Managing the value of financial institutions: Part 3: how CFOs and strategists help create value

Beverly J. Foster

Part 1 of this series discussed the way shareholders value financial institutions. Part 2 contrasted that with how financial institutions measure performance internally, identifying two common areas for improvement: 1) how to better integrate the internal metrics used by the firms and shareholders' valuation; and 2) recognizing that better information is necessary but not sufficient for good decisions. This final article reviews how CFOs, CROs, and corporate strategists can help drive better decisions based on improved information.

A Tough Job, a Unique Opportunity

In introducing the third and final round table panel, conference chairman Thomas Wilson of Mercer Oliver Wyman summarized two of the most important challenges facing financial services CFOs, CROs, and corporate strategy departments:

1. How to provide better information to management by aligning the firm's internal performance metrics with the way shareholders value the company.

2. How to get management to act on the information to ultimately create shareholder value.

[FIGURE 2 OMITTED]

Arguing that even firms with good information often make bad decisions, Wilson urged the panel to look beyond the hard measurement issues discussed by previous panelists and toward softer management issues, arguing that a faulty alignment of decision organization, processes, and incentives is as likely to lead to bad decisions as bad information is.

To illustrate this point, Wilson used a capital management example from a large, global bank that had done an excellent job 1) developing its capital reporting framework covering regulatory and ratings agency perspectives; 2) developing contingency plans; and 3) performing sound competitor analysis. The resulting report was discussed at the traditional Asset/Liability Management Committee (ALCO), chaired by the CFO and with primary representation from Treasury and the trading businesses. ALCO used the information to identify and approve the necessary capital allocation decisions. Given that capital management and capital structure decisions were within ALCO's remit, this seemed reasonable.

What the bank did not immediately realize was that 1) capital allocation is a zero-sum game--if one unit gets the capital, another cannot; and 2) the capital allocation decision has a real strategic impact on relative growth rates and economic profit contributions of the different business units. Experience quickly showed that it was going to be difficult, if not impossible, to make strategic decisions when a number of relevant participants--e.g., the retail, commercial, and corporate bank--were not represented. The bank also quickly recognized that the new capital management process was directly at odds with the strategic planning process that included all relevant participants in other decisions affecting the firm's value, such as earnings, growth, and cost efficiency targets. In essence, this bank was prevented from making good capital allocation decisions not because of a lack of good information but because the decision organization and processes were not aligned to effectively clear the decisions.

What role can the CFO, CRO, and corporate strategist play in helping the organization make better decisions given an improved information basis? Wilson suggested that the answer to this question can be found in the performance measurement framework as outlined in Parts 1 and 2 of this article. That framework integrates earnings, growth, risk, capital, the cost of capital, and shareholders' expectations. Looking at these elements, Wilson concluded that Finance and Risk need to bring to the table three core capabilities to help the firm make better decisions:

1. Value-based planning and management capabilities, including the link to incentives.

2. Balance sheet and capital management capabilities, covering the overall level and structure of capital as well as the financial resiliency and liquidity of the institution.

3. Ability to communicate the company's strategy and performance to the various stakeholders--e.g., investors, ratings agencies, and regulators--to effectively minimize the information gap between shareholders and the firm.

Wilson pointed out that the roles of the CFO, CRO, and corporate strategist increasingly encompass the three core capabilities. These positions are responsible not only for reporting and controlling, but also for strategic planning, balance sheet management, regulatory as well as economic capital attribution, risk and performance controlling, investor relations, and more. Assigning responsibility for these roles is not a guarantee of success, however. How effectively the CFO, CRO, and corporate strategy department pull these levers and make use of the improved performance metrics presents another challenge, one that is radically different in proportions and character from the measurement challenges discussed in Parts 1 and 2 of this article. Rather than taking a financial mathematics approach to answering the question of how to measure performance, the institution must take a more human perspective, getting the right people in the right place to make the right decisions and reinforcing that behavior continuously.

