BY KEN LEVEY
Ken Levey, Vice President of Financial Institutions, Kaufman Hall
To identify current performance management trends and priorities—and their implications in financial institutions—Kaufman Hall conducts an annual survey of CFOs and other senior finance professionals. Executives from more than 100 credit unions, banks, and other financial services institutions participated in the most recent survey, whose findings, implications, and recommendations appear in our2018 CFO Outlook survey report, Performance Management Trends and Priorities in Financial Institutions. This article explores select findings related to budgeting, planning, and profitability.
As you read this,think about priorities and progress in your organization and how they compare with those of institutions represented in these findings.
The Road to Better Budgeting and Planning
The CFO Outlook survey report revealed valuable insights around the length of budgeting cycles, rolling forecasting, and ways to enhance budgeting to support strategic initiatives.
Shorter Budget Cycles Allow Time for Value-Added Analysis
In our 2018 survey, 39 percent of respondents said their annual budgeting process takes more than three months to complete (with some reporting up to six months), and a comparable 40 percent said their budget cycles do not allow adequate time for value-added analysis that can inform strategic decisions.
A significant contributing factor to long budget cycles is the continued reliance on spreadsheets for budgeting: 24 percent of respondents reported that spreadsheets were the primary budgeting tool used by their institution. Data processing with spreadsheets tends to be inefficient, error-prone, and time-consuming, requiring corrections, verifications, and other adjustments.
In contrast, a strategic budgeting process, fully integrated with the institution’s financial and strategic planning efforts, can and should take only two to three months to complete.
Following best practices for the planning process, such as creating accountability for and alignment with strategic plans, and using modern technology, can help many institutions shorten budgeting time frames to free up time and resources for additional analysis.
Rolling Forecasting Increases Accuracy and Agility
Our survey found that 42 percent of respondents use rolling forecasts to complement their annual budgeting process, and another 34 percent have plans to implement rolling forecasts in the near future.Two percent of respondents felt that traditional budgeting processes weren’t needed anymore, as they have replaced them with rolling forecasts.
Institutions that successfully use rolling forecasts commonly perform five functions:
Select the forecast horizon that fits the organization, with three to five years being typical
- Implement a driver-based planning model that incorporates the critical operational data and drivers that influence financial outcomes
- Retain prior-period forecasts for back testing to improve predictive accuracy
- Ensure the institution makes the cultural shift from traditional annual budgeting and forecasting to rolling forecasts
- Leverage technology to support the forecasting process, integrating with operational data sources, enabling collaboration, managing workflow, and storing past forecasts
The improved accuracy and agility provided through rolling forecasts can give finance leaders higher confidence when making decisions and investments to reflect evolving changes in business trends.
Enhanced Budgeting Supports Better Decision Making
The survey asked participants about items and initiatives included in their institution’s budget. Responses were as follows(with multiple responses allowed):
The finance team’s skill in managing performance is directly dependent upon its ability to effectively quantify proposed business strategies through its planning and budgeting process. Budgets should therefore include a wide range of planning and analytic initiatives. Based on survey results, three areas within budgeting showed opportunity for improvement: multi-scenario analysis, cash flow planning, and forecasted funds transfer pricing (FTP).
Only 41 percent of responding institutions use multi-scenario analysis as part of their budgeting process.
With increased volatility in today’s operating environment, institutions that can quickly model multiple scenarios will be better prepared to intelligently adjust their strategy based on changing conditions. To better predict financial outcomes and support the right initiatives, institutions should consider these action items:
- Identify the key factors that define the market, such as interest rates, consumer behavior, market conditions, and product innovation
- Agree on the baseline/“most likely” scenario
- Develop targets, strategies, and plans
- Craft relevant scenarios that describe a range of potential operating environments
- Test alternative scenarios to identify their impact on plans and budgets
- Identify early warning triggers and corresponding tolerance ranges for each scenario
- Make adjustments as necessary when triggers are activated
Running stress scenarios and forecasts as part of an iterative process—taking into account the impact of pressures on shares/deposits, loans, and credit—enables financial institutions to assess the effect of potential changes before finalizing the budget. The finance team can then establish appropriate targets and formulate mitigation plans for likely scenarios.
Cash Flow Planning
The 2018 survey also indicated that only 49 percent of respondents include cash flow-based planning in their budgeting process. This practice lets financial institutions amortize individual customer records into cash flows and aggregate them in any dimension. Critical steps to the process include leveraging core transaction system data, completing the balance sheet plan, and ensuring the institution makes an appropriate cultural shift to this new methodology.
