Performance Measurement in Banking: Beyond ROE
Karr, John
INTRODUCTION
Banks are increasingly using return on equity as the ultimate performance scorecard. The adoption of risk-adjusted capital adequacy guidelines, successive years of poor profitability and the conceptual and practical failings of previously used measures, such as asset growth, have led management to focus on return on equity (ROE). They are measuring the ROE’s of each of the bank’s component parts, such as sectors, lines of business and products. This shareholder value-oriented framework has spawned considerable changes not only in the way that performance is measured, but in the management processes used to plan, operate and control the bank (see Appendix).
However, bank executives arc finding that measuring risk-adjusted return on equity, while important, is not the entire story. Just as their counterparts in manufacturing and process industries discovered, the ROE report card provides a summary level picture of which parts of the bank are contributing to – or detracting from – shareholder value. It does not provide information as to the “how’s” or “why’s” of performance, much as a thermometer provides little in the way of diagnosis. Moreover, it does not indicate progress in terms of the bank’s strategic agenda. While the product of sophisticated analytical, allocation and reporting mechanisms, it alone is inadequate.
Therefore, adoption of a broader set of performance measurement indicators is required. The indicators are needed to provide a better sense of performance along strategic lines, as well as to show how drivers of value are affecting the institution. Other industries have led the charge. Our experience with banks suggests that they, too, are establishing institutionwide and line-of-business metrics that go beyond ROE to provide more insight into performance.
THE PROBLEMATIC MEASUREMENT FRAMEWORK
As astute observers of management have noted, it it’s not measured, it’s not delivered. But what should banks measure? Bank executives wrestle with this problem continually. Many end up blaming the management information systems for producing the wrong stuff. However, bank MIS produces either what is asked of it or, lacking guidance from policy makers, what is easiest to retrieve. Unfortunately, shooting the messenger (i.e., MIS) is simpler than taking the time and effort to define what is truly relevant information.
In fairness, bank strategies and objectives evolve over time, which can cause “disconnect” between required measurements and extant systems. Also, banks have increasingly adopted line-of-business (LOB) organizational structures for management purposes which render their previous legal-entity-focused reporting mechanisms obsolete. However, bank managers as a rule have not taken the time to fully define the measurement frameworks they are using for the bank and its component parts, and which need to be supported by MIS. The adoption of share holder value and return on equity as key parts of the overall measurement framework has complicated matters.
For example, Exhibit I (see page 59) shows several possible dimensions of bank measurement systems. All are of value – though to different persons within the bank. Each combination of dimensions also has value. But is is unlikely that one single measurement system can support all of the combinations that are needed by the various organizations, levels and positions throughout the bank. Yet many banks do expect one system to provide all of the information needed to “steer the ship,” and to focus on one set of indicators which reflect a true and comprehensive picture of performance.
THE IMPLICATIONS
Essentially, bank measurement systems are heavily weighted towards providing historical financial results. Whether at a bank-wide, line-of-business, legal entity or product level, performance is usually characterized in terms of income statement or balance sheet tenus. Even advanced systems which can report risk-adjusted return on equity for multiple views of the bank merely (and we use the term advisedly) shift, splice and recalculate underlying financial data to produce their ROE results.
While financially-oriented perspectives on performance, particularly those which are ROE based, arc important, they arc incomplete:
* Important non-financial indicators are lacking.
* Cross-organization measurements arc both rare and subject to considerable debate.
* Forward-looking views are excluded.
* Measures tend to be inwardly focused and lack external benchmarks or points of reference.
* Outcomes are shown rather than drivers.
As a result, reported measurements are not as useful as they otherwise might be. Determining the bank’s progress in carrying out a strategic agenda is particularly difficult. This dilutes the overall effectiveness of providing shareholder value and ROE measures, which are at their foundations strategic indicators.
THE EMERGING VISION
A new vision is emerging which better aligns measurements with objectives, and which looks beyond historical financial indicators. The vision is primarily concerned with strategic linkages, but its premises can be generalized throughout the organization and used to reshape tactical measurements as well. As expressed by Professor Robert Eccles of the Harvard Business School:
“…senior executives…have recognized that new strategies and competitive realities demand new measurement systems. Now they are deeply engaged in defining and developing those systems for their companies.”
The new vision complements the adoption of shareholder value and riskadjusted ROE as the ultimate scorecards of bank financial performance. As shown in Exhibit II (see page 61), strategies – at the LOG, strategic business unit (SBU) product, or any other level – consist of the combination of resources and processes aimed at markets and customers. The strategies in turn affect the factors that drive value. These factors can include expense levels and structures, pricing, risk, capital, service, quality and a host of other variables, all of which can contribute to the attainment of net growth in shareholder value.