Wilson left the panelists with three questions:

1. How do you see your roles along this more human dimension?

2. How can you help the company clear difficult, zero-sum strategic decisions, e.g., define the optimal strategy, set meaningful targets and continuously reinforce the execution of that strategy?

3. What capabilities do you personally need to help the institution make better decisions on whatever information basis is available?

Tom Woods, Senior Executive, Vice President and Chief Financial Officer, CIBC

When I became CFO five years ago, we wrote a research report, as any research analyst would do, on each business, treating each as a stand-alone business. We played back our analyses of how the market would view each business to the management team--only a few members of the team had any previous experience in the investment industry.

A CFO's department must arbitrate which businesses will be the potential winners--a tall order. CIBC has 37 individual businesses to assess each quarter in terms of the people, the value proposition, and both current competitive advantage and "aspirational" competitive advantage. Making a judgment about the credibility of aspirations entails keen understanding of the quality of the people and the business. We also must evaluate the current mood of the investment community--investors, analysts, ratings agencies, and, to some extent, the financial media. We listen to each of our competitor's quarterly earnings Webcasts and try to read between the lines as well.

At the end of the year, my team sits down with each of the three business-unit groups, each of which has eight to 10 lines of business. We rate each of our 37 businesses on a scale of one to five--not on how they did against plan, but how they did against the competitors in the market environment that actually transpired three to 12 months after the plan was actually put in place. These are tough sessions because those people know that they're going to be paid based in part on Finance's assessment of how they performed.

Following large corporate loan losses, private equity write-offs, and some other challenges faced in 2002, bank investors, for the most part, no longer wanted to pay anywhere near the option value they had in previous years. Growth is valued to a degree, but now it's also assurance that the bank doesn't have volatility and the potential to make mistakes. And who are the bank investors? Often, it is dividend funds or funds that don't necessarily have to be in the first and second quartile all the time but must avoid being in the third or fourth quartile too often. Many large financial institutions reacted by reducing their private equity business mix and exiting or severely limiting corporate lending to any entity with a high-risk profile. The whole business mix shift to retail banking and wealth management occurred post 2002.

[FIGURE 3 OMITTED]

A performance culture within the bank is influenced by the extent to which businesses get paid fair incentive compensation for the risks they take or for continuing to generate consistent earnings. CIBC emphasizes all the metrics--SVA, RAROC, top-line growth, and market share--but at the end of the day it's a judgment call, and this works much better with a cohesive management team that's been together for a long time. The institution must decide the kind of business mix it wants, how risk averse it wants to be, whether it will retain earnings or pay them out to shareholders, and where it wants to position itself relative to the competition. These decisions relate not just to bond rating, but also to the premium to be paid on avoiding negative surprises.

I spend the equivalent of one month a year with an increasingly select group of investors. Although most big companies debate how much time should be spent talking with hedge fund investors, we do spend a fair amount of time with them--not because they're long-term investors (they're not), but because they're sharp and have good questions. It's a dialogue that we value. But no question: You have to keep in touch with investors. Finance also must engage the board more than ever before, particularly in light of today's legal environment. Management must never assume it can move forward with a corporate strategy without the active engagement of the board.

Elizabeth Monrad, EVP and CFO, TIAA-CREF

Since 1918, TIAA-CREF has offered pensions and other financial products for employees of colleges, universities, organizations, and for other not-for-profits. Ranked 68th on Fortune magazine's list of largest companies, TIAA-CREF is recognized as the largest private pension system in the U.S., with about $345 billion in assets and 3.1 million pension participants.

Because our customers own TIAA-CREF, we don't have the tension or trade-offs between what the customers want and what's best for the shareholders. As CFO, my goal is to help the businesses with their strategic planning by showing them what is going well and what is not going so well, which involves a good deal of modeling work and financial planning in general. I also have oversight responsibility for treasury, taxes, the ratings agencies, investment accounting, internal audit, corporate facilities, procurements and disbursements, and the actuarial function within our insurance company.

