Part 3: THE BIG PICTURE:
STRATEGIC PLANNING,
RISK MANAGEMENT, ASSET-LIABILITY MANAGEMENT,
AND CAPITAL ADEQUACY

Chapter 7: Managing Value and Risk: Bank
Corporate Strategy and Strategic Planning in the
Financial-Services Industry

Chapter 8: Risk Management: Asset-Liability
Management (ALM) and Interest-Rate Risk

Chapter 9: Capital and Dividend Management:
Theory, Regulation, and Practice
Chapter 7
1
CHAPTER 7
Managing Value and Risk:
Bank Corporate Strategy and
Strategic Planning in the
Financial-Services Industry
Chapter 7
2
LEARNING OBJECTIVES
TO UNDERSTAND …





A bank’s strategic business plan, its framework for
risk management, and its strategy for corporate
control
Valuation maximization, alternative managerial
motives, and economic value added (EVA)
How to value a bank
Transfer pricing and shared costs
Managing value and risk and their effects on bank
performance
Chapter 7
3
JUSTICE HOLMES AND
WHERE AM I GOING?

The trinity of questions for strategic planners:





1. Where is the bank today?
2. Where is it going?
3. How is it going to get there?
A risk-index view: E(ROA) => expected
return, CAP => leverage (capital adequacy),
and s => variability of earnings (risk)
Apply the three questions to these three key
variables
Chapter 7
4
Bank’s Overall Corporate
Strategy and Strategic Plan –
Three Critical Components

A Business Plan

A Framework for Risk Management

Strategies for Corporate Control
Chapter 7
5
The Corporate Objective:
Managing Value

Value Added – Companies may have both
Value Creators and Value Destroyers, or

Add Value to the Company’s existing
businesses – may mean getting out of
unprofitable businesses
Chapter 7
6
How To Value A Bank


Role of Transfer Pricing - Refers to the setting
of prices for transactions among subsidiaries
of banks/bank holding companies (BHCs),
where prices are not subject to market
determination
The Equity Approach and Free Cash Flow to
Shareholders
Chapter 7
7
The Equity Approach:


Estimate Free Cash Flows and Discount
it at the Cost of Equity
Cost of Equity represents shareholders’
required rate of return – Estimated by
using the Capital Asset Pricing Model
(CAPM)
ke = Rf + ß(km – Rf )
Chapter 7
8
Capital Asset Pricing
Model (CAPM)
ke = Rf + ß(km – Rf )
ke = Shareholders’ required rate of
return
Rf = Risk-free rate
ß = The Bank’s/BHC’s Beta
km = Return on the market portfolio
For Example: Citigroup’s Cost of Equity (ke)
ke = 6.0% + 1.3(11.5% - 6%) = 13.15%
Chapter 7
9
Free Cash Flow (FCF)

Free Cash Flow is defined as Net Income
plus noncash outlays minus cash flow
needed to grow the balance sheet (BS)
FCF = CFO + BS sources – BS uses
For Example: Citibank’s FCF
FCF = $15.70b + $110b - $177b = $8.70b
Chapter 7
10
Gordon-Growth Model
(Constant-Growth Model)
V = FCF (1+g)/(k-g)
V = present value
g = expected growth rate
k = shareholders’ required rate of return
Assume g=5%, estimated value for Citigroup
is $112b which is considerably less than
$230b market cap (as of 11/20/00).
V= $8.7b(1+0.05)/(0.1315-0.05) = $112b
Chapter 7
11
Gordon-Growth Model:
Solving for g
To estimate the growth for Citigroup, take
the current market cap and solve for g:
$230b = $8.7b(1+g)/(0.1315-g)
g = 9.02%
The 9% growth is perpetual and an
indication of what analysts expect
earnings to be in the future
Chapter 7
12
The Spread Model

A tool to calculate net income
Assume the following simple b/s for a bank:
Reserves
100
Deposits
Earnings Assets
900
Equity
920
80
If the bank earns 10% on earning assets, pays 5%
for deposits, has a burden of –20, and pays a
marginal tax rate of 30%, NI will be 16.8
NI = [900(0.10)-920(0.05)-20][1-0.3] = 16.8
ROA = 16.8/1000 = 0.0168 or 1.68%
Chapter 7
13
Valuing Banks from the
Inside and from the Outside


Although banks are heavily regulated and subject to
extensive reporting requirements, they are still not
very transparent, which makes them difficult to value
especially to outsiders.
The most challenging areas to value include quality
of the loan portfolio, accounting profits from
borrowing short and lending long, and identifying
business units creating (destroying) value.
Chapter 7
14
Transfer Pricing and
Shared Costs



Since insiders have a more transparent view of credit and
interest-rate exposures, their major dilemma is valuing
business units. There are two reasons for this problem –
transfer pricing and shared costs.
Transfer Pricing – described earlier, very critical how a major
bank sets these internal pricing numbers.
Shared Costs – Involves various business units that use the
same facilities, equipment, and personnel. Generally, a
standard solution to this problem is a cost-accounting system
that allocates overhead or fixed-costs on the basis of services
used.
Chapter 7
15
Financial Management and
Modern Corporate Strategy
A company’s overall corporate
strategy consists of three critical
ingredients:



A strategic business plan,
A framework for risk management, and
A strategy for corporate control.
Chapter 7
16
Strategic Business Planning
in the FSI



Given the removal of geographic and product
restrictions in banking and the ongoing fusion of the
financial-services industry, strategic business planning is
crucial
Product development, marketing, and selling (especially
cross selling), are important ingredients of a bank’s
business plan
Three questions of the planning trinity:

Where is the bank today?

