Managing Banks for Value

7/31/2019 Managing Banks for Value

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Manage Your Bank for Value

The increasing emphasis on shareholder returnsin global financial markets presents enormouschallengesand great opportunitiesfor financialinstitutions. As if to underline this, energeticnewcomers to banking and securitiessuch as

MBNA and E-Trade in the United States andConsors in Germanyare threatening incumbentbanking giants, revolutionizing existing financialbusinesses, and generating some of the indus-trys best returns.

But a few established players, such as LloydsT SB and Bank of New York, ar e achievingreturns that outstrip those of both their bankingpeers and some successful newcomers.Executives at such institutions see themselves asshareholder value managersthat is, they think and act more like investors than traditional man-agers do and they rigorously pursue strategiesthat build shareholder value.

The best approach to shareholder value manage-ment uses a suite of economic measures to track the true performance and prospects of both thebusinesses in a companys portfolio and the com-pany as a whole. (By true performancewe meanthe performance that affects shareholder value.)Instead of tracking earnings, these measuresfocus on the underlying cash flows that a busi-ness generates and the equity investment neededto achieve them. The measures directly relatethe return on risk-based capital to the cost of capital, allowing management to see clearly howmuch value a particular business is creating andhow much more it may generate. This helpsmanagers identify the growth opportunities andthe potential turnarounds that can produce thehighest shareholder returns, as well as theunpromising businesses that it might be best to

exit.

Banks such as Lloyds TSB and Bank of NewYork are exceptional in their rigorous pursuit of shareholder value. Lloyds even has an explicitcommitment to double its share price every threeyears. Other banks, including Chase Manhattanand Deutsche Bank, have embraced thisapproach, too. Since its merger with ChemicalBank, Chase has increasingly used value mea-sures to assess the performance of its various

businesses, and it now even includes those datain its annual report to shareholders.

As more and more banks adopt this approach,the pressure will mount on others to follow suit.Institutional investors increasingly scan theworld for the best investment opportunities.This means that the major banks are having tocompete for the same investment dollar. Thateffect is amplified in continental Europe, wherethe new common currency is rapidly creating aunified investment market. Financial institutionseverywhere have to look beyond national bor-ders and compare themselves with their regionaland global peers. (See the chart RankingReturns to Shareholders.)

Those firms that can attain a position in the toptierand then sustain itwill be able to com-mand a better price for their shares: a powerfulcurrency for acquisitions in a consolidatingindustry. A high and rising stock price will alsogive them the edge in attracting and retainingthe best executives. Success, however, is all toooften temporary; staying at the top is very diffi-cult even for the best companies.

The Tools for Building Superior Value

Most banking leaders still manage by traditionalmeasuressuch as earn ings per share and risk-adjusted return on capital. But, because they arerelatively static, these measures are not the bestones for tracking a companys success in improv-

ing shareholder value. T hey overlook changes in

F I N A N C I A L S E R V I C E S

T H E B OS TO N C ON SULTING G R O U P 1

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value and underestimate the value created forshareholders when managers turn around,improve, and grow businesses.

Total shareholder return, which is the annualpercentage return to common shareholders frominvesting in a companys shares, is the true mea-sure of a companys success in creating value forshareholders. Because macroeconomic factorsaffect the share prices of all companies, actualtotal shareholder returns should be calculatedrelative to a market index or a group of peers.

In addition to such external measures, managersneed internal ones that gauge their success inbuilding the value of specific businesses and helpthem assess the value their strategic actions are

likely to produce. They must be able to under-stand the relationship between these measures

and the external market in order to bridge thetwo effectively. T his suite of internal value-basedmeasures should include total business return,added value on equity, delta added value onequity, and operating cash flow. (See the Guideto Value-Based Measures at the end of thisarticle.)

Such measures allow for a simulation of an inter-

nal capital market that compares the current andprospective performance of each and every busi-ness in a companys portfolio. The firms man-agement can then fashion and monitor theimplementation of customized solutions for itsindividual businessespromoting growth, cuttingcosts, and reallocating capital when appropriatein order to achieve the overall goal of generatingsuperior returns to shareholders.

The Boston Consulting Group has developed avaluation model that allows companies to simu-late the external market value of their variousbusiness units and the effects that their proposedbusiness plans may have on those values. Alarge U.S. commercial bank recently used thismodel to gain a better understanding of the trueeconomic performance of its mortgage and cred-it card businesses. Although the two businessesproduced returns below the cost of capital, therapid rate of improvement in their profitabilitycreated significant shareholder value.

Similarly, one midsize European commercialbank discovered that its treasury division wasearning only a mediocre return that barelymatched the cost of the $1.6 billion the bank hadcommitted to the division. Traditional account-ing measures for operating profits implied thatthe business was highly profitable. But afterdeducting its capital costs, the bank graduallyrealizeddespite the initial protests of the manag-er in chargethat the division was in fact making

little or no economic profit. That insight per-suaded the bank to securitize and sell off many


M A N A G E Y O U R B A N K F O R V A L U E

Ranking Returns to Shareholders

1Covers 652 nancial services companies listed in theCompustat database for which ther e are ve years of data.(Insurance companies are excluded.)