TIAA-CREF has the largest surplus of any life insurance company in the U.S. Its liabilities span decades, so maintaining AAA financial ratings is a top priority. Costs associated with our decision to adopt Sarbanes-Oxley voluntarily were high, but it was a very wise move from the perspective of ensuring that our control environment is as sound as possible. No organization can take its operational effectiveness for granted. Enron taught everyone that putting the deal on the books does not ensure that everything is fine. The culture at Enron did not value responsibility for making sure that the duration and completion of a deal were well executed.

Finance initiatives. A fairly new management team formed in 2003 looked hard at our cost structure, as costs had been rising at about 9% per annum in a soft market when our assets were flat. Among the goals within the firm, those that involve finance are:

* Useful, timely, management reporting.

* A value-creation focus.

* Strong internal controls.

* Efficient processes.

* Superior financial systems.

* Leadership in the annual planning process.

* Technical depth.

* Sound capital allocation and capital management.

* Enterprise view of risk management.

* Compliance discipline with zero defects.

TIAA-CREF's compliance unit has about 80 people, which is significant for an institution with a total head count of about 6,000. In addition, each business area knows that it's part of the job to be, in a sense, a chief compliance officer within its area. Further, at TIAA-CREF, risk management is a stand-alone function that reports to the CEO, but if the CFO isn't close to risk management and there are surprises, the board will wonder what kind of controls the organization has around finance and planning.

So the CFO has to balance multiple constituencies. First, TIAA-CREF has three boards of trustees/overseers. We held 65 meetings of the boards and committees in 2004. The mix of university representatives and business leaders on these boards gives our discussions the feel of a very productive faculty meeting because there are always far more questions and dialogue than agenda time. But their unifying goal is ensuring that TIAA-CREF practices are best in class.

The four ratings agencies also require a lot of my time to help ensure our top ratings. At General Re, where I worked before coming to TIAA-CREF and where we also had the highest ratings, our reviews were about once a year; at TIAA-CREF it's annual on-site reviews and quarterly conference calls with each agency. We never lose touch with them, and we never want to surprise them.

The same time investment applies to the regulators, and we enjoy an excellent relationship with the New York Insurance Department. If something is coming around the corner that they might not be aware of, an ongoing representative on our team makes sure they aren't surprised. As seen by other institutions, when you surprise the board, the ratings agencies, or the regulators, the results can be harsh.

Post Sarbanes-Oxley, I spend far more time with auditors as a CFO. The Public Company Accounting Oversight Board (PCAOB) now has auditors looking much more closely at control systems and judgments the companies are making.

Outside the CFO silo of responsibilities, the CFO role should include being a champion for identifying and encouraging profitable growth opportunities and shareholder value. We must look for opportunities where the investment gains will exceed the company's cost of capital. The CEO expects me to play a key role in the budget process in determining which areas get to the investment dollars and which don't. It can be a challenge interacting with the businesses; although we like to think of Finance as a partner with the businesses, there are times where "no" has to be part of the CFO's vocabulary--and that's hard but necessary.

Value creation. A strong governance structure is integral to value creation, and that begins with getting the culture right. The right leadership team, the right metrics, clear accountability, and supporting incentives all play into getting the culture right. And you must have the people with the right skills, who can make the tough decisions if necessary. The design of management information systems and incentives alike must highlight the company's sources of value and drill down from there.

Value creation also entails a process to make business decisions. TIAA-CREF is implementing economic value added (EVA) on the investment side. EVA will help us by enabling a more risk-adjusted evaluation of the investments that we are making.

Financial planning just can't be something that's done once a year and is independent of the strategic planning process; rather, the two must be integrated as strategic and financial planning. The starting point of their work is the institution's vision. In 2003, TIAA-CREF's CEO wanted to empower people at other levels to figure not what we need to do differently. He created five teams of executives, made up of 60 senior managers representing a cross-section of the organization. Each team had four missions:

1. Look at our marketplace and examine what nut competitors are doing that we should respond to.

2. Examine the economic drivers of our operations. Before I arrived, the focus had been on statutory accounting, which isn't the most useful management reporting tool.