ELEMENTS OF THE NEW VISION
The new vision embraces several important tenets:
Vision and strategy define the appropriate metrics. One size does not fit all. Bank-specific and line-of-business specific measurements – tied to the visions and strategies each has adopted- need to be employed. Traditional systems use one set of measurements common to all businesses. As stated by Peter Burns of CreStates Financial Corp: “We need to develop systems that report how we’re doing in achieving our strategies. This means thinking through which measures are indeed true indicators of strategic accomplishments for each business, and then drilling down into the units within business lines. One measure, such as net income after capital charge or RC)I:, is not robust enough to tell us everything we need to know about the health of the business. Further, you cannot capture the essence of all of our diverse businesses with a uniform set of measures. Everyone’s key measure can’t be spread.”
Vision defines the scope and broad parameters for the measures. It is a statement of the bank’s future state and, by implication, an identification of important areas of emphasis, such as profitability, growth, quality, organizational learning, etc.
Strategy defines the metrics that should be used to gauge performance; for example, a strategy which emphasizes volume and cost advantage implies measuring transactions, market shares and costs relative to competitors. Some measures need to be bank-wide- for example, how the bank as a v. hole is meeting merger implementation schedules. Some measures need to be line-of-business specific- for example, new accounts versus attrition by customer segment.
Linkages to ROE should be defined. Because shareholders demand to be compensated for the risk they assume then they contribute equity to the bank, ROE is the ultimate measure of success in meeting shareholder requirements (at least in the short run). Lines of business which provide returns in excess of the shareholder demanded “hurdle rate” create value.
Those which return less than the hurdle rate destroy value. Lines of business which produce large or rapidly growing amounts of net income after risk-adjusted capital costs are the ones most valuable to the bank.
Therefore, the complete measurement set should reflect the drivers of ROE and net income after capital costs performance. That is, the major value levers which management can push or pull to improve ROE and net income after capital charge growth should be part of the measures. Of course, this requires an understanding of the economics underlying each business.
Dr. Philip Davidson of Signet Banking Corporation puts it as follows: ‘The manufacturing sector has a pretty good historical understanding of how the various components of its !mandais affect ROE. ‘Hie DuPont diagram used in manufacturing industries is an example. The banking industry needs to use a similar framework to help it understand which components drive premium shareholder value in each business line.”
Financial measures alone are insufficient. Financial indicators are indeed important measures of strategic and tactical success. They can help track bank-wide and line-of-business performance, and show contributors to increased shareholder value- e.g., profitability, spreads, fees, credit risk, interest rate risk, capital usage and expense control.
1 lowever, non-financial measures can be equally important and are missing from most banks’ reporting frameworks. Non-financial measures can also help to identify causes, rather that simply report effects. Jim Latchford, when he was Controller at Chemical Bank, developed reports which showed a series of key performance measures (KPS’s), financial and non-financial, for each line-of-business: “The large corporations that I was at prior to joining the Bank all had key performance measurements as part of their management reports. Many of the KPM’s were non-financial in nature. I don’t see how you can successfully run a business without them.”
Operational and market indicators are needed to provide a complete set of measurements, including items such as:
* Head count
* Sen ice quality
* Loan processing time
* New sales calls
* Cross-sales
* Time to market
* Improvement rates
Sometimes optional measures take on vital importance. For example, in a large bank-merger environment, tracking daily or weekly operating statistics can show whether control lapses are present or whether systems consolidations are effective. Developing effective measures can help to quickly identify problems and forestall monetary or customer losses.
Cross-organizational process views are necessary. Because responsibility and accountability are typically exercised throughout management organizational structures, performance is generally measured along similar structural dimensions.
However, such a mapping leaves out measurements of processes which span organizations. Process management is a critical contributor to strategic success. In fact, in some industries, organization structure for administrative reporting purposes is largely irrelevant of how business is conducted and customers are supported.
For example, corporate lending can be viewed as a process involving multiple stages and several organizational units and layers. Measuring each sub-unit on its discreet piece of the process may lead to less than satisfactory total results. Measuring total process performance is especially important if time and quality are strategically valuable. They can suffer when multiple organizations are involved and no beginning-to-end metrics exist.
External perspectives should be included. A considerable failing of most banks’ MIS is that they are purely inwardly focused. External perspectives are needed as benchmarks or goals, and to view the bank as would a customer, shareholder or supplier.
Benchmarks can establish useful reference points as well as targets: Do we want to be the best relative to our peers? Our competitors? All service firms? In the U.S.? Internationally? Are our goals realistic in light of what others have achieved?
Looking at performance as if from without can lead to identification of what factors are important to owners and customers. These are often better indicators of strategic success than inwardly-fixrused measures.
