Category: Finance

What Customers Really Want

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As organizations and organizational units adopt more customer-focused strategies, there is a need to better understand what customers really want.   Although firms can invest years and decades in marketing research on this question, they can also choose to obtain 90% of the value in a single day by facilitating an honest discussion with key leaders and customers.

 Those who have adopted the quality/process view believe that the first step is to confirm that customers mostly (only) care about the perceived value of final results.  They will pay for a value added process or feature, but don’t care about other activities.  Richard Schonberger proposed that all customer needs can fit into a small number of categories, which can be used to define and prioritize the findings.

Customers value final product or service quality.  More today than before; and more tomorrow than today.  Some customers value process quality, because it reduces their risk, serves their customers or is required by regulators.  What quality level is required to remain in business, to meet expectations or to differentiate a product?

Customers value delivery speed.  Product lead times have fallen from weeks to days to hours to minutes.  Service delivery is sometimes measured in seconds. 

Customers value flexibility.  They expect your firm to have the capacity to meet their orders within standard lead times.  They expect you to make exceptions.  As in the Pink Panther movies, they may agree to a standard lead time or capacity, but when they need an exception, they want you to ignore what they told you before.  Expectations regarding flexibility vary widely across industries and firms and can change rapidly.

Customers seek value.  They want lower prices or total cost of ownership.  They want features and benefits that are cost-effective, which meet their needs or which are market leading.  This is a very broad category, but firms must operate with some understanding of what is expected.

Customers value information.  They want business relations with clear information flows, minimal transaction costs and shared accountability for risks.  Ideally, you anticipate and fulfill their needs in a cost free way, without surprises and take care of surprises of all kinds: regulatory, supplier, customer, competitor, acts of god, etc.

Finally, customers value personal relationships.  This varies by culture, industry, firm and purchasing agent.  Business relations are rarely purely business relationships.  Personal connections, loyalties, favors, culture and understanding often matter.

Firms or business units should understand what their customers want.  They should identify minimal, expected and differentiated performance levels.  They should understand relative customer priorities.  This may require formal marketing research or trial policies or pricing exercises to determine real preferences.  This may require sales, marketing, engineering, production and finance to work together like never before.

A consensus one-page QSFVIP customer profile can help to shape decisions at the strategic and tactical levels.

Project Opportunity Analysis Template

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    Opportunity Analysis – Name of Project
     
    1. Key Strategic Priority Areas/Critical Success Factors
10 A Creatively addresses more than one of the nine key strategic priority areas.
7 B Directly targets a significant improvement in one key strategic priority area.
3 C Contributes to the achievement of one key strategic priority area.
  D Provides benefits, but does not address any of the nine key strategic priority areas.
     
    2. Annual Strategic Plan
10 A An integral and significant preplanned component of the annual strategic plan.
7 B An initiative within the annual plan.
3 C Consistent with focus areas of the plan, but not defined as a planned initiative.
  D Provides benefits, but is not connected to the initiatives defined in the plan.
     
    3. Mission, Vision and Precepts 
10 A Creatively addresses more than one precept or component of the mission.
7 B Directly targets a precept or component of the mission.
3 C Contributes to a precept or component of the mission.
  D Provides benefits, but the connection to the mission and precepts is weak.
     
    4. Long-term Strategic Plan
5 A Creatively addresses more than one goal of the plan.
4 B Directly targets a significant improvement in one goal of the plan.
2 C Contributes to the achievement of one goal of the plan.
  D Provides benefits, but does not address specific goals of the plan.
     
    5. Program/Product Portfolio
5 A Builds on an existing area of strength, leveraging a core competency.
4 B Provides services the organization has targeted for growth or improvement.
2 C Addresses an area of weakness considered critical to portfolio of services.
  D Serves a new area, a weak area, or one that de-emphasized.
     
    6. Customer(s) Served
5 A Targeted to serve an existing primary customer group.
4 B Serves a customer group which has been identified for growth potential.
2 C Serves a secondary customer group, by leveraging an existing program.
  D Serves a secondary customer group or channel,  which others could serve as well.
     
    7. Proven Demand for this Service
5 A Members, customers and sponsors have paid for this program before.
4 B Marketing research and tests indicate that this is a top priority service.
2 C Marketing research supports some demand, but dollar value is unproven.
  D Some constituents demand this service, but no research or market proof.
     
    8. Brand Consistency
5 A Service reinforces key brand messages and is promoted with existing vehicles.
4 B Service is consistent with key brand messages, but requires separate promotion.
2 C Service connects with some brand messages and requires separate promotion.
  D Service is not consistent with key brand messages.
     
    9. Delivery Channel Environment
5 A Reinforces historical and current programs and values in delivery organizations..
4 B Consistent with historical programs and values in delivery organizations.
2 C Some degree of innovation or stretch that may be a concern to some players.
  D Innovative program designed to introduce change for delivery partners.
     
    10. Financial Resources
5 A Earns a financial payback of investment in one year or less.
4 B Earns a financial payback in two years or less.
2 C Breaks even in more than 2 years, but provides significant qualitative benefits.
  D Qualitative benefits are deemed to exceed quantitative costs.
     
    11. Sponsor/Funding Resources
5 A Creates a strong opportunity to attract new sponsors and contributions.
4 B An attractive project 80% likely funded in a year, without harming programs.
2 C More than 50% funding chance, but may compete with existing programs.
  D Less than a 50% funding chance or clearly competes with existing programs.
     
    12. Information Technology
5 A Uses existing capabilities without modification.
4 B Uses existing or planned strong capabilities with minor enhancements.
2 C Uses existing capabilities, but requires development outside of current plans.
  D Requires pioneering development work to provide appropriate service.
     
