinsic valuations on its books, but also its future cash flows expected on a ‘going concern’ principle. These future cash flows arise from on-balance sheet business (net interest income) and off-balance sheet business (fee-based incomes like advisory work, commissions, asset management, brokerage, and so on).

Operating in a business environment that is often on the edge, and surviving a regulatory framework that keeps getting stringent in response, banking organizations are compelled to make continual assessments of what creates value and what erodes it. Technology can help make these dynamic evaluations and simulate their impact on shareholder value, using granular data, economic, business, and decision variables, and by embedding domain insights into related IT applications.

Shareholder value reflects an organization's efficiency in using investor money, responsibly and profitably.

Continual assessment of how you fare on this parameter is therefore a business imperative.

What Impacts Shareholder Value of Banks

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The C-suite's concerns around a bank's valuation need to be understood in the context of many internal and external factors. External factors include the economic environment in which the bank operates financial positions of its peers, their influence on re-pricing products and market share. Internal factors include the current state of its balance sheet, profitability of its lines of business, risks, and the constraints or capacities of regulatory capital.

Banks need to strategize for new business models. This can imply a combination of low profitability with new regulatory requirements (for capital adequacy), portfolio sell-offs, re-pricing of existing business lines, non-core business divestments, and reductions in operational costs. In some cases, banks may move away from conventional credit to more fee-based services to improve returns. Change in business models have their implications on shareholder value in the medium to long term.

Ever since the crisis, many major European and North American banks have undertaken the 'repair' of their balance sheets by de-risking and de-leveraging their positions. Balance sheets strengthened for regulatory capital however, imply carrying higher costs (a higher equity spread on bank loans), as well as lower return on equity (ROE) and return on assets (RoA), compared to historical values. Lower profitability is reflective of cautious, conservative, low risk-return activities and a carryover of past burdens in terms of Non-Performing Assets (NPAs) in a sluggish economy as well as high litigation costs.

BASEL III requirements for LCR (Liquidity Coverage Ratio) and Net Stable Funding Requirements (NSFR) will further nudge banks toward liquid (low return) assets. Change in the regulatory environment has influenced this balance sheet repair exercise, thereby impacting valuations.

Profitability or earnings are influenced by investment decisions that may lower Net Interest Margins (NIMs). Decisions on re-pricing and timing of deposits and loans also influences interest rates that in turn impact profits. Other factors include operating efficiency of banks (impacts technology decisions and business models), inflation (impacts salary escalations), and restructuring exercises (which may imply higher cost-to-income ratio). On the other hand, improved asset quality and capital ratios encourage banks to increase loan clientele and promote growth. Restructuring of operations can improve profitability and shareholder value in the long run.

Banks find themselves in varying circumstances of recovery and capital strength proportions, amid business restructuring exercises for restoration of capital or profitability, as well as hangovers of past debt and litigations. Further, current and future economic factors may influence each other in evolving country-specific economic phases. Banking CFOs therefore face multiple challenges, constraints, and factors that influence each other, which in turn might result in an upward or downward spiral in shareholder value.

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Enterprise Performance Management is the Answer

Once established on the basis of financial valuations and cash flows, the enterprise shareholder value can be understood in terms of key financial metrics. These include profitability, operating efficiency, leverage, liquidity, and capital adequacy. A banking enterprise therefore requires a strong EPM system to accurately evaluate itself and its entities— the group, parent, subsidiaries, business lines, value centers, and branches.

This requires EPM systems to have planning, forecasting, budgeting, and performance review capabilities that align with the bank's objectives for enhancing shareholder value. The EPM system should also build in the flexibility for the bank to recast its plans and forecasts if necessary, considering the business or economic cycle it finds itself in.

Designing an Effective EPM System

Any enterprise system for evaluation, tabulation, analysis, and suggestion, is only as good as the data and process definitions fed into it. Hence, the primary requisite of a good EPM system for banking institutions is the access to accurate, current enterprise data. This will ensure the accuracy of projections on profitability, cash flows, and more. Key considerations while designing an EPM system for banks are:

Enterprise data: Granular enterprise data on deposits, loans, investments, and other financial instruments could be related to current balances and contractual terms with regard to interest rates and maturity patterns, cash flows expected from each instrument, and more. These data points are used to calculate their summarized impact at an enterprise level for upcoming forecast periods.

