The corporate centre in a financial conglomerate : governance under fundamental industry changes

In part 1, we discuss 1) the fundamental changes in the financial services industry, 2) financial conglomerate structures and 3) value-based-management. These are core components for understanding the challenges and intentions of corporate level management of financial conglomerates. The financial services industry, financial conglomeration and value orientation In the first chapter, we highlight the major trend of consolidation in the financial services industry. This trend is most visible in business publications, and interacts with other trends. Financial conglomerates grow due to the fact that size is believed to be the answer to many difficulties. Consolidation has an effect on the systemic risk of the financial services industry because consolidation changes the risks of individual institutions, which in turn can affect other institutions. If the risk of an individual financial institution increases, the probability that the institution will fail or become illiquid before settling some of its payment obligations also increases. This increasing risk of an individual institution exposes other institutions directly as payees, or indirectly through contributing to panic runs or securities markets problems. As consolidation continues and non-traditional financial service activities enter into financial service activities by financial services firms, the safety net expand s, thereby imposing additional costs on the financial system. Regulators keep a close watch on the trends in the financial services industry: their objective is to maintain microeconomic stability, protect investors and support financial services firms’ proper behaviour, efficiency and competition. In intervening in consolidation decisions, regulators try to limit the government’s liability and to prevent exploitation of the safety net. To achieve this, regulators are looking for new ways of supervision. New capital requirements for credit, market and operational risk (Basel II), mandatory subordinated debt, a better supervisory structure and guidelines for corporate governance are all under development. The expectation is that, after a period of focus on model-based risk management, regulators will now be increasingly focusing their attention at management processes. Consolidation is a worldwide phe nomenon, primarily taking place in, but not limited to, well-developed economies. Globalisation of markets has contributed to (crossborder) mergers and acquisitions. In the United States, between 1988 and 1997, there has been a decrease in the number of financial services firms by 26.8 percent. In Europe we recognise the same trend: in Germany only there already has been a decline in the number of financial services firms from 5,000 to 36,000 between 1990 and 1995. In Japan and Singapore we see the same trend of consolidation. Although consolidation is primarily a domestic process, we also see cross-border mergers and acquisitions. Various trends contribute to the consolidation drive. For one, technological progress is very important as technology erodes entry barriers; financial services firms face pressures from a wider and more diverse range of competitors. Although information technology is pivotal for the internal processes of the financial services firms, clientfocused technologies make the difference on the market. New technologies support the development of new financial products and these products create new challenges for financial services firms. These products increasingly are capital-market based instead of straightforward savings- or credit facilities. Well-developed economies tend to shift from a bank-based system towards a market-based system in which the majority of the financing need is provided for by the capital market, which requires a efficient distribution in terms of scale and reach. While regulators attempt to supervise the financial system, deregulation leads to increased competition with margins being driven down and requiring scale economies. This dynamic is complemented by the drive to eradicate excess capacity in the global financial services industry. At the same time, and perhaps resulting from these industry changes, the lines of the financial services industry are blurring in various parts of the world. Non- financial services firms are making inroads in the financial services industry. We call this nearbanking and it can be understood to be the activity where non- financial services firms diversify into financial services. It implies that sections of the financial services industry are indeed attractive and that non- financial services firms are of the opinion that the present level of competition does not rule out profitability. This movement also reveals that specific banking and finance skills, once exclusive to financial services firms, have disseminated to other industries. A specific form of near-banking is in-house banking: non- financial firms perform several financial activities for themselves, such as provision of capital, investor relations, short-term financing, banking and custody, credits and collections, portfolio management, and tax optimisation. A special case of near-banking is internet banking. Innovations in communication and information technology has led to the increased possibility of total process automation of searching, buying, selling, producing and distributing and introduces the notion of contract banking, in which a complete package of services for a client consists of the management of contracts for those products individually. Electronic banking operating costs are estimated to be only 25 to 30 percent of the costs of providing financial services through traditional branches. This reduction in cost implies that financial services firms would have to adapt their business model to remain competitive and profitable. At its core, a financial service is about controlling the flow of money and financial information. Due to capital investments, regulations and loose (client) relationships, the internet is not as powerful as expected at first; on the other hand, it will increasingly become a central component of the financial services business. Financial services firms are reacting by setting up separate internet divisions, partnering with technology-oriented firms, and forming alliances with firms in- and outside of the financial services industry. In the second chapter, we discuss financial conglomerate structures. The financial services industry is made up of many types of participants of which financial conglomerates are often the most visible. Financial conglomerates deal with the fundamental changes in the financial services industry in part by choosing an appropriate structure. There are four different prototypes of financial conglomerates recognised, which range from almost complete to very loose integration: the fully integrated, German, British and American variant. These variants find their origin in historical reasons and different legal systems. Financial conglomerates are formed when management feels that this structure is best suited to achieve maximum synergies: economies of scope and scale in production and sales of financial services. Management always intends to increase market capitalization, reduce risk or create access to new products or markets. Synergies, from the firm’s perspective, can be reached in improved client management, when distribution channels are used for more products, simultaneous marketing of products, use of information for different products and the reduction of portfolio risk. From the client’s perspective, synergies may exist in the procurement and use of a