edoc

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

Fiole, Eelco Rokus Willem. The corporate centre in a financial conglomerate : governance under fundamental industry changes. 2002, PhD Thesis, University of Basel, Faculty of Business and Economics.

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Official URL: http://edoc.unibas.ch/diss/DissB_6160

Abstract

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.
Advisors:Schierenbeck, Henner
Committee Members:Wensveen, Dirk M.N. van
Faculties and Departments:06 Faculty of Business and Economics > Departement Wirtschaftswissenschaften > Ehemalige Einheiten Wirtschaftswissenschaften > Bankmanagement und Controlling (Schierenbeck)
Item Type:Thesis
Thesis no:6160
Bibsysno:Link to catalogue
Number of Pages:339
Language:English
Identification Number:
Last Modified:30 Jun 2016 10:41
Deposited On:13 Feb 2009 15:40

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