Macroeconomic indicators: Geography-specific macroeconomic indicators should be defined to assess the impact on projected financials, which should further be modeled in accordingly. These macro-economic indicators include:

Interest rate yield curves applicable to forecasted periods Impact of inflation on the yield curve and associated effects on re-pricing decisions and growth rate Influence of indicators like GDP on deposit, loan growth, and investment sentiments The conjoint set of factors that indicate the stage of the credit cycle that the enterprise will be in a given

period, and related impact, for instance, on lending activities and non-performance allowances for the period

Intrinsic factors: Intrinsic factors that influence banking processes should be modeled into the EPM system. These are:

Factors that influence prepayments of loans (like age and tenure) or make customers switch loans (for instance a change from floating to fixed rates)

Decisions that influence deposits (for instance, their growth, shifts from one type to another) n Transfer pricing decisions that influence deposits and loans (consumer, corporate, inter-bank) n Circumstances that influence re-pricing decisions

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Risk factors and key decision variables: The EPM system must provide a mechanism to identify risk factors and key decision variables to assess the impact on financial projections. The mechanism should help banks:

Identify and aggregate risks, categorized by their nature (for instance, credit, market, liquidity, operational, strategic, and regulatory risks)

Understand the impact of different decision variables (for instance, re-pricing, transfer pricing, strategic growth factors, and more)

Factor in the impact of strategic initiatives that influence market share, revenue, operating costs, and so on

Identify and model in specific litigation costs based on past behavior or future probability Model risk impacts on financials using statistical distributions and simulation techniques

Controls and constraints: The EPM system should provide specific controls and constraints within which all projections can be made. These include:

Factors that constrain or control financial projections (for example, asset liability management (ALM) approaches or guidelines, controlling or limiting parameters indicated in a management plan, loan-deposit ratio, liquidity coverage, fund stability, and other bounding factors)

Ability to predict and set resource requirements (for instance, resources and funds needed to meet the bank's growth requirements in line with its strategic plans)

Quantitative methods: The system should have simulative features, scenario building capabilities, and optimization techniques. These include:

The ability to simulate and stress test projected financial statements for positions, profitability, cash flows, and more

Capital optimization models to reconcile regulatory capital with economic capital and provide metrics for efficient and optimized capital management

Dashboards to view the impact of changing variables by way of 'what-if' analyses or simulation of performance indicators for all aspects of profitability, efficiency, credit, liquidity, and solvency (like ROE, Risk-adjusted Return On Capital (RAROC), NIM, (NIM Customer Spread (CS)%), CIR (Cost Income Ratio),NSFR, LCR, and others)

Data visibility: Holistic, dimensional, pivotal, and granular views of projections and actual results. These include:

Financials and relevant performance indicators classified by organizational dimensions: products, channels, business lines, geographies, large customers, and more

A breakdown of the ROE and RAROC to their elemental components at the enterprise as well as the LoB level, after appropriate allocation of capital and profitability

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Usage of RAROC as a pointer to hurdle rates for channels, LoBs, products, or important customer relationships

Compatibility of budgets and forecasts with financial statements with regard to accounting policies and standards, and the ability to track all line items of financial statements, whether from a group consolidated level or subsidiary level, to requisite detail in books

Shareholder value and its breakdown to all the parameters that influence it

Conclusion

Shareholder value is a pragmatic and holistic measure to assess a bank's financial health. Performance management systems for banking institutions need to go beyond common market multiples and provide deeper insights into future profitability and cash flows, to understand and predict shareholder value. EPM systems need to have requisite analytics capabilities to provide ample granularity regarding this vital parameter in terms of banking metrics like profitability, efficiency, credit, leverage, liquidity, and capital adequacy.

As a bank's shareholder value may grow or erode depending on its macro-economic environment, other than its own business model and capital arrangements, the forecasting mechanism must tie into, and be relevant to the economic cycle or phase in which the organization operates. The logic and algorithms embedded in systems should also necessarily provide the means to simulate stress and optimize financial forecasts while making regulatory capital requirements economically viable.

A convergence of digital solutions, analytics, domain insights, knowledge of standards and regulations, and quantitative methods is needed to calibrate and drive shareholder value across the enterprise.

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