complete financial services package instead of individual products: costs for searching, information, monitoring and transaction may be lower. As switching costs can be higher with a complete services package, clients may be less likely to switch financial services provider. There are also diseconomies of scope, which may jeopardize the advantages of the financial conglomerate structure. We recognize regulation and compliance costs of a large bureaucracy, complexity of managing several businesses, lack of client trust in the use of information on them and decrease of transparency as a result of reduction in market discipline, as potential issues. The advantages of financial conglomeration have not (yet) been proven in practice and good management seems to be paramount to achieving these advantages. As we see in the third chapter, in dealing with environmental turbulence and the optimisation of the structure, financial conglomerates focus on the creation of shareholder value in all their activities. Shareholder value creation can be used as a yardstick to measure how well the financial conglomerate is doing; there is a zone between bankruptcy and absolute value creation leadership, which implies there is space to give other interests a higher priority when necessary. Functional excellence is not the only pre-condition for success, increasingly a client focus, reducing xinefficiency, and company repositioning in the (financial services) industry, e.g. through alliances, becomes important. There are various methodologies to measure shareholder value creation, which in essence is about achieving a return on capital higher than its cost. Shareholder value creation requires a management approach to support this. Corporate aspirations, analytical techniques and management processes should be aligned to assist the financial conglomerate maximise its value by focusing decision making on the key drivers of value: this is called value-based management. Dynamic value drivers should be developed down to the level of detail that aligns the value driver with the decision variables directly under the control of line management. Six characteristics determine to what extent a financial conglomerate is valueoriented: performance drive, value-base, low cost, self-reinforcing processes, two-way communications, and bottom-up and top-down management (dual control approach). Implementing value-based management in financial conglomerates follows the lines of the triad of value-based bank management: value-oriented business philosophy, value-oriented growth policy and value-oriented risk policy. The triad focuses on profitability, goal-oriented management, supported by planning, decision-making, implementation and control, an appropriate organisational and operational structure for the institutionalised controlling cycle, and a management information system reporting transparently on transaction level. The company organisation for valuebased management is the profit centre. Profit centres are organisational units, which are responsible for their own results and are able to decide independently from each other. Profit centres increase revenue and cost transparency, enable faster and a more flexible approaches to (market) changes, improve staff motivation, enhance earnings and value orientation, and allow for objective performance evaluation of management. Profit centres, therefore, improve the management of the financial conglomerate as a whole. The profit centre concept can be implemented when various requirements have been met. These requirements include: decentralisation of management structures, operational independence, correct allocation of costs and revenues and creation of technical accounting and settlement units in accordance with the areas of responsibility. Adjacent to the profit centre concept is lean banking, which focuses on the optimisation of operational processes through well-known concepts from industrial management, including continuous improvement, quality management and customer-focused production. Measuring the results of value-based management is of utmost importance on both corporate and divisional levels, as well as within divisions. Value controlling measures the gap between the market value of the firm and its potential, and supports divisions with the implementation of value-enhancing strategies. This implies that the value controlling system has to be integrated in the corporate philosophy, be accepted by users, adapt flexibly to changes, and have a good cost-benefit relationship. Instruments for value-controlling include the Market Rate Method, which attempts to isolate the revenue contribution made by each individual transaction, Activity Based Costing, which allocates costs more precise to activities than other methods, and Process-oriented Standard Direct Cost Accounting, which uses planned or standard costs for references to the future. The non-financial dimension is assessed with the Balanced Scorecard, which, in addition to the financial view, takes on the following views: customer perspective, internal business process perspective, and organisational learning and growth perspective. The Balanced Scorecard can be seen as a system of (partly) operational measures (i.e. ratios), which are connected to each other via cause-and-effect relationships. One important determinant of shareholder value creation is lowering risk as this results in a lower firm cost of capital. Financial conglomerates, though, accept risk to generate profits. Profitability (volatility) concerns and the financial conglomerate’s ability to carry risk must be taken into account. For financial conglomerates there are five risk categories: systemic risk, company-specific strategic risks, market risk, credit risk, and operational risk. A risk matrix, formed by risk categories affecting the individual business areas, is the core of a risk control system. Allocating internal (risk) capital to the organisational units and activities is common to both value-based management and asset and liability management. The concept of value at risk (VaR) is currently widely used in the financial services industry to ascertain and value the market risks inherent in financial positions. In general, the VaR is treated as a measure of the maximum possible change in the value of a portfolio of financial instruments within a given likelihood and for a specified period and is intended to quantify the potential losses inherent in that portfolio. Credit risk, at a minimum, is the risk of loss due to borrower defaults and is attributed to all units with borrower or counterparty exposure. Credit risk management has evolved from credit scoring of individual borrows to sophisticated aggregate models of borrowers’ default probabilities and the extent of asset recovery. Operational risk is the potential for any disruption in the financial conglomerate’s (operational) processes and includes reputational risk, legal enforcement of contracts and claims, possibly having a severe impact on the financial conglomerate’s perception in the market, share price devaluation and a loss of standing. Underlying causes of operational risk include complacency or a false sense of security, cost, as controlling operational risk can be seen as a new activity, difficulties in measuring operational risk, miscommunication when using jargon, over reliance on outside vendors, incompatible systems, decentralisation complicating oversight of operational risks, and organisation-specific factors. Four types of qualitative guidelines are particularly relevant: industry guidelines for good operations practices, guidelines for internal control, process and resource quality guidelines and regulatory capital