As market conditions evolve, banks must better anticipate changes and more readily adapt their financial plans in response to internal and external challenges. To promote collaboration and deliver the insight needed to respond to business changes, trying four atypical practices will likely gain your bank some traction:
1. Scenario planning beyond the usual
Many banks budget or forecast with just one economic scenario in mind. This is understandable. Most institutions spend hundreds, if not thousands, of hours completing one budget based on one underlying set of assumptions.
Unfortunately, volatility will only increase, these days. So banks that can quickly model multiple scenarios will be better prepared to intelligently adjust their strategy based on changing conditions.
There are seven areas banks should focus on to better predict financial outcomes. They include:
1. Identify the key factors that define your market, such as interest rates, consumer behavior, market conditions, and product innovation.
2. Agree on the baseline/“most likely” scenario.
3. Develop targets, strategies, and plans.
4. Craft relevant scenarios that describe a range of potential operating environments.
5. Test alternative scenarios to identify their impact on plans and budgets.
6. Identify early warning triggers and corresponding tolerance ranges for each scenario.
7. Make adjustments as necessary, when triggers are activated.
This approach to scenario modeling typically takes two forms—externally-oriented scenarios that focus on external drivers (such as interest rates); demographic shifts and competition; and internally-oriented scenarios that focus on factors such as new product offerings, anticipated growth, and workforce expectations.
A blend of both types is beneficial for many banks, as external changes are often a catalyst for internal change.
The proper technology foundation coupled with the right business drivers and necessary business logic will shed light on assumptions and biases that would otherwise be hidden, as well as expand the scope of what is possible with regard to a financial institution’s strategy. Most importantly, it will expose areas of risk as well as areas of opportunity.
2. Replace budgets, with rolling forecasts
Given today’s volatile conditions, banks can no longer rely on historical results as the best predictor of future performance. Now, banks must turn to “driver-based” forecasting that incorporates critical operational data and drivers that directly influence financial outcomes. Examples of such drivers: interest rates and balance sheet growth.
No forecast can predict the future with 100%. Banks can improve forecasts by updating them throughout the year, as opposed to creating an annual budget. Not only do these rolling forecasts better reflect current business conditions and help mitigate risks, but they can help identify new market opportunities and ensure promising initiatives are properly funded to capitalize on what is working.
Rolling forecasts also create a consistent, accurate, and forward-looking financial perspective even in times of uncertainty. Using them can help quickly identify problems and implement necessary course corrections throughout the year.
Because the bank is not constrained to a financial calendar, management can be truly aligned to the business.
3. Leverage funds transfer pricing in profitability measurement
Funds transfer pricing is the most important component in understanding the profitability of a bank’s customers, products, organizational units, and channels. Analyzing how the various contributors to a bank’s net interest margin impact overall profitability provides greater insight by allocating the net interest margin to every account on the balance sheet.
Banks should focus on calculating the funds transfer pricing rate at the customer record level that is based on projected cash flows at the time of origination or re-pricing . This is known as a cash-flow approach.
This approach to funds transfer pricing calculates overall time and balance-weighted transfer rate funding for each cash flow strip. A cash-flow approach to funds transfer pricing also results in more informed and precision decision making regarding product pricing, as well as other key profitability drivers for the bank.
A well-structured funds transfer pricing mechanism will provide a bank with margin clarity at every level of the institution, right down to an individual customer or employee. Once this element is calculated, other factors such as allocating services expenses and capital can be added for a full view of profitability.
4. Encourage better decisions by tying incentive pay to profits
Many banks have established strategic plans, well-constructed budgets, and forecasts. They fully understand the profit contributions of all of their segments. Yet something is missing: They don’t align employee behavior with those plans.
While a well-managed incentive compensation program has the power to positively drive a bank’s financial performance, the recession forced many banks to re-evaluate their existing compensation programs.
Rather than calculating incentives based on factors such as loan volumes or the number of new accounts opened, proactive banks consider risk-adjusted profit contribution as the key performance driver for incentive compensation. For example, instead of incenting loan officers based on loan volume originated, banks are incenting loan officers on each loan’s risk-adjusted return on capital. That measurement takes into account the funds transfer pricing rate, and allocated expenses, loan loss, and capital.
A profitability-based incentive plan will align employees with the bank’s overall strategy. As banks face unprecedented economic and regulatory uncertainty, motivating employees to generate growth that is profitable and within the risk guidelines of the bank is now more important than ever.
About the author
Kenneth M. Levey is the vice-president of financial institutions for Axiom EPM, a provider of financial planning and performance management software for banks.