3. Evaluate our talent management programs and see whether the right incentives, skills, and training were in place. The organization's culture must emphasize the importance of a highly ethical sense.

4. Assess our strategic use of technology.

The resulting recommendations were presented to the board, and we're in the process of executing the strategies developed.

Confronting Reality: Doing What Matters to Get Things Right [Larry Bossidy and Ram Charan, Crown Publishing Group, 2004] opens with a few simple but key questions that need to be answered to understand any business:

1. What's the nature of the game you're in? Do you really understand your business sufficiently?

2. Where is the business going?

3. How does it make money--what are the sources of value creation?

Warren Buffett was the great simplifier. When he acquired General Re in 1998, he wanted the company to focus solely on the combined ratio. But what he was really saying was that he wanted underwriters to focus on underwriting and underwriting profitability and not to worry about other distractions. So he presented one metric: When you boiled it all down, insurance companies are about producing low-cost float, that is, using other people's money at a low cost--ideally, a negative cost. Of course, there are two drivers of value for an insurance company: the underwriting discipline side and the investment side, which Buffett handled as one of the world's great investors. The industry lost underwriting discipline in the 1990s on the primary side as well as the reinsurance side. Life insurance companies need asset/liability management discipline. As primarily a spread management business, its CFO needs to be worried about managing the risk/return trade-offs.

Sol Gindi, Senior Managing Director, Corporate Strategy, Bear Stearns

Bear Stearns established the Corporate Strategy Group to make senior management responsible for institutionalizing certain processes for allocating capital and measuring performance, as well as to give management at the business-unit level greater incentive to work with senior management. Having those two sides work together to implement a process adds value to any firm. It's not easy to do.

In December 1993, Bear Stearns had decided to wait and see how reengineering, quality management, and EVA were working elsewhere before jumping into those initiatives. At the time, Ace Greenberg, our chair, believed we would continue to be even bigger winners if we watch expenses, work for our clients, and keep our feet on the ground and our heads on straight. "Our results will continue to amaze the business schools and maybe they will try to figure out our revolutionary methods," he said

After Bear Stearns became a public company in 1985, we grew very quickly--since 1993, our assets have risen from $25 billion to $250 billion, our capital has grown from $1 billion to more than $40 billion, and our revenues have quintupled. The most effective way to plan and implement strategy in an environment of fast growth is to first ensure standards are implemented across the organization--that the standards are accepted by senior management and business units alike. Business-unit managers will tell you that they can deliver if they know what you need.

A commonsense approach to business will always be the foundation of Bear Stearns's strategic thinking. However, given the growth and diversity of our business lines and management, especially as we put new business online, the biggest value the Corporate Strategy Group offers is to help management agree on the corporate direction and steer the business where we want to go. We have five goals in creating strategy:

1. Give management an idea of how our performance (relative, as opposed to absolute) compares with the competition's. Many ideas of how management could start thinking about their business emerge from that information. We use many of the same metrics described by other panelists to provide that information.

2. Ensure that capital is used efficiently and effectively across the firm. It's important that everyone is judged using the same yardstick.

3. Coordinate efforts across the firm to maximize client relationships.

4. Standardize the analytics around entering new businesses so that we might judge all new business opportunities on an equal playing field. A standard analysis also helps people understand what is expected of them when they enter the new business to be able to gauge their performance.

5. Ensure that the employees' interests and the firm's interests are exactly the same. We believe in employee ownership, and we have managed to retain much of the "partnership culture" that Bear Stearns started with. Aligning interests is one of the strongest drivers in how we promote profitable growth.

The other critical factor is that no matter bow good an idea looks on paper, nothing gets done unless we can assign accountability for getting it done. When that person or group presents results, they know if they have done it well or not. There is no room for debate.