requirements. Operational risk seems to be more in the management realm than in accounting. An overemphasis on the quantitative measurement of operational risks may be dangerous to firms without good management and staff or well-designed processes. Ultimately, the main defence against operational risks must be governance: management and staff who are knowledgeable about the risks and the good processes and systems that embody that knowledge. Discussion of the corporate centre Given that we now understand the major governance issues for financial conglomerates: fundamental changes in the financial services industry, financial conglomerate structures and value-based and (operational) risk management, we discuss the main governance body of financial conglomerates in part 2: the corporate centre. We focus on its nature, management and organisation, and economics In the first chapter, we discuss (de-) centralisation, roles and contribution of the corporate centre. There is an ongoing discussion on the level of decentralisation, i.e. what belongs to the corporate centre and what belongs to the divisions. On the continuum between centralisation and decentralisation, we distinguish between five statuses: core, policy, matrix, service, and autarchy. These statuses have different characteristics and are appropriate in situations of different complexity and environmental dynamics. Decentralisation without coordination leads to a lack of focus. Coordination is implemented with the use of special instruments, which manage the interdependencies between organisational units. In the ranking of increasing coordination, we recognise the following instruments: company (sub) culture, role standardisation, self-management, plans, programs, and personal instruction. In conjunction with issues of decentralisation and coordination is the issue of influence of the corporate centre. Influence can be seen as the result of decisions of design and the implemented level of decentralisation; influence tends to be highest in the general planning areas e.g. setting of budgets and financial targets, major capital investments, business strategy and new business creation. Influence tends to be lower in the functional areas e.g. human resources and marketing. Companies with greater diversity tend to have more decentralised decision-making. Striking the correct influence balance, i.e. fine tuning decentralisation and coordination proves to be difficult. Continuous tests are necessary to assess if the influence exercised is appropriate and effective. High levels of influence in combination with a very diverse portfolio could indicate either that the company is too centralised in its decisionmaking, or that the portfolio is insufficiently focused. On the other hand, low levels of influence in combination with a focused portfolio could indicate that the company is missing opportunities to add value. There are two different types of corporate centres: separate and embedded corporate centres. The latter type is integrated in the main division and is most common when the company comprises either a single major division together with a few minor divisions. If the minor divisions develop into more major operations, such companies tend to move to the separate corporate centre form. In this study, focusing on financial conglomerates, we concentrate on the separate corporate centre. Another typology for (parts of) the corporate centre is determined by the intensity of coordination; we distinguish between the operational, financial, and management holding. We recognise that companies can optimise their centralised services by placing them in divisions, which, depending on qualifications, regional or functional considerations, are the best location for those activities. From a strategy viewpoint, we can assume that the corporate centre, as instrument of corporate management, is primarily there to help develop and implement the overall corporate strategy. Hence, the aim is to combine the advantages of the flexibility and autonomy of the divisions with the unified strategic direction and management of the company as a whole. High performing firms do not distinguish themselves from the low performers by being more or less diversified or more or less decentralised: high performers have a better fit between their diversification strategy and the role their corporate centre performs, even in dynamic circumstances. There are three requirements for value creation by the corporate centre: 1) opportunity, 2) skills and resources, and 3) the degree of understanding by the corporate centre. Opportunities arise from an imperfect fit between divisions and the environment. The following five types of opportunities are distinguished: build, stretch, link, leverage and portfolio development. Synergy, the notion that the whole is larger than the sum of its parts, is hard to quantify and proves hard to reach in financial conglomerates. One way to realise the synergy potential is to identify affinities and critical interrelationships within the group, develop and analyse value chains per division and look for common characteristics, formulation of a strategy in coordination with corporate and division strategies with goals supporting the pursuit of interrelationships, and configuration of the synergy activities by e.g. centralisation of these activities on a separate location. In these steps, different instruments can be deployed: change of attitude of management, structuring collaboration, and supporting systems and procedures. Obstacles to achieving synergy include a classic, one-dimensional strategic planning approach, predominant vertical organisational boundaries, lack of motivation, and a lack of symmetric benefits in interrelationships. In the second chapter we focus on the management and organisation of the corporate centre. The form of the corporate centre is decreasingly determined by historical and cultural differences and increasingly by industry trends. Further, when a firm is active in a regulated industry, such as the financial services industry, the corporate centre has to take special influences into account: (quasi) government supervision introduces additional administrative overheads, and the lack of competition associated with operating in regulated industries tends to permit higher costs. Organisational economics highlight other managerial issues in financial conglomerates: the agency problem between corporate centre and divisional managers, moral hazard, coordinating costs, the tension between coordination and organisational design, motivation problems, and costs for influencing (ensuring correct distribution of costs and revenues). These issues can be dealt with by focusing on minimizing costs and eradicating inefficiencies. Corporate centres evolve as a result of change in the overall size of the company, change in the level of influence corporate managers have over divisional decisions, change in the level of services provided to the business divisions, and concern about the cost-effectiveness of the corporate centre. In pursuing corporate centre goals, management has to face several issues: reducing cost, defining a role and purpose, sufficiently skilling the corporate centre, developing positive relationships with the divisions, and, if appropriate, designing and managing shared services. In managing financial conglomerates, three corporate centre management styles can be distinguished: Strategic Planning, Strategic Control, and Financial Control. Each of these styles has different characteristics and varies in the degree of planning and control influence. Five tradeoffs, leading to a specific style, can be identified: leadership versus autonomy, coordination and