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Principles of the Well Managed Bank
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The well managed bank is an approach to modern banking defined as a bank that adheres to the fundamental principles of banking, as defined by the Supreme Court of the United States definition established in 1899: A bank is an institution, usually incorporated with power to issue its promissory notes intended to circulate as money (known as bank notes); or to receive the money of others on general deposit, to form a joint fund that shall be used by the institution, for its own benefit, for one or more of the purposes of making temporary loans and discounts; of dealing in notes, foreign and domestic bills of exchange, coin, bullion, credits, and the remission of money; or with both these powers, and with the privileges, in addition to these basic powers, of receiving special deposits and making collections for the holders of negotiable paper, if the institution sees fit to engage in such business. Within this definition, there are three pillars of banking - customers, capital and staff. To receiver the money of others on general deposit - refers to customers, to form a joint fund that shall be used by the institution, for its own benefit, for one or more of the purposes of making temporary loans and discounts; of dealing in notes, foreign and domestic bills of exchange, coin, bullion, credits, and the remission of money; or with both these powers, and with the privileges, in addition to these basic powers, of receiving special deposits - this refers to the capital upon which banks are founded and run, and finally, the last part of the definition, which refers to the decision makers within the bank, illustrates the staff and people that work for and within the bank. This wide-accepted definition of banking can be distilled down to banks being a well-blended mix of customers, capital and staff. This definition was expounded upon and made succint by US Justice Holmes 1901: "The real business of the banker is to obtain deposits of money which he may use for his own profit by lending it out again." A shift in banks’ ideological thinking helps to determine when and how banks strayed from these principles. While the principles remained the same in terms of obtaining deposits of money with the intention of lending them out again in an effort to profit, the manner and focus in which they obtained those profits and the tools and structure used to get there changed. The banking landscape shifted toward fast profit making and increased exposure to risk. While turning out record profits, banks were leaving themselves exposed and vulnerable - weaknesses which eventually manifested themselves in an inability to gather short term credit and liquidity, which was both one of the causes and symptoms of the Financial crisis of 2007-2010. Banks had become accustomed to being able to shed unwanted investments easily and found themselves holding investments they neither wanted nor fully understood as confidence ebbed in the financial markets. When, how and why did the shift toward fast profit making occur - and how did banks view themselves? Before the global recession, banks were focused on fast growth built around expanding their customer bases, and continuous innovation in their product lines in order to attract customers and increase their share of their customers’ business. Today, banks are more conservative and their focus is on managing their key resources for long term profitability. Vikram Pandit, chief executive of Citigroup summarized the 180 degree shift in ideology toward this conservative viewpoint: “At the heart of it, we are a bank, not a financial supermarket. We are a bank.” Pandit’s text can be interpreted to read that Citigroup was turning away from fast profit generation, innovation for the sake of marketing and investment and business decisions based purely on short term impact. Instead, one can see a return to something closer to the definitions of banking mentioned above. This represents the change in attitude necessary for banks to survive and to move forward. A renewed focus on customers, capital and staff is the foundation upon which a sustained banking recovery will be built. These three pillars represent the new school of thought in the banking space: the well managed bank. This approach is being enacted on a global scale; organizations such as the Canadian Bankers Association have also clearly referenced a return to employees, customers and investors - which is, in turn; customers, capital and staff. What constitutes a well managed bank At a high level, a bank should engage in the prudent management of its assets. This means that it needs to balance the interests of its owners and other stakeholders both now and in the future. Assets need to be deployed efficiently in a way which is aimed to maximise current profits. However, they also need to be applied in a way which seems likely to produce future revenue streams and opportunities, balanced against the likelihood of future losses resulting from unforeseen events. In other words, risk needs to be taken into account - and the longer the time period that the bank uses for its business planning, the more import risk management and mitigation techniques become. A bank has three main assets; its customers, its staff and its capital. Customers All of a bank’s business and revenue is derived from dealing with its customers. This is true for all kinds of banking; Retail, Private, Corporate and Wholesale. It is necessary for a bank to understand clearly which kind of customer it has, and which kind of customer it wants. It is then necessary to map products and instruments to these customer types. The whole strategy of dealing with marketing, customer insight, customer relationship management and customer servicing derives from this understanding. In all of this a bank needs to continue to bear in mind both short-term and long-term profitability. This means that the disciplines of profitability measurement at customer segment level and risk management need to permeate the operational and management processes. The operational activities