Where is the bank going?

How is the bank going to get there?
Chapter 7
17
Strategic Planning –
SWOT Analysis

The overall process of determining where the
organization is today is called the situation audit.
The cornerstone of this audit is SWOT Analysis.
SWOT stands for:

Strengths

Weaknesses

Opportunities

Threats
Chapter 7
18
Strategic Outcomes –
Cause-and-Effect
Relationships and Questions




Financial Perspective – If our strategy is successful,
how will the company look to its shareholders? And, as
an important corollary for a bank, how will it look to its
uninsured creditors?
Customer Perspective – To achieve our vision, how
must we look to our customers?
Internal Perspective – To satisfy our customers, at
which processes must we excel?
Learning-and-Growth Perspective – To achieve our
vision, how must the organization assimilate and
improve?
Chapter 7
19
Techniques Used in Strategic
Planning – Top Five

Portfolio Analysis

“Brainstorming”

Simulation Models

Cash-Flow Analysis

Market Research
Chapter 7
20
A Marketing Approach –
The Five Ps

Product

Place

Price

Promotion

People
Chapter 7
21
Economic Value
Added (EVA)


Managers focus their attention to the critical problem
of allocating and managing capital, the fundamental
task of modern finance.
EVA can be defined as:
EVA = [Return on Capital – Cost of Capital] x Capital
Invested at the Margin
EVA = [r-k]K = rK - kK
Chapter 7
22
EVA-Based, ManagementCompensation Plans

Such plans provide incentives for managers
to:
 Increase the efficiency of asset in place,
 Expand assets as long as the rate of return
on new projects exceeds the cost of capital,
and
 Contract or redeploy underperforming
assets.
Chapter 7
23
Strategic Planning – From
Banc One to Bank One

For over twenty five years the same corporate vision
endured but Banc One wanted to expand beyond the
Midwest through acquisition

Through expansion the bank kept existing management
in place, consolidated back-office operations, build up
the retail business, and never bought a bank more than
one-third the parent company’s size
Chapter 7
24
CEO TURNOVER


John B. McCoy, after his ouster, said:
“There's a lot more intensity in absolutely
hitting the numbers 100%. Everything you
read in the [press] is, "So and so made 14
cents, equal to what was expected on the
street." It's not a range anymore, it's a very
specific number, which makes it a very much
black-and-white thing. It's only going to get
tougher, because you can't give guidance
anymore.”
Chapter 7
25
A Framework for
Risk Management



Resulting from the deflation in energy, agricultural, and
real estate prices created major credit-risk problems for
U.S. commercial banks in the ‘70s, ‘80s, and ‘90s.
Therefore, it is crucial that banks have a framework for
risk management (R/M) and for selling riskmanagement services to clients.
R/M can be conducted on a bank’s balance sheet
through portfolio composition or off balance sheet using
R/M weapons derived from the technology of financial
engineering.
Chapter 7
26
Risk Management –
Three Pillars



Making good investment decisions creates corporate
value.
Generating enough cash flow internally is the key to
making good investments.
Since cash flow can be disrupted by adverse
movements in external factors such as interest rates,
exchange rates, and commodity prices, a company’s
ability to invest can be jeopardized.
Chapter 7
27
Strategies for
Corporate Control


In the age in which financial services firms are
either gobbling or being gobbled, it is important
that a bank can effectively manage their cash flows
and investment opportunities
Geography and product expansion has changed the
industry tremendously and bank mergers are more
tricky because the benefits and costs are not
always obvious
Chapter 7
28
THE RAILROAD SYNDROME


“Unless banks reconceptualize what business they
are in, they will be out of business. In the next few
years, we will witness many bank mergers and bank
failures. When I was a young person growing up
with the memories of the Depression all around me,
bank failures meant the end of the world. Today
bank failures only mean that, like the railroaders,
some bankers are just waiting around for their virtue
to be rewarded. There will still be abundant banking
services available from many kinds of institutions.”
John Naisbitt, Megatrends [1982], p. 92.
Chapter 7
29
CAN COMMUNITY BANKS
SURVIVE?


Fed governor Ferguson [2000] notes:
“Knowledge about local markets and
skills and experience in operating in
them” are what community bankers
bring to the table. This combination
presents community bankers with the
best opportunity to manage value and
create it for their owners.
Chapter 7
30
CHAPTER SUMMARY


In managing value and risk, banks need
a business plan – a corporate strategy
for avoiding the railroad syndrome
In addition, they need:


1. A framework for risk management
2. A strategy for competing in the market
for corporate control (i.e., for buying and
selling companies)
Chapter 7
31