co-operation versus clear responsibilities and accountability, thorough analysis and planning versus entrepreneurial speed and responsiveness, long-term strategic targets versus shortterm financial targets, and flexible strategies versus tight controls. In contributing to divisions the corporate centre can have different roles. A role can be seen as an instrument the corporate centre can use to manage the divisions; choosing the correct role or roles is essential for the firm’s performance. The role of the corporate centre is correct if the extent and intensity of business coordination match the potential value contribution of the corporate centre. In changing circumstances, strategies evolve and the extent to which (parts of) the corporate centre plays a specific role also evolves. In designing a corporate centre, it is useful to start with the core role. This is a matter of ensuring that all corporate obligations can be professionally discharged. The second step is to identify the major (intended) sources of added value by the corporate centre: the added value role. Staffing and support processes are essential. Companies that can find no major value added opportunities should consider to demerge, or to reduce the corporate centre to the core role only. The third step is to focus attention on shared services, which may or may not be placed in the corporate centre: the shared services role. Activities that are common to more than one division and non-strategic to the firm can be centralised in a shared services unit. Earlier studies have shown which functions are common in financial conglomerates’ corporate centres as discussed and clarified in this study. Corporate centre functions that outsource tend to employ fewer staff. Notwithstanding this fact, they are not as small as might be expected; as outsourcing increases, the net positive effect in terms of staff levels decreases. In Europe, the core role typically accounts for around 40 percent of corporate centre’ staff, whereas in the USA it accounts for around 25 to 40 percent, and in Japan around 20 percent. The extent to which the corporate centre provides services to divisions has a substantial influence on corporate centre staffing. Further, as the company size doubles, the size of activities in the core role tends to increase by no more than about 50 percent with each doubling, which indicates that there are significant economies of scale in core role activities. On average, financial services firms have three to four times the corporate centre staff as manufacturing companies of comparable sizes. Although companies in the financial services industry can have many linkages between divisions, it is unlikely that this accounts for the larger corporate centre by itself. The level and nature of corporate centre functional influence is a driving factor in shaping the number of corporate centre staff. Large corporate centre staffs are not generally rated more effective in supporting corporate strategy than smaller ones. It is the skill of the staff and the added value from their activities that matter more than their numbers or cost. At the same time, large corporate centre staffs are fully justified provided they are genuinely needed to support value creation opportunities. Since the core role activities are fairly similar from firm to firm, benchmarking the size and cost of these functions against other companies is possible and useful: the study provides for a calculation model on core role staffing. In the third chapter, we focus on corporate centre economics. As an organisational unit with its own mission, strategy and goals, control is indispensable. Control of corporate centre costs should be initiated at the highest level. Corporate centre’s staffs do not have the direct profit motivation that exists in commercial divisions. No company, furthermore, adds staff to the corporate centre with the expectation that they will affect compensatory savings in corporate centre costs, which will improve profits. Perhaps more than in any other important aspect of operations, effectiveness of corporate centre control reflects the attitude and style of senior corporate management. One way to control corporate centre cost and to develop a profit motivation in the corporate centre is to implement the profit centre concept. This requires the corporate centre to have revenues; these revenues can be (replicated) market-based allocations (transfer prices). Thus the corporate centre can have both revenues and costs, and the balance can be said to represent a corporate centre profit or loss. This approach permits the adoption of the same methods of budgeting and reporting on variances as used in the divisions. Corporate centre controlling can be seen as successful when the controlling organisation has helped to increase line managers' performance. This implies that the controlling function has to be aligned with the corporate strategy and infrastructure. The basis for this controlling infrastructure is formed by a value based cost management philosophy, an organisational responsibility for cost management, an institutionalised controlling cycle for cost management, and an appropriate controlling information system. As controlling corporate centre cost is more a management than a spending problem and because of the importance and special nature of this function, an especially formed mandate is justified. General corporate centre cost is to be supervised by a special appointed executive, the corporate centre controller. This supervision takes place over a great diversity of activities. Supervision of these areas, then, is different from supervision in the divisional lines where organisational level is normally equivalent to depth of experience in that line. The corporate centre controller can provide the essential management link required by both senior management and all corporate centre departments. The purpose of corporate centre controlling is to limit costs of the corporate centre, and to develop efficiencies in the performance of corporate centre functions, similar to those that in divisions. The functions of planning, control and supervision of corporate centre costs can be delegated only to a management level superior to the corporate centre functions. This is virtually untenable unless it receives the full support of the most senior level management. It is in the areas within the corporate centre that tendencies toward empire building can be quite pronounced, making solid control necessary. Corporate centre planning and control is an ongoing loop in which both activities are continuously performed and intertwined. This loop is the core of the controlling activity. Corporate centre planning and control have different levels: goals and problem analysis, development of decision proposals, decision and implementation, and supervision and analysis of deviations. Controlling, finalising the process, functions as the link between planning- decision-, and implementation processes. A central element in controlling is business planning, which contributes in three ways: 1) assisting in the adaptation of the organisation to its environment by means of monitoring and forecasting changes in the environment, fo rmulating environmental and strategic scenarios, 2) providing an integration role in an organisation in the sense of acting as a communication channel and 3) providing a control mechanism to monitor performance of (parts of) the corporate centre against plans. Planning can be done in three manners: top-down, bottom-up or a combination of these two (counter flow process) and adhere to different principles; we distinguish between strategic and operative planning, revo lving planning, flexible