This is, as an example, the budget of the Moscow branch of a Russian bank. We are in March 2000, and the March 2000 figures have just been calculated. The last three columns, on the right, show the year-to-date (January to March) actual figures for last year (1999), this year (2000) and show also the year-to-date figures such as expected in the budget.

The first three columns give the monthly actual figures since the beginning of the year 2000.

The lines detail first the main items of the revenues, before showing the details of the expenses, with a split between direct and indirect costs.

The budget compared with last year results

As determined by the branch, the revenue budgeted for the first three months of the year are of 11,250 (in thousands of RUR), compared to 8,000 the year before, which is a significant increase. The branch intends to push savings accounts, credit cards and unit trusts, with only a slight increase of the loan activities.

With a quite high level of costs, 1999 revenues did just cover the direct expenses. By increasing its revenues and slowly decreasing its direct costs, the branch should show in 2000, according to the budget, a much higher level of earnings before indirect costs (charges for the head-office functions) and taxes.

The purpose of the branch, within the direct costs, is to encourage a salary scheme giving more incentives linked to the activity, and to reduce the fixed staff costs. Communications, travel and entertainment costs should decrease as well, according to the budget. The branch is ready, nevertheless, to spend more in equipment.

As a whole, the branch thinks that it could generate earnings, before indirect costs and taxes, big enough to be profitable ( +1,950) after all expenses, compared to a net loss over the same period of 1999 (-1,150).

Realisation 2000 compared to the budget

In terms of revenues, the first three months of this year show a lower level than expected, with the branch missing its targets on pretty much all the products. It is however too early to judge if the budget will not be reached at all in 2000. The month of March has been better than February, and February was better than January. Therefore, the branch manager can still think that it is not the time yet to take a very strong corrective action.

Such as realised, the first three months figures show that the direct costs have decreased more than expected in the budget, mainly because the variable staff costs are less that forecast (revenues being also lower than forecasted). As a whole, the direct costs seem to be well under control.

Example. Samplebank year 2000 budget – Moscow branch

Key ratios

One important for the branch is linked to the direct expenses. Their relative level, compared to the revenues, is to be monitored. In year-to-date 1999, the ratio was 94% (7,575 / 8,000). In the budget, the target was a ratio of 62%, more in line with the average benchmark in the banking area. The realised 2000 figure generated a ratio of 72%.

Within the expenses, the staff costs are usually the most important cost. In 1999, the total staff costs (fixed and variable) accounted for 62% of the direct costs (41% of the revenues). They were forecasted at 64% in the budget, and the realised ratio in 2000 was 63%. The interest of the new strategy of the branch is to increase the share of the variable staff costs, actually linked to activity generated by the staff, and to have less fixed costs. Therefore, there would be an increase in the variable staff costs only if the turnover has been higher.

What to do?

The actual trend shows that the actual figures are in line with the budget on the expense side. The management should follow the impact of its new salary policy, and also ensure that the communication costs will not continue to increase.

On the revenue side, the targets are not yet reached. It is probably the time to meet with the commercial managers to see if a stronger stimulus could be given to the action of the salespeople. It is only in two to three months that a significant corrective action, or a change in the budget, would have to be considered if the year-to-date revenues are still under their budget.

As already said, this is not a theoretical exercise. This is the tool that will be used by all the operational areas to project their activity in the future, and then to check that they effectively realise what they planned.

This is also the tool a head-office uses to monitor the overall activity during one budget exercise (usually one year). It is by checking that the profit centres keep in line with their budgets that the top management can have a clear view of the trend.

A interactive annual exercise

The format of the budget is a standard one, established by the head-office. The format is usually send to the profit centres at the end of one year, for the following budget year, or at the beginning of this budget year. Demands, request and explanations go with the format. It could be asked, for instance, to tend to a decrease of some expenses, or to show benchmark specific ratios Each profit centre prepares its budget, then discuss it with its reporting line (regional group, commercial department at the head-office, for instance). Once discussed, all the budgets are consolidated and presented at the top management. Depending on this global view, judged good and realistic enough or considered as too slow to show certain changes, it could be asked to some profit centres o review their expectations.