underpinning this need to be executed efficiently. This means that only appropriate products are targeted to customers. In this case, appropriate means both products which a customer is likely to actually purchase, and which the bank is likely to actually successfully originate to the customer. In this way, little effort is wasted in starting sales processes which are unlikely to have a successful outcome. This does, of course, have the incidental benefit of increasing customer satisfaction with the bank. This kind of customer-centric approach based on customer insight and a tight link with both profitability and risk data is applicable across all kinds of banking. It is a useful tool when selling retail deposit or credit solutions to individuals; it is equally applicable when selling bonds to other banks, structured products to high net worth individuals and cash management solutions to corporations. Many banks have survived for many years without applying to much focus in this area; operating in this way seems unlikely to remain viable given the changed economic and social environment in which banks now find themselves. Staff A bank’s staff represents its ability to respond to market changes, to innovate products and to execute and service its commercial operations. Technology operates within a bank by leveraging the judgment and abilities of the bank’s staff, but a bank still needs the skills and experience of people. Skilled staff are, however, inherently non-scalable and expensive. They are thus a scarce resource and should be applied where they generate the greatest revenue or mitigate the greatest risk. There are two main approaches to achieving this, and any individual bank may adopt both of these at the same time according to which is the most useful and appropriate for any given situation. In the first instance, intricate yet repetitive activities should be automated as much as possible. In effect this allows the armies of clerks which were previously used for back-office and operational roles to be re-deployed to more revenue focused activities. A prime example of this is the bank reconciliation process. This forms a core financial discipline in the avoidance of error and fraud within a bank, and is intrinsic to the bank being able to know its own financial position with any degree of certainty. The task is basically repetitive, but can require a fair degree of judgment in deciding what makes a reconciliation match. Added to this, there is potentially a high volume of data needing processing in this area. The use of automated matching and reconciliation software removes the need to have so many of a bank’s scarce staff employed in doing this - clearly the better the technology, the higher the match rate and thus the greater the automated efficiency. In the second instance, technology is used in a bank to make sure that pieces of work are delivered to the appropriate staff according to their importance and the overall workload of the organization. In the process of doing this, simpler categorization and decision-based tasks can be automated using rules or similar technology. This is generally referred to as Business Process Management. As a discipline, it views the banking business primarily as a collection of processes which link together analytic or processing activities. Its aim is to optimize this in terms of efficiency and risk control. Since many of these activities are carried out by a bank’s staff, this impacts the efficiency with which these staff are used. To gain real benefit from Business Process Management, it is necessary to see it as operating with a lifecycle. In the first instance the existing business processes are modeled, preferably using an interactive, graphical tool. These may then be worked on to gain efficiency and other improvements. As part of this, it can be useful to run simulations which enable different operational and business scenarios to be played out. Once a set of processes has been decided upon, these can be deployed for operational use. At this point, their real-world execution is monitored both for real-time operational management but also, more importantly, for subsequent analysis. This is usually referred to as Business Activity Monitoring. The main benefit derived from the subsequent analysis is that the real-world execution can be compared against the process simulations which were executed earlier in the process design lifecycle. This offers the ability to be able to learn from real-world execution and hence to improve the process design. Capital A bank’s capital represents the initial funds contributed by the banks shareholders. It operates as a buffer to allow the bank to sustain losses and liquidity problems in the short term. Modern regulatory and banking thought limits the size of the bank’s business according to how much capital the bank has. The importance of capital to banks globally cannot be understated, and its relation to banks' management structure has been noted by governments around the world. As with staff, capital is thus, by definition, a scarce resource within the bank. It should therefore be used in a way which generates the best long-term profits, and should be preserved by trying to ensure that the bank reduces the level of risk it embraces to an appropriate and manageable level. Although it is easy to measure how staff is used, it is not so simple with capital. This is because capital is never actually used until the bank sustains a loss or liquidity shortage - and then it is too late to either try to measure whether there is sufficient capital or to start to calculate how best to use the limited amount of capital at a bank’s disposal. Instead, capital is “allocated” to different parts of the business according to their likelihood of using that capital in the future. This equates to the chance of a loss or other capital consuming event happening in any particular part of the business - in other words, the risk. Capital is thus allocated according to risk of a transaction or business line within a bank. The measurement of risk comprises of two main dimensions; the probability of a loss occurring, and the size and impact of that loss if it