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Chapter 71 Part 3: THE BIG PICTURE: STRATEGIC PLANNING, RISK MANAGEMENT, ASSET-LIABILITY MANAGEMENT, AND CAPITAL ADEQUACY Chapter 7: Managing Value and.

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Presentation on theme: "Chapter 71 Part 3: THE BIG PICTURE: STRATEGIC PLANNING, RISK MANAGEMENT, ASSET-LIABILITY MANAGEMENT, AND CAPITAL ADEQUACY Chapter 7: Managing Value and."— Presentation transcript:

1 Chapter 71 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

2 Chapter 72 CHAPTER 7 Managing Value and Risk: Bank Corporate Strategy and Strategic Planning in the Financial-Services Industry

3 Chapter 73 LEARNING OBJECTIVES 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 TO UNDERSTAND …

4 Chapter 74 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

5 Chapter 75 Bank’s Overall Corporate Strategy and Strategic Plan – Three Critical Components A Business Plan A Framework for Risk Management Strategies for Corporate Control

6 Chapter 76 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

7 Chapter 77 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

8 Chapter 78 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) k e = R f + ß(k m – R f )

9 Chapter 79 Capital Asset Pricing Model (CAPM) k e = R f + ß(k m – R f ) k e = Shareholders’ required rate of return R f = Risk-free rate ß = The Bank’s/BHC’s Beta k m = Return on the market portfolio For Example: Citigroup’s Cost of Equity (k e ) k e = 6.0% + 1.3(11.5% - 6%) = 13.15%

10 Chapter 710 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

11 Chapter 711 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)/( ) = $112b

12 Chapter 712 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)/( g) g = 9.02% The 9% growth is perpetual and an indication of what analysts expect earnings to be in the future

13 Chapter 713 The Spread Model A tool to calculate net income Assume the following simple b/s for a bank: Reserves 100Deposits920 Earnings Assets 900Equity 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 = or 1.68%

14 Chapter 714 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.

15 Chapter 715 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.

16 Chapter 716 Financial Management and Modern Corporate Strategy A company’s overall corporate strategy consists of three critical ingredients: business plan A strategic business plan, risk management A framework for risk management, and corporate control A strategy for corporate control.

17 Chapter 717 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?

18 Chapter 718 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

19 Chapter 719 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?

20 Chapter 720 Techniques Used in Strategic Planning – Top Five Portfolio Analysis “Brainstorming” Simulation Models Cash-Flow Analysis Market Research

21 Chapter 721 A Marketing Approach – The Five Ps Product Place Price Promotion People

22 Chapter 722 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

23 Chapter 723 EVA-Based, Management- Compensation 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.

24 Chapter 724 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

25 Chapter 725 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.”

26 Chapter 726 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 risk- management 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.

27 Chapter 727 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.

28 Chapter 728 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

29 Chapter 729 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.

30 Chapter 730 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.

31 Chapter 731 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)


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