An exercise by branch and product line

The condition to have a real operational budget supporting the implementation of a strategy is to have the various budgets fitting the characteristics of the profit centres, either branches or product line activities, as well as those of the head-office support functions. Obviously, the total of all the budgets should be equal to the final budget of the bank.

Regular comparisons, analysis

Each month, after the accounting departments produce the final monthly figures, the last actual results are compared with the figures of the past (same period of last year) and to the expectations. If the differences are significant, the managers should analyse the reasons of these differences. This is the way the managers use the budget to monitor their activity.

They could decide, from this analysis, to take corrective actions and organise their teams to do so.

The bank publishes consolidated financial statements, which show audited figures. These figures are then used, internally and externally, to compare one year to another and see the actual trend in the bank risk profile and profitability. The main information is:

Balance sheet and off balance-sheet tables: size, liquidity and maturity of the assets and liabilities are key elements to be analysed.

Profit and loss report: revenue and expenses due to interests (loans, deposits, dividends on securities) are split from commissions, fees and revenues from trading activities.

Risk statement: for the last few years, annual statements of banks, especially in Western countries, have showed more and more qualitative information about the activity, the risk profile and the risk management. In case of a very active trading book, a precise analysis of its risk/return is also done.

Some key ratios:

On asset quality, the amount of loan provision, compared to the total of the net loans, is meaningful. Variations from one year to another and concentrations of provisions have to be analysed carefully.

Operating efficiency, such as measured by the operating expenses compared to the total revenue, is also normally closely monitored by the banks, which determine long-term targets on that ratio.

In terms of off balance-sheet figures, the loan commitments compared to the total assets are also a useful ratio.

ROC (Return On Capital) and RAROC (Risk Adjusted Return On Capital)

What matters is not only the bank’s net profit, after all expenses and taxes, but also its actual return on capital invested and, when the calculation is possible, the return adjusted from the risks taken.

As for the ROC, investors and analysts expect that a specific industrial activity should generate a minimum ROC, considered as a benchmark. For instance, this level can be set at more than 10%. For Western banks, a higher figure (around 15%) has even be recently very often considered as a benchmark. It would be at least more than the risk free rate of an investment: why to put some capital, develop systems and have a huge staff if it is to have a return below the risk free rate (Government securities)?

The need to have a RAROC comes from the rules developed since the 1988 Cook ratio. Banks have to build-up a capital cushion to cover their weighted risks. Depending on the quality and maturity of the assets, the weights are more or less penalising. RAROC takes into account the return on capital adjusted from these types of risks. Normally, banks should integrate this risk weighting in the price of their products. That is why RAROC is today a better measure of the real profitability of a banking institution.

Analysis by product and operational units

All the above analysis should be run by major profit centres (branches, product lines). This is a way to have all these profit centres feeling fully responsible of the overall results of the banks, and being judged on a consistent basis.

The different reports have to be carefully checked each time they are produced (daily for the turnover, monthly for the profit and loss of the month, quarterly and yearly for more comprehensive figures). First, a regular review means that the reader has the figures in his (her) mind, and will react when something is not what is expected. He (she) will then ask questions, the possible answers being an error or an exceptional figure to be investigated. Once the figures are proved to be correct, a regular review allows a dialog, when necessary, between the head-office and the branch managers, or, at the local level, between the branch manager and his (her) teams.

The risk of not analysing regularly the different reporting tools is to be passive with the figures, and not proactive.

Effectiveness of strategies and actions

The results of a new strategy are not granted. The process is a dynamic one, and the fine-tuning of the action will be done through the reporting showing the evolution of the implementation of the strategy. The various reports are the basis, once double-checked, for a discussion of the results already achieved and the validity of the expectations. If, for one product or one commercial action, there is a growing discrepancy, month by month, between what was planned and what has already been realised, it is the time to think about a corrective decision.