Forward looks are important. Performance measurement systems, by their nature, show historical results actually achieved. They often show performance versus plan, and versus prior periods. However, they rarely project prospective views.
The predominance of such a “rear-view mirror” orientation hinders management’s abilities to interpret the consequences of the results that arc reported. For example, what is that impact on shareholder value if spreads are below plan? How does a relationship management strategy suffer if loan processing time targets are not met?
Another element in looking forward via measurement systems is the adoption of measures which encompass organizational learning. Measurement systems should foster continuous improvement and impart a vision of a well-defined future state. They should also help to identify systemic barriers to improvement.
Measurement sets need to be robust, complementary· and concise. Managers will deliver what’s being measured. As a result, performance metrics need to be chosen with care. They also need to be reexaimned or refreshed as the business changes.
The portfolio of performance measurements should reflect the key factors accepting strategic success. They need to be balanced so that one factor is not emphasi/ed at the expense of another which is equally important. And, as previously stated, they need to be tailored to the specific business units and management levels.
The measures and targets should be chosen so that they all reflect contributions to success; in other word, they should indicate progress in the same direction. Employing several competing or contradictory indicators and changing which of them will be stressed is an obvious problem which is all too often encountered.
Finally, the measurements should be limited. Managers generally have a thirst for performance measurement data, much of which is useful to decision-making and monitoring. However, not all useful measurement data needs to be embodied in formal performance reports. A small, salient set is more valuable to tracking strategic performance than a broader and less focused group.
lMPLICAriONS OFTHE NEW PERFORMANCE MEASUREMENT FRAMEWORK itaea
Clearly, the major benefit of the new measurement framework is the closer linkage between strategies and metrics, and between objectives and results. However, the new vision has other corollary benefits which are important in their own right.
* It prompts managers to articulate what success means along more than one dimension. By complementing financial measures with others, it helps move managers beyond viewing such things as asset growth or net income growth as indicators of strategic success. Success as seen by shareholders is return on equity that meets or exceeds their requirements. Success as seen by customers, suppliers or employees is likely to take different forms.
* It forces managers to carefully think through their strategies and identify which factors have the greatest leverage on success. Simply identifying an ROE target and turning the troops loose is inadequate. Determining which value drivers have the most impact on success, and what factors under management control can be brought to bear on those drivers, requires careful consideration. The exercise of developing the key performance measures which best demonstrate strategic progress can help refine strategies or identify errors in the logic underlying them.
* Il helps communicate and transmit strategy throughout the organization. An all tcx) common problem is that strategies are poorly understood by managers in various levels and parts of the bank. As a result, their efforts are neither cohesive nor in line with the strategic agenda formulated by the organization’s executives. However, by forcing executives to define the metrics by which success and strategic process are measured, strategies are more easily communicated. Also, by layering appropriate performance measurements at successively lower levels which ultimately tie to strategic objectives, more unified actions are encouraged.
Other management processes beyond reporting will be affected by the new performance measurement vision. The continuum of results, rewards and resource allocations helps shape the organization and its strategies, which in turn affect performance measures. Planning and control processes may feel the greatest initial impacts. However, the impacts of the new vision w ill eventually affect all principal processes of the bank- including rewards and compensation.
CONCLUSION
Development of a robu.st set of performance measures can be challenging. It is especially difficult for organizations which have not formalized their strategies, do not understand how value drivers affect results, or are comfortable with the one-dimensional financial view of the world traditionally found. Even the adoption of risk-adjusted ROE is a start, not an end, to the challenge.
Development of key performance measures does not imply that tried-andtue control mechanisms such as budgets are to be thrown in the dustbin of history. They are necessary and appropriate tools for management of certain areas. Rather, it implies that other measures be brought into play to give a fuller picture of business performance, along dimensions which reflect more than financial scorekeeping.
REFERENCES
Robert Eccles, “The Performance Measurement Manifesto,” Harvard Business Review, January-February 1991, pp. 131-137.
Michael Goold and John J. Quinn, Strategic Control, Economist Books, (London, 1990), 239 pp.
H. James Harrington, “Business process Improvement, ” McGraw-Hill (New York, 1991), 274 pp.
H. Thomas Johnson and Robert S. Kaplan, Relevance Lost, Harvard Business School Press (Boston, 1987), 269 pp.
Robert S. Kaplan and David P. Northon, “Measure Performance with a Balanced Scorecard,” Harvard Business Review, January-February 1992, pp.71-79.
John Karr, “What’s Wrong With Capital Allocation Methods?” Bank Accounting & Finance, Summer 1992, pp. 41-45.
Peter Senge, The Fifth Discipline, Doubleday/Currency, (New York, 1990), 424 pp.
by John Karr*
* Consultant, Ernst & Young, New York City Office
Copyright National Association for Bank Cost & Management Accounting 2005
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