and elastic planning, and planning for avoidance of manipulation. Specifically for the treasury department, the controlling department analyses the treasury risks and decides on the valuation methodologies. Budgets, amounts for revenues and/or costs, which are fixed for an organisational unit for a period of time, form a guideline for decisions and activities of organisational units. Budgeting, allowing for analysis of deviations, therefore fulfils several functions: coordination of organisational units, strategic planning, motivation so that managers have the ability to manoeuvre within the budget, allocation of resources, goal-setting functions, launching of activities, and controlling. Budgeting can be successful if the results are in an acceptable proportion to the efforts, when the contents remain consistent with corporate goals, and when the budget does not lead to or support wrong decisions. In order to achieve this, goals should be agreed upon, priorities should be clear, bud geted costs should be manageable by the corresponding manager, who should also be responsible for the budget, and budgets should remain fixed as long as basic assumptions do not change. Reducing corporate centre costs can be difficult as corporate centre services are often of an intellectual nature, have a high level of complexity and can be non-repetitive. Also, if no attempt is made to compare corporate centre departments to a, possibly replicated, external market, there will be no competitive pressure to keep costs low. Last but not least resistance exists with corporate centre managers, often based on historical issues, bad experiences or overrating of their own capacities. This implies that besides corporate centre controlling, extra measures are appropriate: general cost awareness and a continuous overhaul to keep structures lean, comparison of resource use in the corporate centre and divisions, continuous process improvements, periodical check on the economics of in- and outsourcing, implementation of standardised relationships, and continuous activity analysis. Caution must be expressed here: there does not appear to be any support for the idea that financial conglomerates with smaller corporate centres have greater financial success. The corporate centres of companies that had profitability and shareholder value return above the average for their country were, in terms of staffing, around 20 percent larger than those of companies with below average profitability. Different ways to optimise corporate centre cost are overhead value analysis and zero-based budgeting. The first method is aimed to create transparency between costs produced and required services and the potential mismatch between those two. This is a one-off exercise and might therefore only have a temporary effect. Effects include less bureaucracy, increased motivation of participants, increased transparency, transfer of knowledge between divisions, and collection of ideas for improvements other than cost savings. Zero-based budgeting also forms a fundamental way of analysing corporate centre costs. Departmental goals are set, after which resource allocation takes place. In the allocation process costs receive great scrutiny, which may lead to lower spending levels. As this is a recurring analysis, zero-based budgeting is a more fundamental approach. Allocation raises strategic questions about outsourcing and competencies. Transparency and focused goals are other results. Difficulties could include lacking employee motivation, underestimation of the effort needed to explore alternatives and the approximation of cost increases when services quantity or quality has to increase. In addition to financial measurement, benchmarks representing value drivers, provide in instruments to measure (improvements in) performance and to identify problems when goals are not reached. Benchmarks can be used statically, when the benchmark is used only on a specific point in time, and dynamically, when a benchmark is used over a time period. Often, benchmarks are based on financial ratios, derived from the management accounts. However, benchmarks can be derived from financial as well as non- financial information and should be a result of combining the dimensions of the Balanced Scorecard. Benchmark requirements include consistency and applicability over time, comparability with internal and external best practices, measuring the intended effect, and linking to the incentive system to support motivation. In designing benchmarks, non- or part-financial control measurements compare outputs to a predetermined measurement scale and focus on errors and shortfalls against goals. Ideally, control measures should be objective, complete and responsive. Cost allocation, a widespread practice, comes into play to when the corporate centre transfers its cost to divisions to recognise (virtual) corporate centre revenues. The purposes for cost allocation are to make economic decisions for resource allocation, to motivate managers and employees, to measure income and assets for reporting to internal and external parties, and to justify costs. There are six criteria for cost allocation: cause-and-effect, benefits received, fairness or equity, ability to bear, independence of cost objectives, and neutrality. Allocation functions for shared services include: transaction, planning, to supply prices to be used in planning processes, management, result allocation, motivation, and influence of behaviour. Although allocating core role costs through Activity Based Costing could increase transparency, allocating these costs is inevitably arbitrary as this seeks to divide something, which is almost indivisible and incorrigible, meaning that, although transparent, they cannot be proved correct or incorrect. Another way of approaching cost allocation of the corporate centre core functions is where these costs are seen as a corporate centre levy: a flat levy and/or a profit-dependent levy. Micro-economics suggests that at the point where marginal costs equals marginal revenues, i.e. where the division works at its optimal point, a flat fixed levy for divisions does not have any positive effect for the group. Using variable income levy for divisions result s in the optimal point for the group. Although using the levy analogy makes the issue tangible, a further detailed exploration is difficult as it does not answer the question how high this levy rate should be. With this analogy, we can see that allocating the costs for core functions can be used as management tool. There is no other business economic reason other than that management wants to influence behaviour of divisional managers. A multiple decision process can provide a solution to the question of what should be paid for corporate centre services. The marketplace provides a process for services. The nearest equivalent that can be offered in respect to corporate centre services is that the total cost of any item of controllable corporate centre cost must be authorised by and charged to the person consuming that item. Corporate centre costs, which are charged to profit centres on the basis of actual use can meet acceptance relatively easy, provided, however, that the charge receiving manager in fact has complete control over such use in the same way he does over his other costs. If he is not equally free to use competing external services, any responsibility attributed to him for parts of corporate centre costs is fictional to a degree. Price setting for corporate centre cost allocation can be done in three ways: 1) (replicated) market prices, 2) cost prices, and 3) negotiated prices. A division can use (replicated) market prices to reconstruct the external market