SOURCES : Compustat data and BCG analysis.

Average Annual Total Shareholder Return(December 1993December 1998)

Number ofcompanies 1

600

500

400

300

200

100

0 80 60 40 20 0 20 40 60 80

CharlesSchwab (64.7)

MBNA (44.2)

American Express (32.9)Citigroup (32.7)

Morgan Stanley (28.8)Chase (32.7)Wells Fargo (30.1)Merrill Lynch (28.2)

ANZ (23.6)Bank of America (23.2)

Standard Chartered Bank (20.5)

ABN-Amro (22.3)

PNC (18.2)

Bayerische Hypo-und Vereinsbank (22.1)

ING Groep (18.5)

BankOne (15.7)HSBC (13.6)J.P. Morgan (13.0)

Bankers Trust (7.0)Socit Gnrale (6.6)

Deutsche Bank (5.2)

Sumitomo Bank (9.4)

MitsubishiTrust (8.9)

Average annual total shareholder return (%)

First quartile = 26.1%

Second quartile = 17.7%

Third quartile = 6.7%

Lloyds TSB (39.0)Bank of New York (45.6)

100 120


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treasury assets, freeing up capital for investmentin more productive parts of its business andimproving the returns of its treasury.

Using this approach, one of Europes biggestbanks determined that its corporate customerbusiness had much greater potential for creatingvalue than its asset management unit. Eventhough the corporate customer business was not

making very much money, the analysis revealedthat the bank could quickly turn it into a solidprofit producer by reallocating capital to its cashmanagement division. The bank is now alsousing value-based measures in the accountingsystems that line managers use to run their busi-nesses.

Implementing Value Management

Banks should adopt cer ta in fundamentalapproaches as they set out to build their strate-gies for shareholder value management.

T hey should compare their total shareholderreturns regularly with those of their peers,including the successful newcomers to theirbusinesses. They should also be explicit abouttheir value-creation targets.

T hey should implement value managementstep by step. First, they should perform a valueaudit to determine which businesses have thepotential to create value. Then they shouldweigh the conclusions against other strategicconsiderations and decide which businesses tobuild, which to try to turn around, and whichto downplay or sell. Finally, they should ana-lyze and break down the various drivers of value so that line management knows what tofocus on in order to meet the rms value-cre-ation objectives.

T hey should ensure that everyone in the

organization understands his or her role in thevalue-creation strategy. That requires driving

the measures down through the organizationand involving everyone in the effort to buildshareholder value. Top-level managers shouldcommission audits to discover what creates andwhat destroys value in each of the rms indi-vidual businesses.

T hey should tie managers incentives to the

value-based measures linked to the economicperformance of both individual business unitsand the company as a whole.

T hey should use the insights that value-basedmeasures provide to nd and exploit promisingopportunities in both new and traditional busi-nesses.

Shareholder value management will help banks

and securities firms meet the challenges of theincreasingly competitive global financial market.With strategies grounded in the principles of value management, they will be better ableto achieve and maintain a leadership position

and they will earn richer returns for their share-holders.

Geoffrey NicholsonHans Weiss

Daniel Stelter

Geoffrey Nicholson is a vice president in the NewYork office of T he Boston Con su ltin g Grou p. H e canbe con tacted a t n icholson [email protected] . H an sW eiss is a v ice presiden t in the firms M u n ich office. H e ca n be con ta ct ed a t w eiss .h a n [email protected] . Da n iel S telter is a lso a v ice p res i-d en t in B CGs M u n ich of f ice. H e ca n be con ta ct ed a t stelter.d an [email protected].

T he Boston Consulting Group, Inc. 1999




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Guide to Value-Based Measures

Added value on equity (AVE) measures earn-ings that exceed the cost of capital. AVE is calcu-lated by multiplying the difference between thereturn on equity and the cost of equity capital bythe equity capital employed.

AVE convergence valuat ion models simulatethe market value of businesses as if the business-es were traded separately on a stock exchange.The valuation methodology relies on empiricaland theoretical findings that show that returnsand growth converge to long-term averages overtime. The models are used for calculating totalbusiness return.

Del ta added va lue on equ i ty (DAVE) is thechange in AVE over a certain time period and isan internal measure for value creation. DAVE,which is closely correlated to relative total share-holder return, considers value creation through

change in profitability and through growth of the business. It can be used to set value targetsfor individual businesses.

Total business return (TB R) is an internal mea-sure for evaluating the actual or planned valuecreation of a business unit. T BR, which is analo-gous to total shareholder return, measures

changes in the simulated market value of a busi-ness unit and in its free cash flow.

Total shareholder return (TSR) is the annualpercentage return to common shareholders frominvesting in a companys shares.

Relative total shareholder return (RTSR) isthe return shareholders earn from investing in acompanys shares, relative to the return earnedfrom an investment in a relevant benchmark index.



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Managing Banks for Value