Ken Huguessen, Senior Partner, Mercer HR Consulting, Toronto

The bulk of my group's work at Mercer Oliver Wyman is advising compensation committees on the compensation for a company's top executives. Much of our work with financial institutions is with investment and commercial banking. We've found that line bankers dislike almost any measure of capital allocation for two reasons:

1. Some don't understand it, and who among us wants to be compensated using a measure we do not understand?

2. Some who do understand capital allocation hate it even more. These bankers are a little like the bank robber who gets caught at the door by the policeman, except that they're running away with the balance sheet, getting into all kinds of activities without paying for them. Sometimes they make a good deal of money having taken risks they never knew they took.

You can't fix everything with compensation, especially if you have no idea of your vision and mission and no particular strategy for achieving it. Likewise, compensation isn't the key if the company is structured wrong and doesn't have the right people in the right divisions. The best you can hope to do with compensation is make sure it's not a source of dissatisfaction. Best-in-class employees generally do what they do because they love their work, they have a sense of purpose, and they're part of a team.

While there is much talk of using the real cost of capital to fund different activities and of ensuring the institution understands where it's making money (as opposed to where it thinks it's making money), only a small minority of institutions actually do that. The vast majority make their money by generating revenue. At the very top of the house, stock price and relative stock price generally are not a bad proxy for estimating the risk and return your investors think is embedded in the business. So it's useful to ensure that the top of the house is very seriously invested, and permanently so, using various kinds of stock plans that don't allow people to flip in and out depending on their expectation about the market.

That said, it is, in fact, extremely important to have capital allocation done right. Two reasons come immediately to mind:

1. People in the investment division of a universal bank must understand that there is risk that, in some instances, may be betting the balance sheet of the whole bank.

2. It's very important to allocate among the various operating units within the investment bank. There can be huge differences between just the straight-fee and balance-sheet-oriented businesses. The CFO thus needs to be the policeman protecting shareholders in where and how money is made.

Many people looking at Figure 7 (next page) would say that life gets better as we move to the right. But increasing alignment with shareholder values has more to do with other factors:

* What and who you're trying to measure.

* Getting direct drive for the majority of people who are revenue producers.

* Getting stock in the hands of the people who have to oversee the venture on behalf of the shareholders.

* Acceptable returns for most people in the institution are a constraint, not a goal. While they are a constraint employees need to learn to live with, they do not provide a goal that can be incentivized.

Studies have shown that better governance leads to rich shareholders. But that's a little like saying you're going to get rich if you buy insurance. You need good governance and you need insurance, but essentially they are costs of ensuring you don't have sudden, nasty surprises in the course of doing business.

Dylan Roberts, Director, Finance and Risk, Mercer Oliver Wyman

Everyone recognizes that standard GAAP accounting metrics don't provide a very good line of sight to economic value creation. So it's good that economic performance metrics take risk-adjusted capital allocations into account. As Charles Monet said in an earlier presentation, performance metrics in banking have a lot of influence on decisions like loan pricing, yet people struggle with how to use those metrics and bake them into strategic planning approaches. Several practical challenges make that difficult:

* Picking the appropriate timeframe for value measurement.

* Setting value-creation targets appropriately.

* Balancing intrinsic value metrics with traditional (e.g., accounting) metrics.

* Picking a course of action when value creation may not be possible.

Picking the appropriate time frame for value measurement. True market value is driven by a multiyear view of risk-adjusted cash flows. But it's a huge stretch for most institutions to redefine their strategic planning process along long-term metrics. Annual forecasts and annual budgeting and annual targeting are important, and they're always going to be important. The trick is to also incorporate a view of longer-term impacts.

Forward views of growth, obviously, are going to be an important driver of your perspective on shareholder value. But it's hard to come up with a reliable view of forward growth; we may feel better growth prospects for one business over another, but we need to be able to quantify the underlying assumptions. It's terrific if someone managing a business is able to come up with a great strategic plan that reorients the business toward activities expected to have higher growth in years two, three, four, five, and six. But a lot of people would be uncomfortable increasing the compensation of that business's manager now based on economic performance metrics, preferring to wait until the result forecast actually pans out.

