INTRODUCTION

The approach here will be to begin with a brief look at the terms of reference of financial performance when banking was in its embryonic stage compared to its present form. Various change factors affecting bank management and performance and how they have contributed to a new kind of thinking in banking - “shareholder value thinking” are then visited. This is followed by an examination of the risk/return trade-off concept, bank performance and risks and their corresponding measures.

THE EARLY DAYS OF BANKING

In the early days of banking, good financial performance was more a measure of growth, balance sheet size, and maximising overall returns. While pursuing these objectives, bank managers sought to manage attendant risks which have always been a regular feature of bank management.

MODERN BANKING

Banking in the 1990s has changed radically. Bank managers now are faced with the unenviable task of improving financial performance while managing risks more diverse and complex in nature. This has been brought on by deregulation (relaxed banking structures and conduct rules), intense competition both from financial non-financial firms and rapid technological change which has resulted in more sophisticated forms of products and services.

Other factors that have impacted include marketisation (general trend encompassing change factors above) which have forced banks to become more demand-oriented, globalisation (market integration at the domestic and international levels), internationalisation (export of banking products and services), re-regulation which is the reinstatement of rigid regulatory rules, securitisation (repackaging and selling pool of assets to create additional liquidity) and off balance sheet (OBS) banking which are non- cash positions not entered on conventional balance sheet..

CHANGING APPROACH TO DEFINITION OF FINANCIAL PERFORMANCE

With the change factors outlined, the terms of reference for financial performance changed. It is now defined more in terms of profitability and or return. By extension, profitable and return on equity driven growth are the new indicators of good financial performance as opposed to “growth and size for size’s sake”. Banks have also focused more on overall bank risks and the risk management function. Increasingly also, SWM or shareholder wealth maximisation has become the primary objective of modern day bank management.

SHAREHOLDER WEALTH MAXIMIZATION

SWM is essentially maximising the owner’s equity or investment in the business. This maximisation process is function of asset management, liability management and capital adequacy and dividend management. In essence, the manager is focused on maximising shareholder value by balancing the risks and returns associated with the stated managerial areas of decision making named in the sentence preceding. This is essentially the risk/return trade-off scenario.

This scenario (risk/return trade-off) at a fundamental level, holds that different levels of return are associated with different risk levels. Higher risk levels must be compensated with higher returns. Value maximisation, which is increasingly the objective of bank managers, must ensure that that this risk/return trade-off is fulfilled. Thus bank profitability and or returns must be balanced with attendant risks which have been magnified by technological change, competition, marketisation, securitisation, OBS banking, etceteras. This concept in sum is SWM or “shareholder value thinking”.

With SWM therefore, the risk/return trade-off or making returns commensurate with certain levels of risk is paramount. Banks must be able to isolate, quantify and manage the important trade-offs of risk against return.

PERFORMANCE AND RISK EXPOSURE

In order to achieve this, performance and risk areas of banking must be clearly identified measured and properly managed. It is through this process which is as a result of the SWM objective or “shareholder value thinking” that bank financial performance may be improved.

Performance Measures 

Performance areas typical of banking are interest revenue, interest expense, provision for loan losses, non-interest income, and non-interest expense. Measures include net margin (net income to revenues), IM - interest margin (net interest differential to earning assets), AU - asset utilisation (revenues to assets), leverage multiplier (total assets to equity). ROA (net income to total assets) and ROE (net income to equity).

As a performance measure, ROE and its decomposition provides excellent analysis in that it points to areas of good, bad or indifferent performance. At the first stage of decomposition, ROE is a product of ROA and the leverage multiplier. ROA (which is essentially a product of the AU and net margin) tells the bank how efficiently its financial resources are been used and indicates areas where improvements may be necessary.

The AU ratio further decomposes into the fixed asset, receivables and inventory ratios. While these ratios, in particular the inventory ratio, may not be very meaningful from a banks standpoint, they provide further clues as to how management is using its assets. The net margin ratio is a product of the gross margin and the required expense ratio. These ratios tell management how profitable its operations are and the kind of coverage required for operating costs.

In addition to ROE and its decomposition into ROA, etceteras, the size and timing of returns along with future revenue prospects are also very important to the overall SWM objective.

Risk Factors 

Risk concerns and measures are many. These include environmental, management, delivery and financial risks which arrive from the banking characteristics - environment, human resources, financial services and balance sheet respectively.

Environmental risks are external to the firm and are legislative, economic, competitive and regulatory in nature. Management risks are extremely important in present day banking. They include compensation risks, defalcation, organisational and ability risks. Delivery risks arise from operational, technological, strategic considerations and new-product introductions.

Financial risks include credit, liquidity interest rate risk (the basic portfolio risks of banking) and capital risk. Credit risk is the possibility of default by a borrower and is usually measured by loans to assets or non performing loans to loans ratios. Other indicators include loan concentration to a particular industry, rapid loan growth, etceteras. In the early 1990s many Jamaican banks took immense credit risks as evidenced by the steep rise in loan volumes. Today many banking failures have been as a result of this period of recklessness.