Adaptation of a strategy

If a strategy or the actions to implement the strategy have to be changed, the prospective figures are to be adapted too, especially in a revised budget. The question is to keep the right balance between necessary but not too frequent adjustments. It could be confusing and useless to permanently change the targets. Operational people in charge of developing an activity will not have a clear perspective, and the tools will not allow to actually compare the present situation with the main objectives.

That is why a revised budget should remain exceptional, with precise explanations about the changes and their purposes.

Assessing a strategy is something to be done by the different levels of management involved in the change. Depending on their responsibilities, the interest will be different, and the information tools will be adapted as well. The top management of the bank would be more interested in global activity and profitability indicators, and by the financial statements showing, internally and to the Board and the shareholders, the actual situation.

Role of the financial department

The key function here is the financial or accounting department of the bank, consolidating and validating the statements that constitute, once audited by the external auditors, the official and published figures regarding the balance-sheet, the profit and loss figures and the risk statement

Operational use of a budget

As a complement to the global financial figures, the budget is the tool allowing the management to quantify the expected return of its strategy, and to project the revenues, the costs and the profitability. Then, on a day-to-day or month-to-month basis, the actual results can be compared with the expectations, and a corrective action can be decided if necessary.

The budget can be established at any business unit level, with a consolidation for the whole bank. A discussion of the budget proposals between the business unit and the head-office, when the budget is established (end of the year for the following year), is usually very useful. The consistency of the figures, the determination of the targets can be discussed in order to be sure that the expectations are both stimulating and realistic.

The first understanding of these functions is naturally the controls being done to ensure the local and central management that the activity is run the way it is expected. These controls can be considered as essential ex-post reviews of an activity. However, internal control and audit departments can add more to the management of a company than these first level functions.

Internal control departments are usually closer to the day-to-day activity of a bank’s profit centres than the audit function, reporting normally to the general to management and the board of the bank. The audit department runs medium- to long-term missions (up to 2-3 months) on specific areas or branches.

An audit review can result in a validation of a specific area or branch management, or in requests for changes (strategy, people, organisation, and procedures). In that aspect, the audit department has also the power to propose and push to enforce the necessary changes.

As for the internal control departments, their day-to-day responsibility is to review the correct application of the procedures and the way the processes are run. Because they know very well the operational activity and all the support functions, these departments are also useful in the comments or the proposals they can made to improve the functioning of a branch or of a specific area.

The management can then expect from them not only a quick reaction and reporting when things are going wrong, but also a capacity to help a structure in its organisation, the efficiency and safety of its processes.

The day-to-day mission of the internal control

Internal functions are usually attached to operational units. When they do not exist, because of the too small size of the business unit, someone usually is in charge of a part of the function. It could be someone from the back-office or from the operation department.

The first task of the function is to ensure that the procedures are adequately followed by the different services under its jurisdiction. The checking can be run through regular audits of the different departments (for instance, commercial, back-office, accounting and payments), as well as through special missions when something is going wrong (claims, incidents, warning signals).

The internal control can also establish daily report, with some indicators showing the quality of the processing. The list of indicators, if not comprehensive, can be:

Number of the deals (tickets) processed in the different areas

Number of errors in the processing

Pending issues (confirmations, payments) not yet solved; date since the beginning of the issue.

Financial penalties (due to problems with clients and counterparts, delays in payments).

All these indicators can be warning signals, involving a reaction from the internal control people. It could be to call the department showing a problem, to understand the issue and see how to solve it as quickly as possible, or to propose another organisation, when a problem seems to be a permanent one, or even to propose to reinforce an area under pressure. Thus, permanent overtime in the back-office, with a high number of delays and errors could mean that the back-office is understaffed and should hired more people.

