The increasingly competitive inroads of mutual funds, credit cards, investment, and mortgage brokers (among others) threaten the profitable relationships upon which banks have depended for their growth. This threat has led the far-sighted to "reinvent" their franchises, driven by the realization that to do nothing is to face the slow erosion of franchise value, in turn the source of renewable profit.

Yet little attention has been given to measuring the magnitude and effectiveness of a bank reinvention strategy, at least in a manner that bank stock analysts and investors can easily understand. Since pharmaceutical manufacturers disclose and discuss their R&D, why shouldn't the repositioning expenditures of banks receive similar treatment?

Admittedly, the data depend on judgments that two professionals may not always agree on. As a result, interbank comparisons are apt to be "soft." But does this drawback really diminish the value of such information -- especially when the profit implications may sometimes be quite striking?

In this article we propose an analytic paradigm which addresses three questions.

* First, what is reinvention -- and more to the point, how can we quantify a bank's reinvention budget?

* Second, can we also pinpoint this budget as a fraction of the efficiency ratio, letting us look at the bank both gross and net of its "R&D" investment?

* Finally, as the investment begins to pay off, what indexes let us track the success of the reinvention programs?

Reinvention defined. Our goal here in not to choose among strategic pathways. Let's assume that's been done. How do we then define reinvention as a basis for quantifying an annual budget?

In his recent work with Centura Banks Inc. of Rocky Mount, N.C., to prepare data for an analyst presentation, coauthor David Cates noted the following points:

* Reinvention comprises all those steps (and costs) required to reposition the bank in terms of management information systems, organizational redesign, process and product redesign, training in sales and service, market research and advertising based on this research, and staffing of new functions as well as certain severance and outplacement expenses. It is a concept that includes the concept of "reengineering" though much broader in its scope.

* The major subheadings of the reinvention budget are the key strategic programs the bank has undertaken. Within each program, the various types of cost are enumerated. It goes without saying, of course, that capitalized costs are represented in the budget by their amortized amounts, though at Centura most of the budget is made up of fully expensed investment.

* As a "sunset"-type control on the budget each program is reviewed with an eye to diminish or elimination line items as these achieve their profit or productivity goals. To put it another way, we want to record and analyze only those repositioning costs that represent temporarily unproductive outlays.

Impact on the efficiency ratio. Let's suppose that we succeed in isolating a reinvention budget, say for 1993, that equals 7% of operating expense. The mysteries of arithmetic assure us that the efficiency ratio (operating expense divided by the sum of net interest income and noninterest income) will be equally impacted.

To illustrate: If the bank's allinclusive ratio is 63%, the ratio will be 58.6% excluding the reinvention budget.

What does this tell us? The answer, of course, depends on the strategic cogency of the reinvention strategy.

If the bank is merely throwing dollars at problems, such expenditures may never become productive. If, on the other hand, the strategy is well and shrewdly planned, with feasible performance targets for each program, today's temporarily unproductive investment will blossom into profitable revenue growth tomorrow.

One outcome, therefore, may be a continuation of reinvention budgets in which new programs succeed old, and the efficiency ratio stays above 60%. If growth of franchise value and profitable revenue are the outcomes, a gross efficiency ration north of 60% is a small price to pay.

Compare this hypothetical scenario with that of Complacent State Bank, whose efficiency ratio of 58% is the envy of its peer group. If this nominally appealing ratio, however, is achieved without significant investment in the future, only good luck can stand in the way of franchise deterioration.

Our point, to summarize, is that if efficiency analysis is to remain blind to the costs and benefits of strategic repositioning, it loses a good part of its potential meaning.

Tracking the payoff. None of the foregoing means much if we lack a yardstick for measuring the effectiveness of the reinvention budget. Fortunately, the analytic tools are at hand, though they must be used with care. We identify four such tools:

* Growth of operating income. Two revenue streams comprise operating income: net interest income and noninterest income, both as scrubbed as possible of nonrecurring elements. Since one of the hallmarks of good strategy is sustainable growth of revenue, we should look to this number. Unfortunately, the rules of accounting don't require that all current growth be reflected in prior-period statements. Thus it is hard to isolate that portion of revenue growth stemming from acquisitions.

* Operating income per employee. In a strategically successful bank we should typically expect to see more "product" per employee, as revenue rise faster than headcount.

The devil in this ratio, of course, is a temporarily distortive impact caused by the material onset of outsourcing. That is, when headcount is replaced by a service contract, the apparent rise in the ratio doesn't necessarily signal strategic victory.

Assuming, however that such distortions are not only rare but detectable (by other means), our reliance on this useful productivity ratio is not misplaced.

* Compensation per employee. Absent material outsourcing, we would expect the successful bank not only to lift its product per employee, but also gradually to widen the gap between product and compensation. To illustrate, we have found that strong profitability in consumer-oriented branch banking tends to occur when compensation consumes less than 30% of operating income.

* Efficiency ratio. If this powerfully diagnostic ratio shows modest and steady improvement, especially in conjunction with the other yardsticks mentioned here, the conclusion is hard to avoid that strategic repositioning is paying off.

As we said earlier, of course, it is smart to look at the ratio both gross and net of reinvention expenses.

The competitive flux in financial services threatens banks but also creates strategic opportunities for astute players. The costs of strategic repositioning can be large, but so can be the payoff resulting from these outlays.

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