Liquidity risk is the ability to meet cash obligations as they fall due. Good measures are loans to deposits and liquid assets to deposits ratios. As has been experienced in Jamaica however, liquidity problems can be dangerous as word gets out quickly impairing the banks ability to source borrowed funds.

Interest rate risk is the resulting exposure to a bank’s interest earnings from possible changes in interest rates. Interest rate risk is usually measured by the level of interest sensitive assets to interest sensitive liabilities. In recent times Jamaican banks have been plagued by massive swings in interest rates and as such any mismatch between assets and liabilities have been extreme in impact on earnings.

Leverage risk is measured by comparing equity to deposits or to assets. This measure usually gives a good indication of the extent to which asset values can fall before depositors are affected. This measure is particularly important in American banks where lending is based strongly on strong capital base.

SHAREHOLDER VALUE THINKING

Shareholder value thinking then is about balancing all these risks against return levels with the measurers described serving as management tools. In modern banks, therefore, identifying, measuring and managing risks and returns are very important. Traditionally, these functions were performed by treasury units in banks and senior management. However with the changed nature of banking, banks are increasingly making use of asset and liability management committees and risk management units.

THE ROLE OF THE ASSET & LIABILITY COMMITTEE

The asset and liability management committee (ALCO), typically comprising CEO and senior management, sets targets for risk and returns and reviews the existing and projected balance sheet structure and OBS positions. Risk management units are responsible for identifying overall risks and assisting the risk control function. Through these units, new products such as swaps, futures and options have become popular in hedging risk positions.

Even though SWM or shareholder value thinking has not being embraced in Jamaica, many banks have set up asset and liability management committees and risk management units to more ably handle growing complexity and diversity of risks and the pressure to remain profitable.

BENCHMARKING AGAINST PEERS

Having the necessary infrastructure such as asset and liability committees, risk management units is important. However, just as important is a well co-ordinated process of identifying measuring and managing risks and return measures and ultimately setting performance and risk targets. This includes: (a) looking at how other peer banks have gone about establishing or identifying these measures, (b) how the risk and returns have been measured by similar banks, and (c) deciding on and setting realistic, achievable targets.

ECONOMIC MODELS 

By focusing on what other banks are doing or essentially incorporating market thinking makes for higher standards of performance. This is essentially reinforced by the growing popularity of using economic models as measure of value by the proponents of “shareholder value thinking”. With the traditional accounting method the market price of a firms share is the earnings per share (EPS) times an earnings multiple. Since the earnings multiple is market determined; managers need only focus on maximising the EPS. The accounting model has however been criticised for its omission price of time and risk considerations.

The economic model on the other hand essentially incorporates the time value of cash flow streams. Cash flow being the gross revenues minus the cost of financial liabilities over head costs and taxation levied against bank. The stream is discounted at a rate of interest adjusted for risk.

RAPM TECHNIQUES 

From the preceding, it can be seen the financial performance may be improved through “shareholder value thinking”. Importantly, with the passage of time the concept has been enhanced by more sophisticated risk/return measures such as return on risk adjusted capital and risk adjusted return on capital. Of late risk adjusted return on risk adjusted capital has become the leading edge. These RAPM techniques have been made popular by Bankers Trust.

Value At Risk

Another revolutionary concept in bank risk management is “value-at-risk” (VAR). This essentially is the use of correlation technology to determine the extent of an institution’s money at risk. In addition to VAR and RAPM, concepts such as value added and economic value added (EVA) are becoming mainstream. The reduction of cost/income ratios are integral to the value added concept while EVA focuses on income made at the margin less the amount to compensate investors for given risk levels.

DRAWBACKS TO SHAREHOLDER VALUE THINKING

SWM or shareholder value thinking therefore has been shown to be a recent concept. While relatively new it has already undergone some change through these new and more sophisticated measures and is becoming more widely embraced. Despite its growing popularity however the concept has drawbacks:

The first is that while financial performance may be improved through “shareholder value thinking” managers may at times have other interests at heart than SWM. This is the classic agency problem where stockholders and managers want to maximise their own utility or there is a conflict of interest between the two groups. For example management for various reasons may feel that size is what really matters and as such sets this as the objective at the expense of SWM.

An extension of the argument in the paragraph immediately preceding is that managers may become more focused on other objectives other SWM. By the some token, however, too much focus on SWM may be to the detriment of other important corporate objectives. Such objectives may of course be critical in the overall objective of SWM.

FINAL THOUGHTS ON SHAREHOLDER WEALTH MAXIMIZATION

In concluding, it has been shown the how financial performance may be improved through shareholder value thinking which is about SWM. SWM, it has been shown, not only focuses on balancing returns as ROE and ROA but also size and timing of returns and future prospects against risk levels. Despite some drawbacks, systematic identification and management of risk and return areas and measure while incorporating economic valuation models can improve financial performance.