The addition of cash flow planning will result in much higher precision with regard to balance, net interest income, and margin projections; increased accountability for line-of-business stakeholders; improved focus on incremental new business; stronger “What if?” scenario modeling; greater insight into performance; and inclusion of forecasted FTP, as described next.
The final area identified for budgeting enhancement is the addition of forecasted FTP. Of survey respondents, only 50 percent currently include it in their budgeting process.
Adding FTP forecasting allows finance teams to more accurately predict actual performance (predictive analysis), including the expected net interest margin (spread) and income (dollars) by initiative and segment. Forecasted FTP can also be used to improve prescriptive analysis, helping finance leaders to identify the best outcomes and how those results will be achieved. Analyzing the actual results compared with the budgeted results from a net interest margin perspective can enable leaders to:
Evaluate the relative value of strategic initiative options
- Create a standard measure across markets and between teams
- Remove the impact of the interest rate environment from goal setting
Improving and Leveraging Profitability Analysis
Kaufman Hall’s 2018 CFO Outlook survey revealed important findings around profitability analysis, including the need to understand profitability across dimensions, strategies to improve profitability measurement, and the value in leveraging profitability metrics to inform incentive compensation.
Understanding Profitability Across Dimensions
Profitability is at the heart of any financial institution’s long- and short-term strategy. It is concerning to see that only 16 percent of survey respondents say they have a clear understanding of the profitability of their products, members/customers, and channels.Notably, this is lower than last year’s survey, when 22 percent of respondents indicated they had a clear understanding of profitability across these dimensions.
Further, while more than 88 percent of this year’s survey respondents say it is important to monitor member/customer, product, channel, and officer dimensions of profitability, only 45-55 percentactually monitor these specific dimensions at their institution.Without such monitoring, finance leaders will not have the data required to gain understanding of profitability dimensions.
Clearly, there is work to be done. An improved understanding of both costs and net interest margin will yield a more accurate and complete picture of profitability.
Only 40 percent of respondents allocate costs to products, members/customers, or their institution (using a driver-based, percentage-based, or activity-based approach), while 53 percent say they would apply an activity-based approach to improve cost allocation.
By allocating costs to the institution’s departments, members/customers, and products, executives will improve visibility into the profitability of each dimension.
To better understand costs, institutions use a variety of cost accounting methodologies. In 2017, Kaufman Hall conducted a profitability survey jointly with the Association for Management Information in Financial Services (AMIfs, now part of the Financial Managers Society [FMS]). In that study, the most common methodologies used were:
- Driver-based (69 percent), such as number of accounts opened and outstanding balances
- Member/customer account transaction volumes (51 percent), such as number of shares/deposits and loan advances
The use of solid data represents best practice for establishing costs to enhance profitability analysis.
Survey responses indicated a troubling decrease in the use of FTP to more accurately measure net interest margin. Last year, our survey indicated that 74 percent of respondents used FTP in their profitability process (either an instrumentlevel-based approach or a simple pooled approach), and 9 percent planned to use it. This year, only 65 percent are currently using some form of FTP analysis in their profitability process, and 12 percent have plans to adopt FTP.
The goal of FTP is to accurately and rationally measure the cost or credit of funds in support of profitability measurement, margin measurement, product pricing, and decentralized decision making.
FTP helpsorganizations answer questions such as:
Which loan products are profitable?
- Which branches are losing money?
- Are shares/deposits profitable?
- Which members/customers are profitable?
Kaufman Hall recommends an instrument-level (“matchedterm”) approach. The inclusion of a transfer pricing methodology radically changes the understanding of the makeup of net interest margin and how the institution’s activities have contributed to it.
Leveraging Profitability Analytics to Improve Incentive Compensation
Profitability analytics also support transparent and well-designed incentive compensation programs.
While 42 percent of survey respondents include profitability as a metric in calculating employee incentive compensation, 36 percent do not currently include that metric, but would like to do so, and the remaining 22 percent have no plans to consider a profitability metric.
Incentive compensation most often is tied to loan and share/deposit volumes and metrics associated with volume growth, such as number of referrals or accounts opened. It is critical to factor in profitability, rewarding contributions to profitable growth rather than just increased business.
Data and tools already available as part of high-quality enterprise performance management systems can be leveraged for development and management of profitability-based incentive compensation programs.