within the firm. Significant advantages are that profit centres act as independent market participants, market prices lead to maximum profits for divisions and the group alike, market prices are objective, understandable and accepted, and market prices for internal services do not crowd out external market transactions. When (replicated) market prices are not realisable, cost-based methods come into sight. Clear advantages include the ease of determination and the low administrative effort needed as data is already captured in accounting systems. By having internal service prices determined by negotiations, an internal market is constructed and decentralisation is supported. The negotiation process starts when a department, which would like to be paid for internally supplied services, presents a price list to internal customers. These customers then can benchmark the prices externally and can accept or decline. A pre-condition should be that internal customers have complete information on product- and market conditions and that market participation is possible. Costs can be allocated in a sequential and simultaneous way. Under the sequential process the costs are closed out from one profit centre to another. No other allocation within the structure occurs at the time of close out. The simultaneous process on the other hand involves multiple allocations between profit centres concurrently. Under this method it is possible for a profit centre to receive an allocation from a centre that is also a recipient of its allocation, with transparency on transaction level. Development and application of an Integrated Corporate Centre Concept for financial conglomerates In part 3, we arrive at the integrated corporate centre concept for financial conglomerates (ICCC), which we compare with four corporate centres of financial conglomerates. This ICCC is a synthesis of parts 1 and 2 and focuses insights of those parts. The concept is an addition to the literature on management issues in financial conglomerates and suggests an approach to deal with governance issues. It also forms a comprehensive benchmark for financial conglomerates’ corporate centres and as such will be used to evaluate corporate centres of four financial conglomerates. The ICCC consists of three core elements, which interact with each other: corporate centre nature, corporate centre management and organisation, and corporate centre economics. The case studies are the corporate centres of the financial conglomerates ABN AMRO Bank, Credit Suisse Group, Deutsche Bank, and UBS, studied during 2000. They serve to show to what extent financial conglomerates have implemented the integrated corporate centre concept and to provide in a first feedback on the concept. In the first chapter we present the ICCC. As financial conglomerates are confronted with similar industry changes and show herd behaviour they move towards the same conglomerate organisational form. As more efficiency in production and consumption of financial services can and should be reached to cope with the industry changes, financial conglomerates more and more separate their different activities, leading to relative independent divisions and sub-divisions, which are organised around certain product-market combinations. Increasingly, with respect to their organisational structure, these divisions resemble their stand-alone competitors while still remaining part of a conglomerate structure. This increasing separateness within financial conglomerates can be recognised as a move towards the American variant of universal banking. The distinction between different variants of universal banking becomes a dichotomy between stronger and weaker forms of conglomeration; the American variant then is the weak form of conglomeration. Partially, the move of financial conglomerates towards the weak form of conglomeration from more centralised structures results in the creation of the corporate centre as an organisational unit where the executive board and specific staff departments reside. For the corporate centre the basic premise must be to decentralise activities to divisions if they do not have a group mission; activities with a group mission should remain in the corporate centre. When decentralising, care should be taken with the levels of separateness. It must be enough to be able to compete successfully, whilst at the same time synergies must be captured. Those operational and non-strategic activities, which would benefit from aggregation resulting in the ability to reach scale economies, should be centralised in the financial conglomerate where the centralisation conditions are the best, most probably outside of the corporate centre. These shared services could then compete with outside suppliers. A separate analysis would be necessary to determine if outsourcing of these services could make sense in terms of product quality and costs. In general, the group benefits if divisions are offered fewer centralised services; this indeed implies that outsourcing centralised services strengthens group performance. We propose to reserve two roles for the corporate centre, but note though that corporate centre departments can show elements of both roles and eve n might have shared service components. These roles are core and added value. If senior management thinks it necessary, the corporate centre can also perform a shared services role. However, if there is no strategic need, then these shared services should be placed outside the corporate centre and we propose to principally exclude shared services of the corporate centre, and judge on inclusion on a case-by case basis. Using this structure ensures that all corporate centre activities can be judged individually by their nature and contribution. Activities and influence of the corporate centre have to be limited to what is necessary for fulfilling the core role and what is possible, in terms of potential, for the added value role. The core role takes place in the core and policy statuses; this means that centralisation will take place. The added value role takes place in the policy and matrix statuses; this means that decentralisation will take place. Corporate centre influence is mostly general and less functio nal in nature, although the latter is not completely out of the scope of the corporate centre. We propose to include Group Finance & Control, Group Human Resources, Group Tax, Group Legal & Compliance, Group Audit, Group Public Relations, Group Risk Manage ment, Group Development, Group Marketing, and Group Treasury. Changes in the financial services industry are most visible in the divisions where managers are confronted with new competitive realities. However, corporate centre managers will be confronted as well. In the study we show which departments are affected by specific environmental dynamics. The coordination instruments of the corporate centre vary by function, but we recognise that, depending on its status (core, policy, and matrix) all instruments, such as personal instruction, programs, plans, selfmanagement, role standardisation and (sub) culture, can be appropriate. Given the dynamics in the financial industry, divisions of financial conglomerates will continue to find themselves reacting imperfectly to these dynamics. The contribution of the corporate centre in a financial conglomerate therefore lies in supporting the growth of the business by repositioning (build proposition), and by reinventing the group by reshuffling of businesses with different characteristics (portfolio development proposition). Also, the corporate centre can support divisions in becoming more efficient by using resource allocation in a restricted way (stretch proposition). Perhaps