did occur. A bank therefore needs to measure all kinds of risk. Typically this will include market risk, credit risk and operational risk. Following the events in 2007 and 2008, these are now increasingly joined by liquidity risk - a measurement of how long a bank could survive if its access to liquid funds from the market became constrained or ceased altogether. Having thus established how capital is allocated according to various risk management mechanisms, the bank must finally ensure that these allocations are correct in terms of revenue as return on capital. In other words, could overall revenue be increased if the business shifted to focus on different priorities and thus the pattern of capital allocation changed. A Structured Approach to Managing Resources Banks need to concentrate on how they use these three assets. In the case of customers, they need to make sure that the customer profiles they have are appropriate to their business, and that they maximise long term customer profitability by selling the most appropriate products and instruments to these customers that they can - appropriate both in terms of immediate profitability and in terms of long term customer satisfaction and hence likelihood of enjoying repeat business. In the cases of staff and capital, where both are constrained resources, the requirement is to ensure that they are used in the most efficient way in terms of sustainable revenue and risk. All of these three assets can be better managed if a structured approach is taken to them. Specifically, there are at least four stages to this structure. Understanding A bank needs to be able to understand how much of each of these assets it has, what they comprise and how they are organised. Without first establishing this understanding, no further progress is really possible. There are many different ways in which this can be achieved; some illustrative examples are set out here: ::* Customers Customer profiling and segmentation is only possible if a bank has an overview of each of its customers. This needs to include contact and product portfolio information, but also other data such as financial information, past transaction history and anything else which helps the bank to get a rounded picture of the person or company. All data becomes useful, including data which a bank does have access to but does not normally collect at customer level. A good example of this would be product offers which the customer has positively rejected, together with the reason for this rejection ::* Staff As described above, a Business Process Management approach can help a bank to implement Business Activity Monitoring. An analysis of this will give a bank the understanding of how its staff is currently deployed. ::* Capital An understanding of the risk allocation of capital in a bank requires there to be some kind of centralized risk warehouse with an appropriate analytic set running against it. Allocation Once a bank has an understanding of the assets it has, it can then consider how they should be allocated. They key is to aim for sustainable profit generation. In the short term this is mainly focused on certain net revenues, since only income and variable direct costs can be changed. As the time horizon lengthens, it is necessary to take into account risk. Risk is the financially quantified likely rate of loss given events occurring which are not part of the original business plan. It is important to concentrate on both the short term and long term views to arrive at this sustainable, profitable business model. Measurement One the allocations have been made in practice, it is very important that their actual performance is measured against their expected performance. Without this, there is only a very limited scope for improvement. The measurement has to take place both at a macro objective level as well as at a more detailed level - without a reasonable level of granularity it is hard to draw firm conclusions. This implies that a bank has to have adequate profitability and risk systems in place to allow this measurement to happen with appropriate granularity and with appropriate accuracy. Learning Having measured how the bank and its assets performed, it is possible for a bank to draw conclusions from this. These can then be used to improve all parts of the lifecycle. It could be that a better understanding of the assets is needed, it could be that the allocations were made on the basis of a too simplistic or flawed set of models, or it could be that it was not possible to appropriately measure the usage and outcomes. It could, of course, be that the assets are insufficient or of the wrong type. The real value of the overall approach is only realized when this last, learning stage is undertaken. Utilizing the principles of a well managed bank The key principle of a well managed bank is that banks should look to their three fundamental assets and consider how they can leverage them to create sustainable profitability and growth. In the years leading up to 2007, some banks lost sight of this and became overly focused on achieving growth in the short term at all costs. This was based on the understanding that a bank could always find funding in the market, and that a bank could always dispose of assets it did not want, or buy in new assets to be held on a temporary basis in order to give its book a different balance. These assumptions proved to be invalid, hence leaving some banks with only the remains of a growth strategy in place. This proved not to be sustainable in either the long or short term, and well managed banks not only survived, but continue to thrive. Banks can gain great advantage by examining how they use the three assets of Customers, Staff and Capital. Every increase in the efficiency of how these assets are allocated and effectiveness of how they are managed will help the bank move to a more sustainable profit model. If the bank looks at all three of these assets in a holistic way, and adopts a broad based approach to understand, allocate, measure and then learn from how they are used, then it could be considered to be a well managed bank. See Also
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