Financial Accounting Standard 131, which went into effect at the beginning of this calendar year, changes the way all publicly traded banks report information about segments of their business.
It requires selected segment information in quarterly and annual reports to shareholders.
The task facing banks is how best to gather the information needed to comply with FAS 131 and present their story.
One solution is to install an economic profit (EP) or value management system. There is renewed interest in this type of system, which is currently used by only a handful of banks.
Unlike other operating measures such as returns on assets or equity, economic profits, the metric used in value-based systems, is a dollar measure of performance. It represents the value created by a bank in the period being measured.
More important, the system can be leveraged to achieve targeted gains in shareholder value.
Used properly, the system can help develop capital allocations, hurdle rates, and operating measures of value creation for the corporation as a whole, business lines, or geographical regions.
An EP management system installation can also identify the key value drivers for lines of business, and measure value-creation strategies, including those for acquisition and divestiture, or market entry.
All of this helps determine which steps would create the most value. If a turnaround of disappointing segments is not imminent, management can communicate the game plan. The system buys time for the bank.
While high-performance banks will benefit from more disclosure, institutions with weak segments will be exposed and asked to explain why their strategy isn't working. By defining plans in terms of value creation before the fact-rather than as a reaction to poor results-potential damage to investor confidence is minimized.
Still, some chief financial officers are wary about FAS 131 because it limits their ability to manage and smooth earnings across segments-which indeed it does. With EP management systems, value creation becomes the mantra. In the incentive structure, value creation occurs over the long term. Quarter-to-quarter earnings targets become less meaningful.
Another worry expressed by bank CFOs is that FAS 131 puts pressure on short-term performance for lines of business, at the expense of long-term growth. An EP management system helps combat this by providing a way to convey to investors an organization's long-term growth plans in value terms.
Also, short-term blips in reported earnings can be rationalized and better explained.
There is a proven link between implementation of value-based systems and increases in stock value. To wit, certain analysts today are using economic profit techniques to analyze stocks for buy/sell/hold recommendations and portfolio decision-making. By communicating in analyst-speak, bankers can report their segment results in ways that explain their strategies and show how the numbers reflect current or future growth in value creation. Better information to analysts can lead to potentially higher ratings and share price.
The issue of compensation in relation to a manager's effectiveness can't be overlooked. Instead of the traditional criteria used in performance critiques, such as meeting budgets and plans, EP objectively reveals how much a manager has (or hasn't) improved value creation in his or her segment.
Underachievers are soon identified. Because EP is linked to compensation, people are encouraged to explore ways the organization should be run and improved.
Of course, a change in financial reporting does not automatically lead to higher profitability.
"Pleased as we are with FAS 131, bankers must still be armed with real information about which of their businesses earn robust returns and which are dragging down overall performance," says analyst Diane Merdian of Montgomery Securities. "Those with the best, not the most, information make the better resource decisions.
"Capital is one of the most important parts of running a banking business. If one measures (and pays) line-of-business managers on their net income contributions after charging a cost of capital, they will quit asking for capital when they can't earn more than it costs."
At Deutsche Morgan Grenfell, the consensus is that "an economic management framework in banking is inevitably linked to the risk management of the organization," says Tim Opler, director of global markets. "When I advise financial and nonfinancial institutions in corporate strategy and asset/liability management, the fundamental concepts of the economic value framework assist firms in evaluating the benefits of significant balance sheet change."
Arnold Ziegel, senior industry analyst, global banks, with Citibank in New York, has seen the impact of value-based measurement in his work with global customers.
"Income can be created with moderate use of capital through the careful selection of strategic alliances and partnerships, funding via capital markets, and a market strategy that provides differentiation of commodity products," he says. "Our banking clients are starting to focus on value management frameworks and value drivers to make these capital and strategic decisions wisely."
Rather than looking upon FAS 131 as an unnecessary evil, banks should view it as an excellent opportunity to get on the same page with analysts while providing insights into their organization's financial health and stability.
The rule also provides an excellent opportunity to consider using a value-based management system. One thing is for sure: Whatever measurement scheme a bank chooses to use, FAS 131 is here to stay, and in the lexicon of the '90s, "get used to it."