the most important potential contribution of the corporate centre is the capability of the corporate centre to facilitate synergies (link and leverage propositions); by having the overview over the different divisions, the corporate centre should actively initiate synergy proposals, aimed at both scale and scope economies in production and consumption and design and deploy different instruments. Identifying and eliminating boundaries for synergy is also important. As value-based management and operational risk management are becoming important issues for financial conglomerates, these issues are significant for the corporate centre in two manners: 1) insofar as the corporate centre departments perform a group task, they should promote and integrate value-based management and operational risk management in all their services offered to the divisions, and 2) the corporate centre departments themselves should implement value-based management and operational risk management in their own processes. The fact that the corporate centre does not have direct links to external customers can lure corporate centre management into the trap of false security. Corporate centre officials, often equipped with far-reaching authorities, can have great influence on value and risk and should be aware of that. In the study we propose scoring tables for measuring value based and operational risk management. We have identified six problems of the corporate centre in governing a financial conglomerate. The agency problem between the corporate centre and the divisions can be solved using performance contracts. In these contracts, market conditions should be replicated and top management preferences can be reflected. Moral hazard can be avoided if the incentive structure of managers is consistently symmetrical. This can be achieved by paying positive and negative bonuses, i.e. deductions, out on an escrow account, which is blocked for a period of three to five years. These bonuses vary with swings in the valuation of the corporate centre and the group. The coordination problem can be tackled by forming formal communication channels, such as committees, while at the same time adjusting the compensation systems to reflect the extra effort and result from these communications; this is also a mechanism useful for supporting synergies. Having a detailed and well-accessible information system provides a tool to deal with difficulties in organisational design. As the organisation structure does not vary with the environment by itself, we cannot expect that the organisation structure in itself enables solutions; the organisation structure should be empowered, i.e. give rise to initiation of the solution. Incentive systems, which take individual motivation in account should support motivational issues; however, the more individual the sys tem becomes the more difficult to standardise processes. A high level of transparency ensures that influence costs remain limited. On the continuum between the strategic planning and financial control management styles, the management style of the corporate centre in the financial conglomerate should be positioned between strategic and financial control. In this way, the corporate centre fits the weak form of conglomeration. The emphasis is on managing multiple separate profit centres, each with relatively independent responsibilities. In the strategic review process, the corporate centre can challenge divisions, especially where synergies are concerned. The planning process is focused on target agreements rather than on the means. A tight control system ensures strong incentives for the divisions to deliver. Resource allocation is similar to the mechanisms in the capital markets, however a longer perspective is chosen than short-term profits. Decentralised organisation structures should overlap in the sense that committees are formed in which synergies can be explored. These committees should be chaired by representative divisional rotation (including the corporate centre). In this manner, the committee members all are responsible for realising the potential benefits. As detailed long-term strategic planning becomes increasingly difficult in the financial services industry, the focus has to be put more on the mid-term with short-term indicators. Strategy development should take place in the divisions and on a group level in the corporate centre. Although the level of detail should not be too high, the strategic plans should result in financial projections. These top-down and bottom-up processes should interact, but only after the first plans are formulated, and should result in a complete strategy. Divisions have far-reaching autonomy within the stated mission and central policy objectives of the group, although they do have to take into account that corporate centre functions might need certain divisional input. Controls should always be such that results can be compared to competitors and other divisions. In addition, for the corporate centre, benchmarking should yield useful insights. A staffing calculation model gives a good indication how the core role of a corporate centre can be staffed. Large corporate centre staffs are not generally rated as more effective in supporting corporate strategy than small ones. As the financial conglomerate grows, in terms of headcount, the corporate centre grows slower, which points to scale effects. Financial conglomerates increasingly have more specialised divisions; this can be understood as an increase in the transparency and understanding of the level of diversification. This implies that more emphasis should be put on financial measures than strategic measures for assessing a division’s performance. Principally, the corporate centre should be managed as a profit centre. This does not mean that corporate centre departments should make a monetary profit: it means that the behaviour of corporate centre managers and staff should be modelled as if the department was a market participant in its own right. Cost allocations out of the corporate centre can be seen as revenues. However, if revenues prove unable to be calculated, the revenue side of the corporate centre department can be expressed in market-based financial or non- financial benchmarks, expressing efforts and results of the corporate centre (department). Better or same benchmark performances point to a proper relationship between cost and benefit. The corporate centre should have an appropriate controlling organisation and mandate. Controlling activities will be more extensive when the corporate centre grows. Similar to the cost development of the corporate centre to the cost development of the financial conglomerate as a whole, if the corporate centre controller (CCCL) has the proper organisation and mandate, the controlling function would grow less fast than the corporate centre. This mandate should encompass projections, revenue and cost budgeting, planning, investment and (budget) performance review process, authority in the field of information and recommendation in matters of corporate centre expense, instrumental in effecting changes in corporate centre costs, divisional policy, the interpreting of firm-wide plans and projects insofar as they affect corporate centre planning, and executive contact for adjudication of interdepartmental matters, source of studies and analyses of more efficient ways to perform corporate centre functions, particularly in the area of overlapping procedures, enforcement of plans to reduce corporate centre costs. It is important to stress that if the controlling mandate is too narrow, the level of management support for the CCCL is too low, or if the CCCL lacks resources and