The Peer Group Benchmark - A Bankers Guide To Profitability and Risk Management

Published on August 29, 2024

Today's bankers are challenged with both meeting financial regulations and generating sufficient profits for the bank’s shareholders at an acceptable level of risk. This means, for example, having regard to the Bank for International Settlements (BIS) Capital Adequacy Regulations or their local implementation. In order to fund loans, banks are required to put up capital as well as deposited funds, ensuring loans comply with the capital buffer requirements. The Basel regulations typically require a bank to hold 8% capital and 92% debt to fund a single loan. However, due to the competitive nature of banking and the incredibly tight margins in the lending business, banks have developed innovative and creative ways to increase the shareholder value of capital at risk. Banks realized that not all assets carry the same levels of risk, so the capital at risk should be weighted accordingly—holding more capital for riskier assets and vice versa.

Thus, loans are weighted according to risk, and the total capital buffer is based on Risk Weighted Assets, which helps banks be more efficient with their capital. Improving the risk profile of capital allocation means holding more capital against risky assets and less capital for lower risk assets. In this way, lending banks can choose which assets they want to hold on their balance sheet and determine the level of risk that is acceptable to the bank and its shareholders. Shareholder Value, a key metric used by banks, is only created if the bank generates Economic Profit—Profit After Tax less a charge for the Capital At Risk (Economic Capital). The calculation of economic capital is, of course, reliant on the Risk Weighted Assets mentioned above.

The Challenge

The client’s Cost Income profile had suffered since the fall in revenue that resulted in the wake of the great financial crisis. The back office of a bank tends to have a higher proportion of fixed costs than the front office. Thus, the marginal impact of a reduction in sales significantly impacts profitability. The lights must be kept on, and the bank must look at every avenue to transform the situation. In determining the strategy for performance improvement, it is first necessary to undertake a strategic review. This requires not only examining the internal operations, headcounts, and financial performance of the bank but also conducting several peer group comparisons. One of the diagnostics I use in benchmarking is the Basel Regulations—Capital Adequacy regulations. Please note that this is not a regulated activity but a strategic management exercise to compare the bank’s position and performance across a range of widely accepted benchmarks.

Bigham Consulting's High Impact Management Approach™

Comparing banks against each other is not a simple task, as they publish a plethora of regulatory metrics. Bigham Consulting’s approach is to recreate the measures from first principles. First, we determine the peer group. Once this is defined, we collect a broad range of financial and non-financial information. The client, who used a range of benchmarks, had data on both people and processes. Understanding Cost Per Head and Cost Per Process is more useful than it might seem. The value in benchmarking is having the ability to flex forecasts and carry out sensitivity analysis on the metrics being measured.

To make sensible comparisons, we recreate financial statements for all banks. This is a simple exercise, and to clean the data, we use a consolidation model to make journal adjustments where necessary. This ensures the final adjusted financial statements allow for comparing like with like. The cleansed output is then used to build a data warehouse or database. The Benchmark Model is populated from this data warehouse, which holds the data for all banks in the peer group. We can then pull data into the benchmark model for any of the banks and compare them to the group. Metrics are modeled in PHP or Javascript so all comparisons are on a like-for-like basis.

Note, we are not using published metrics but published financial data to recreate the metrics ourselves. I believe this is a purer form of benchmarking any KPI. For example, Return on Equity (ROE) is reported by all banks, but our method provides better insights. ROE is comprised of five economic drivers: Earnings on Assets (Earnings/Assets), the Funding Cost Ratio (derived from Net Interest Margin and Interest Charges as a percentage of Debt), the Operational Expenses Ratio (Operational Expenses/Assets), the Taxation Ratio (Profit before tax multiplied by the Tax Rate), and the Leverage Ratio. These five metrics create a mathematical proof for ROE, which is simply Profit After Tax/Equity.

Bigham Consulting implemented its proprietary High Impact Management Approach™ By breaking the bank’s performance into the economic drivers of return, we can benchmark each bank against its peers on a level playing field by metric. This includes balance sheet and P&L metrics. We build benchmarks for :

• the Tier 1 Capital Ratio, The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's central bank).
• the Liquidity Coverage Ratio The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets that financial institutions must hold to ensure that they can meet their short-term obligations and ride out any disruptions in the market. It is mandated by international banking agreements known as the Basel Accords.
• the Net Stable Funding Ratio The NSFR presents the proportion of long term assets funded by stable funding and is calculated as the amount of Available Stable Funding (ASF) divided by the amount of Required Stable Funding (RSF) over a one-year horizon.
• the Asset Utilisation Ratio (Turnover Ratio)The asset turnover ratio analyzes how well a company uses its assets to drive sales. The ratio is calculated by dividing a company's net sales for a specific period by the average total assets the company held over the same period. The asset turnover ratio can be modified to analyze only the fixed assets of a company.

Results and Impact

The implementation of our High Impact Management Approach™, the client bank can take a deep dive into any metric to stresstest or perform sensitivity analysis. For example the Operational Expenses Ratio, is comprised of two numbers: Operational Expenses and Assets. To improve the metric, we stress test both the numerator and denominator. For example improvement to the bank’s operating costs will improve the metric.

Therefore we can flex the operating model, which utilises our process and head counts to measure the marginal impact of a given strategy, eg a location strategy test or a grade pyramid arbitrage test or offshoring or outsourcing tests would demonstrate the marginal value of the particular strategy relative to peers and ensure the impact on on the operational expense ratio is material, i.e. High Impact™, and makes sense within the context of the five year plan for the bank. This adds tremendous value to the plan by providing a way to measure peer group impacts by metric on any strategic decision, not just cost management but all aspects of the asset-liability gambit. The benchmark is just one element of the diagnostic tool set used in our prooprietary High Impact Management Approach™ this is a proven framework for delivering sustainable, high-impact results in complex, fast-moving industries like banking and finance.