Appropriately setting value-creation targets. The common view is that metrics are meaningful and will get management attention only if they are baked into annual target setting and performance measurement processes. But let's look at the inherent challenges:

* How do you balance top-down and bottom-up targeting? Business-unit heads, arguably, will have the best idea of an appropriate value-creation target for their businesses. Senior management, on the other hand, may be coming in with a top-down corporate target and take the contrary view that they don't really care what business heads think is reasonable, opting to throw out a 20% shareholder value-creation metric and try to hit it. Also, in terms of how targets should be denominated, should you look at absolute dollars of value creation or growth rates of value creation? Finally, it's great for senior management to say they're going to grow shareholder value by 10% or 15% per year, every year, because it provides a simple rallying cry for the corporation. But what do you do with that at the business-unit level? Is each unit expected to hit that same mark? If not, how do you differentiate fairly? All of the aforementioned challenges are strategic planning challenges, independent of whether you're using shareholder value metrics or accounting metrics. But they do complicate the process of getting value out of your investment in metrics.

* How do you balance intrinsic value metrics or economic performance metrics with traditional metrics? Businesses sometimes find themselves in the situation where the best way to create intrinsic value--as measured by any of the models--involves reducing market share or even accounting earnings, which is very painful to contemplate. Besides, the intrinsic value created in this way may or may not show up in share price reaction. The first thing analysts look at is market share, so how does management do the right thing if market, accounting, and intrinsic value metrics are saying different things?

My view is that over time the market will reward measures taken to increase intrinsic value, but others don't want to fight the market now and will go instead with maintaining or increasing shareholder value today. Others may take what they believe to be a balanced approach--thinking about both long-term value and current earnings and current accounting metrics, which sounds rational but is very messy.

* How do you pick a course of action? Let's say you're a corporate lender operating in a market where corporate loan prices simply are not economically rational. During one instance, a private equity investor told us, "We'd love to do value-based pricing, but we might as well just shut the bank down. We'd never write another loan. I guarantee you there is not a single loan available in this market that would pass those hurdles." A market leader who wants to stay in the market will rationalize that once things improve, customers will value that the maket leader continued to hang in there rather than to drop the activity as economically irrational.

No perfect answer. There's no perfect answer when trying to resolve economic value metrics with business pressures, but in general I believe that at the extreme ends, people fall into one of two camps:

1. Incrementalists, who treat value metrics as additional input to their performance reports and as a complement to traditional accounting metrics; leave established management processes intact; and accept that the culture and the mindset may not change. The incrementalist will find that people may continue to do things that look good on an accounting basis but destroy shareholder value going forward.

2. Revolutionaries, who know the market looks at accounting metrics, who know two-thirds of the staff are terrified at the idea of linking incentive bonuses to economic profit, but who also know it's the right thing to do. The revolutionary will retool around those metrics, knowing that may break some eggs, and make people uncomfortable to the point of leaving the company.

There are people who try to stake out something in between. But I don't believe any of them ever feel they've gotten it exactly right.

Figure 1
Three Levers Managed by the Finance Function

                                                  Strategic Finance
Driver            Examples of Tactical Levers       Capabilities

Adjusted Net      Revenue optimization
income               --Cross-sell
                     --Managing customer skew
                  Cost reduction
                  Business portfolio management      Value-based
                                                  Strategic Planning
Growth             Expand footprint                 and Management
                      --Products/services
                      --Customer segments
                   Penetration/share of wallet
                   Realign to grow markets

Economic           Capital structure
Capital             (equity, hybrid, debt)
                   Capital required
                      --Economic/risk
                      --Rating aspiration          Balance Sheet and
                                                   Capital Management
Cost of Capital    Rating aspiration/leverage
                   Portfolio mix

Perception Gap     Disclosure                     Communication Policy
                   Guidance

Contact Beverly Foster by e-mail at [email protected].

Beverly Foster is editor of The RMA Journal. This three-part series derives a one-day conference sponsored by RMA. Mercer Oliver Wyman, PRMIA, CAS, and Microsoft.

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