Missions of the internal audit

Working for the top management of the bank, reporting to the highest level of the institution (the president) and sometimes also to the Board, the audit is the function in charge of reviewing the whole departments of a bank to explain the president how things actually work, is risks are under control, and if some changes have to be done.

The audit should be sufficiently staffed, with several teams (depending on the missions, teams can have from four to ten people), senior people in charge of the teams, and a manager being able, by his (her) experience and seniority, to convince the top management of the bank. In most of the banks, members of the audit come from different areas of the bank and do not stay more than a few years (three to five) in the audit. This is a way to mix different experiences, to maintain a good level of expertise, and to have people with a high potential to return to the operational departments after a few years of in-depth analysis of the various activities of the bank.

Usually, a part of the audit’s time is organised in order to ensure a regular review of all the units and departments. For instance, two functional head-office units (accountings, systems) and two business units (the New-York subsidiary and the trade finance department) will be reviewed during the first quarter of the year. All of these reviews will be comprehensive, with a final opinion given on the organisation, the profitability if any, the quality of the people, the risk management. If necessary, the audit can propose a change in the activity, another organisation or a change in people. The request for changes will be discussed with the unit’s manager and, then the top management of the bank. It can be officially asked the unit’s manager to follow the audit recommendations.

In any type of company, there is a need of clear definitions of functions and processes, which are detailed in a manual of procedures. Such a manual ensures, if used, that the processes, duties, controls are the same in all the entities of the company. It brings consistency and safety to an organisation. The best-managed western banks usually show a strong organisation, with the procedure manual being often called “the Bible”.

However, it could happen that the actual process is different from what is described in the book. The real life of the bank does not correspond to the scheme privileged by the management. It could be due to the inadequacy or obsolescence of the procedure manual. It could also be the consequence of habits difficult to change, even if the changes will be positive for the company.

That is why it is fundamental, on one side, to design a procedures manual dealing effectively with the day-to-day practical issues of the various departments of a bank and, on the other side, to regularly control the overall process to see if the procedures are actually enforced.

Scope of the procedures

Procedures should describe things such as:

The allocation of duties and responsibilities in all the administrative areas, such as back-office, accounting and settlements (which department is in charge of what).

The precise processes of all the administrative tasks (for instance, the documents to fill in, the input of an operation into the system, the double checking).

The organisation of the authorisation process (which departments are in charge of giving the authorisations, what to do in case of a specific operation).

The format of the reports, their frequency and their destination.

What to do in case of a problem, the departments and people to inform.

For instance, at a branch level, the process of a specific product will be the following:

To conclude an operation on that product with a client, the salesperson will use the document XXX (standard document for the all bank for this product), fill it in with all the required information, and ask the client to sign and date the document.

The document will then be passed to the back-office for a double-checking.

The operation will be input in the system, under the screen YYY. Once input, check the confirmation printed by the system, and send a copy to the customer, another copy being kept in the back-office files.

Enforcement of the procedures

Clear signals have to be sent by the head-office to push he entities to apply the procedures and their update versions. It is under the responsibility of the entity’s manager to do so. He can delegate it to the operation manager or to the controller, if there is any in the branch.

Permanent checking that the procedures are up-to-date and correctly followed

A bank will make sure that any new activity, a change in the organisation or in the systems, involving changes in the way the people work, is reflected in an adaptation of the procedures. The procedure manual is an alive document, enriched methodically and regularly. The respect of the procedures is to be checked at a local level, within the branch, and by the audits run by the central audit function of the bank.

Normally, a branch network can only sell products authorised by the head-office, with details given for each of the product (minimum and maximum size by operation, margin or fee depending on the size). When an operation, on a customer’s request or because a branch may think about a specific offer well adapted to its market, a special authorisation or framework of possibilities is to be discussed between the branch and the head-office.