information, effective control cannot be established. Recognising the corporate centre as a profit centre allows us to estimate the necessary variables to use in the direct methods for the measurement of value creation. Based on regression analysis of peer comparisons, this could be relatively straightforward but would consume quite some resources if done for reporting purposes only. If we would like to measure the value added of the corporate centre as part of the group instead of as a standalone unit, then the typical problem that revenues are lacking appears. Only the shareholder value creation of revenue generating profitoriented units can be measured directly. This means that, from a methodological point of view, a direct calculation for standalone business or otherwise revenue generating entities, is not possible for the corporate centre. We therefore present an indirect way of calculating added shareholder value of the corporate centre. We call this the Residual Value-method (ResVar- method) and principally it calculates the generated value by the corporate centre as the difference between the generated value of the divisions and the difference in market value of the group over a period of time. In using the ResVar-method, we should calculate the generated value of the divisions before cost allocation of corporate centre’s core and added value roles. Cost allocation should only be done for shared services, if they exist, delivering departments are to be seen as internal service providers comparable with external service providers. Moreover, the corporate centre does not create value without causing costs. The result is that we can completely observe the corporate centre effect: the effect that divisions are members of a group and governed by a corporate centre. The assumption is that divisions benefit from being a member of the group and that the corporate centre is responsible for the synergies: divisions by themselves, left to their own devices, would not strive for interdivisional synergies. Capital market participants, shareholders and group management should take careful consideration (e.g. splitting up the financial conglomerate, selling the stock etc.) when the standalone divisions produce a higher added value than the group value. The study also presents detailed benchmarks for costs levels for the corporate centre in financial conglomerates. As corporate centres in financial conglomerates vary, this benchmark can help as a first orientation for approximation purposes. In order to maximise insight in and control over costs, cost accounting should be done along the lines of work processes, in which value- and cost drivers are distinguished. Activity-Based Costing and Process Standard Direct Costing are appropriate instruments in this respect. In revenue accounting for the treasury function, Market Interest Rate-method should be used. As discussed, the corporate centre principally has two types of roles and functions, core and added value; shared services could be part of the corporate centre. Allocations for core functions should be seen as a corporate centre cost charge and are motivated by corporate interests. This means that corporate level management can decide how this burden is distributed over the divisions, portraying what corporate level management judges its efforts for the divisions but without giving the impression of an arbitrary allocation. The allocation performs the motivation and influencing functions. Criteria for the corporate centre cost charge should be fairness, neutrality and benefits received. If this burden falls on the corporate centre, then the charge is against group profit and is not used to influence divisions. This is the easiest method but has the effect that divisions experience the corporate centre to be for free or even perceive the corporate centre to be value destroying. Allocations for addedvalue functions should be justified by costs incurred. The best criteria for this type of allocation are cause and effect, and benefits received. The allocation performs the result allocation, transaction and motivational functions. If they exist, shared-service costs can be allocated based on the replication of a market place. This is done to justify costs and to compute reimbursement and to make economic decisions for resource allocation. Cause and effect, and benefits received must be the main criteria. In setting prices, it is important that the divisions do not form a captive market. Market prices are the main prices used, but cost-based prices might apply. As services might only be partly available on the market, prices should reflect this part availability. Negotiated prices, containing elements of market based prices and cost based prices are appropriate here. In order to have transparency in the real flows between the corporate centre and divisions, allocations should take place in a simultaneous way without netting. In the second and third chapters, we discuss four case studies and compare these with the theoretical findings of the first chapter in part 3. After recent reorganisations, the financial conglomerates in the case studies show a tendency to move from more centralised organisational structures, the strong form of conglomeration, towards the weak form of conglomeration as regional and intransparent structures are reorganised in divisions focused on product/market combinations and a corporate centre. The main difference between the financial conglomerates lies in the presence or absence of an extra management layer between a major division and the executive board. This move towards the weak form of conglomeration is not complete yet, which results in that financial conglomerates are in between variants. Difficult organisational transformation, paired with motivational issues, results in inefficiencies. Also this may lead to incomplete governance, allowing for adverse consequences. Of the case studies, three out of four use shareholder value as tool for performance measurement. To what extent value-based management, including an institutionalised controlling cycle, is implemented in the case studies, is difficult to observe. The study includes a detailed comparison of the case studies with the ICCC. Although there are differences in reporting lines, the case studies indeed match the ICCC to a large extent. What is striking, is that functions according to ICCC are largely present, implementation of value-based management and operational risk management is unclear, coordination instruments are sometimes mixed and not focused, the moral hazard problem is not solved and transparency is sometimes low, there is no unambiguous choice for a single management style, staffing is lower than the benchmark allows, there is a cost centre orientation and only one financial conglomerate has a value measurement, and cost allocation is performed, but remains difficult to initiate and implement. Although financial conglomerates make serious attempts, it seems difficult to decide on and implement the ICCC unambiguously. This might lead to an ineffective corporate centre. There may be organisational obstacles within the financial conglomerates preventing reaching a dynamic state, oscillating around the ideal corporate centre. These obstacles can include the perception that implementing the ICCC is not needed or possible, conflicts of interest between managers, unawareness of the importance of a well- functioning corporate centre, and a focus on only keeping costs low. A clear implementation of the ICCC would enable an effective and efficient corporate centre reaping the benefits of synergies, which would allow financial conglomerate structures to prove their worth and prove manager’s actions right.