Collaborative Cash Flow Margin Planning

Journal of Performance Management, 2005 by Pierone, Peri

INTRODUCTION

Each year, hundreds of financial institutions are faced with the onerous task of developing an annual budget. While many aspects of the planning process are difficult to prepare and administer, no aspect is more daunting than the balance sheet and margin.

Despite expending a great deal of time and effort in preparing the margin component, in the end most organizations are not confident in the quality of their numbers. This is a significant problem: balance sheet/margin is the primary earnings engine for most financial institutions and incentive compensation is often tied to its performance, yet real accountability for margin is lacking. If institutions do not measure performance correctly (or measure it too simplistically), they run the risk of motivating behavior that is dilutive or even destructive to the overall profitability of the institution.

In this paper, we review the shortcomings of traditional approaches to planning the balance sheet and present a more effective solution, Collaborative Cash Flow Margin Planning (CCFMP).

BACKGROUND

Most financial institutions divide the responsibility for planning the balance sheet to two areas: the ALM team which supports the ALCO process, and the finance team which administers the annual budget (and, increasingly, some form of forecasting1). The table below reviews some of the key differences between the ALM function and the finance/budgeting function.

Generally, the software designed to support the efforts of the two teams reflects these differences. ALM systems are designed almost exclusively with precision in view. The ability to model a myriad of financial instruments accurately is key to almost every design decision. In contrast, the goal of budgeting systems is to create a technical infrastructure that can engage contributors across the enterprise. The primary focus is the collection and consolidation of numbers, workflow management, and ease of use for both the administrator and the end user. ALM systems are focused on risk in aggregate and typically have no use for funds transfer pricing, whereas planning systems have a disaggregated viewpoint of the balance sheet and seek to understand contribution by business unit, and correspondingly need funds transfer pricing.

Graphically depicted, ALM systems are high on precision but low on ease of use and collaboration. Conversely, traditional budgeting systems are high on collaboration and ease of use, but woefully lacking in modeling and precision. The goal of CCFMP is to deliver on both fronts (quadrant 2 in the diagram).

The purpose of this article is to propose a new paradigm; a marriage between traditional ALM and budgeting approaches called Collaborative Cash Flow Margin Planning (CCFMP). The goals of this approach are to:

* Offer greater precision with regard to net interest income/ margin and the balance sheet projections

* Increase accountability for margin among the various lines of business

* Focus plan contributors on incremental new business goals - both volume and spread

* Support forward-rate funds transfer pricing, so that business units can plan under the same paradigm in which they are being measured for actual or historical performance

* Facilitate stronger modeling capabilities such as the ability to process meaningful "what if" scenarios

* Provide greater insight into balance sheet and margin performance

Instead of modeling one enterprise balance sheet as ALM typically does, CCFMP creates tens, hundreds, or even thousands of planning unit balance sheets - each reflective of the product mix, pricing and other nuances of the local markets they serve. With the incorporation of forward FTP, CCFMP is positioned to include economic capital allocations, service transfer costs and other features that allow each planning unit to be measured on a risk-adjusted return basis. Using CCFMP, organizational profitability can be merged with the planning process, thereby applying a consistent view of the business regardless of whether it is forward-looking or historically-focused. The absence of forward FTP and a cash-flow based planning methodology such as CCFMP negates any ability to merge these views.

TRADITIONAL APPROACHES TO FINANCIAL PLANNING AND ANALYSIS (FP&A)

There are numerous approaches that institutions have traditionally employed to produce net interest income/margin and balance sheet projections for the annual plan or quarterly forecast. These approaches include:

1. Plan volumes only

This approach touches only half of the equation. Any discipline or control with pricing is lost, not to mention the inability to per form any scenario modeling.

2. Use the ALM forecast generated for the consolidated institution

While this approach yields reasonable results at the consolidated level, it is weak on collaboration, participation and accountability. It also does not provide any visibility into the contributions being made by particular branches, regions or lines of business.

3. Take an ALM projection and distribute it down to lower levels in the organization, either proportionally or subjectively