Customers

As already mentioned before, credit risk is the most important risk a bank has to address. The key task is thus to establish a solid credit risk framework, with the methodology being determined and validated at the head-office level. The quantity and quality of the people working in that area are fundamental for the bank. Regarding the authorisation, for the branches, to deal with the customers, there are two possibilities:

For the normal range of private clients, being rarely customers of more than a few branches of the same banking group, general criteria will be determined by the head-office and given to the branches. It relates usually to the customer’s revenue and assets, customers being very often ranked to show their worthiness and solvability (for instance, a rank from 1 to 5 or stars). Then, once a client accepted for operations involving lending issues, such as an overdraft or a mortgage, the size of the operation will depend on criteria also pre-determined. They are linked to the capacity of the customer, taking into account his (her) assets and revenue, to reimburse its short-term or long-term borrowings. This capacity is generally expressed with a ratio. For instance the reimbursements should not exceed 25%-30% of the salary, except if enough customer’s assets, easily usable or sellable, are kept with the bank.

For major customers, such as big companies or private clients representing a potential significant credit exposure, the credit department of the head-office usually determines a global authorisation, and follows up the global exposure of the bank related to these clients. Some authorisations cold be delegated to the branches having the principal account of the customer. In addition, specific authorisations could be given on a case by case basis, with the branch discussing a proposal with the head-office.

Market risk and funding issues

As explained before, the branches should not have the authorisation either to do their own funding or to have market risks. These two elements should be managed at the head-office level. If, in exceptional case, because of national or regional characteristics, some branches have to manage this type of exposures, it would be within a precise framework determined with the departments in charge at the head-office’s level.

As already mentioned, an effective delegation by the head-office to the profit centres is a crucial condition of success. In order to send clear messages, priorities have to be precisely defined, with timing for each of them.

Identification of key tasks

Each strategy requires, to be implemented, a certain number of key tasks, for instance:

Information for the network, coming from the head-office, about the new strategy, the products concerned by it, their prices, the related organisation

Delegation of a set of objectives and authorisations

Production of a marketing document for the customers

Production of documents to be filled in by the branches when they sell the new product

Adaptation of the computer systems (or new developments), in order to allow the branches to input the activity related to a new product (volume and price, by client)

Adaptation of the accounts

A comprehensive identification of all the tasks related to a project is crucial to avoid problems that could go against the desired targets. For instance, if the systems can not deal with a new product, the branches could be in trouble when they want to process it and the clients could be unhappy with the information they receive from the bank. It could undermine the strategy and even damage the image of the bank.

Allocation of responsibilities

For each of these key tasks, a department or a service (marketing, systems, and accounts) has to be clearly in charge, with a deadline. The co-ordination of the whole work to be done is essential, and it is usually more efficient to have a person dedicated to the project. This project manager could work in the commercial department of the bank.

Specific case of a matrix organisation

It is more and more common for the banks to be organised under a matrix structure. It means that a global commercial department is in charge of the branches, with sometimes several regional offices to assist it, with product line managers being in the same time responsible of the development of specific activities. Therefore, a branch manager has two lines of reporting: his (her) regional office and the commercial department, as well as the head office’s product line manager. The revenue of the branch is made of the sum of all the revenue by product. Normally, if the analytical tools are correctly designed, there should be no discrepancies between the total announced by all the branches and the total produced by all the product lines (assuming that the whole activity of the bank is split in product lines).

Matrix organisations are useful because they allow having on one side very specialised and professional people, knowing very well a product, its market and characteristics, and, on the other side, salespeople of the branches totally dedicated to offer their clients what the product lines produce. The trouble is when the split of responsibilities between the two areas of the bank is not clear enough, with potential conflicts of interest. The monitoring of an efficient matrix organisation requires defining the rules of the game, the various responsibilities, and the criteria to judge and compensate the people working in the different areas (product lines and branches).

Incentives and rewards

It is usual, in the banking area, to pay the staff, mainly the salespeople, not only with a fixed salary, but also with variable compensation. To help in the process of reaching a specific target, the incentive schemes have to be adequately designed. If a product, judged as a key element of the strategy, generate less commissions for the salespeople than another product, less strategic or less profitable, the risk for the bank is to go against its own objectives.

Each bank has its own culture and organisational choice. Depending on these elements, the head-office gives more or less autonomy to its profit centres, either branches or product lines. In terms of efficiency and dynamism, it is however usually better to give the profit centres the direct responsibility of their activity, and to stimulate them to do so.

Whatever the balance between the head-office’s responsibility of the profit centres’ one, the definition of the role of each of them has to be established, with a precise allocation of responsibility and clear reporting and communication lines.

The framework presented below represents what could be a good organisation between the head-offices and the entities. This is not the only efficient scheme, but a basis to be adapted according to each bank’s own specificity.

Responsibility of the branch in the implementation of a new strategy

A new strategy is discussed and approved at a top management level, with a strong input of the commercial manager. Then, objectives and budgets are determined and delegated. From that moment on, the prime responsibility of the commercial success of the strategy should be at the branch and profit centre level.

The branch manager is in charge of organising his (her) teams, giving them targets and incentive schemes to reach the objectives. He is has to carefully monitor the development of the activity, in order to check if the actual business is in line with the expectations. If not, the first step of any corrective action will be at that branch level too.

Role of the head-office

The head-office should have a few main functions: to ensure the consistency of the overall strategy, to determine the acceptable risk/profitability profile of the bank, to set up standards and to offer tools and expertise to the profit centres. It is also of the head-office’s responsibility to monitor the risk framework (delegation of limits and follow-up of them), and to be in charge of the entire treasury and funding issues.

In terms of support functions, the head-office will ensure that the computer systems are adequately designed for the network, and that they are consistent. The branches generally use the same standard programs, developed for them by the group systems centre. The reporting will also be a standard one, to allow an easy consolidation.

Dialogue between the head-office and the branches

This dialogue occurs on different items, mainly:

The delegation of limits, the use of these limits, special authorisations

First, this regards the credit limits, crucial for the network. The branches have specific delegations, including those related to the lending activity, within which they can work. In case of a branch wishing to go over its limits with one client, it will be discussed with the risk department of the head-office (or sometimes with a regional office responsible of a set of branches in the area) to see how the situation can be dealt with. In some cases, the branch can have a temporary authorisation.

Similarly, the report showing, on a regular basis, the use of limits will be discussed, if necessary between the head-office and the branches. The exercise is especially important once a year, when the authorisations are reviewed. The new limits can then be adjusted to take into account their effective use, and it will be to the branches to argue about their needs.

The results of the strategy

Regular reports allow the head-office to judge of the results of a new strategy, either product by product, or type of clients by type of clients, or branch by branch, or for any combination of these criteria. If the results are not on line with the expectations, discussions could occur between a manager at the head-office level (or at the regional level) and the branch manager to understand the reasons of the discrepancies and to think about possible actions.

The funding issue

This is a crucial point in many emerging countries. Normally, the funding responsibility lies only at the head-office level. It is under the centre’s responsibility to fund the group, and to manage its assets and liabilities exposure. Depending on the risk profile of the group and on the overall cost of the funds, the group will authorise certain operations, with a maximum maturity. In the same time, internal funding costs will be charged to the branches, with an indication of the extra margin to add to these costs. The extra margin is the branches’ contribution to the revenue of the banking group.

This scheme is the most efficient to ensure that the overall exposure is under control, and to assess the cost of its management. However, another pattern sometimes exists, where the branches, or a regional office, are in charge of their own funding, at least for a part of it. In that case, the branch would have to integrate the regional constraints (for instance no possibility of funding for maturities over 12 months) in its own strategy. At least, the branch should be helped by the head-office, in terms of methodology or to determine a risk profile.