    13. Delivery/Operations/Processing Capabilities
5 A Uses existing strong capabilities without modification.
4 B Uses existing strong capabilities with minor enhancements.
2 C Uses existing capabilities, but requires significant development.
  D Requires pioneering development work to provide appropriate service.
     
    14. Human Resources
5 A Service can be provided by existing staff and structure.
4 B Service requires some additions to staff in existing categories.
2 C Service requires new staff skills and minor adjustments to structure.
  D Service requires major initiatives in recruiting, retention and structure.
     
    15. Monitoring and Evaluation
5 A Success is easily measured by existing measurement and evaluation tools.
4 B Success can be measured with only minor enhancements to current system.
2 C Success can be measured, but will require adjustments to existing measures.
  D Success is difficult, if not cost prohibitive, to measure directly.

Outsourcing Success

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After four decades of outsourcing in many functions and industries, it is clear that success requires more than leverage.  Outsourcing success requires a compelling rationale, a clear and flexible framework and positive personal relationships.

The rationale for outsourcing is based upon core competencies, provider capabilities, economics, strategy and fit.

  1. Buyer core competencies can not be outsourced.  The provider must deliver the outsourced function as a true core competency, not just a low price.  The provider is able to own responsibility for the outsourced function.  The provider has world-class skills and invests in improvements.  The provider is well-capitalized and experienced in the customer’s industry.  There is no beta site or learning by doing dimension.
  2. The provider has the skills and culture to be a third-party provider, including a customer service mentality, flexibility, creativity and change management skills wrapped around professional competence.
  3. The contract allows the buyer and provider to both win financially.  The provider is capable of reducing unit costs each year.  The provider’s initial bid and investment make economic sense.  The provider can justify a fully qualified account manager dedicated to making this contract work.
  4. The buyer has a clear strategic reason for outsourcing and has structured the deal to ensure its delivery.  This can be cost, quality, capacity, service, delivery time, risk management, creativity, technology, systems or intellectual property access.
  5. The hand-off from buyer to provider is a good fit.  Either the function can be very well-defined and delegated cleanly or the function is inherently virtual and both firms thrive in a matrix environment.  The buyer emphasizes product innovation or customer intimacy and the provider delivers operational excellence (or some other clear division).  The provider is able to perform in the buyer’s steady state or high growth and change environment.  The provider is comfortable with the buyer’s status in the Fortune 100, Fortune 1000 or middle market world.

 

The framework for an outsourcing agreement is well-defined, flexible, empowering, balanced and aligned.

  1. The contract is detailed, comprehensive and robust and meets the needs of finance, legal and operations.  The strategic objectives and measures of success are clearly defined.
  2. The contract is a model of world-class delegation.  Important results are defined, but the means to achieving them is left to the provider.  Micromanagement and administrivia is avoided like the plague. 
  3. The relationship between single agents for the buyer and provider is clearly defined.  The provider account manager is welcomed as a full business partner on the buyer’s staff.  A competent buyer rep is assigned to manage the contract, with his career depending upon its success.  The two reps are given the authority and flexibility to manage day-to-day issues.  A dispute resolution framework, including billing, is defined.  The contract supports a wide range of operating conditions and triggers for re-opening negotiations.
  4. The provider has adequate capacity and power in the agreement to succeed.  The minimum and maximum volumes are reasonable.  The provider has a fair economic deal and leverage to negotiate as required.
  5. Contract incentives align the interests of the buyer and provider.  The contract provides time for the provider to digest start-up costs and benefit from learning curve effects.  Each side benefits from greatly increased service volume.

 

The relationship between the buyer and provider reflects a true partnership, shared resources, trust, opportunities and planning.

  1. The partnership anoints the provider as the sole provider of services in their category.  The contract gives the provider reasonable security and expectations of ongoing business unless someone clearly outbids them.  The business is not re-bid based upon opportunities.  The business is not divided by high and low margin components.
  2. The buyer and provider work together to find every opportunity to leverage their skills, suppliers and knowledge.  Terms reflect the firm with the lower cost of capital.  Transaction and billing costs are minimized, assuming good faith.  Everything learned in the bidding process is incorporated into the contract.  The contract recognizes that there are inherent trade-offs between costs and services.
  3. A trusting relationship is developed.  The provider is on-site, attends meetings and communicates with the buyer daily.  The provider has a quality management system that provides confidence.  The provider is transparent in sharing information and risks, including competitive intelligence. 
  4. Both parties actively promote win/win opportunities.  The buyer is an active reference for the provider.  The buyer seeks new products, services and applications from the provider at list price. 
  5. The provider is involved in the planning process.  They attend strategic planning meetings.  They get 90 day notice of annual budget targets.  Both parties negotiate annual changes in good faith.

 

Buyers tend to have greater leverage in outsourcing services.  To achieve the best long-term results, they need to negotiate long-term win/win deals with providers.

Prioritize, If You Dare!

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“Managers do things right; leaders do the right things”.  In the current environment, where the “right things” of new products, customers and deals are on hold, the best leadership may lie in prioritizing existing operations.  In essence, prioritization is choosing to “do the right things” within the existing portfolio of activities.

Prioritization begins with the calculation of net benefits.  Maximizing benefits or minimizing costs is insufficient.  Priorities reside in those activities with the greatest net benefits.  This can be defined as benefits minus costs, as a payback period or as return on investment (ROI) or net present value (NPV) for large projects.  The comparison of costs and benefits is the essence of this approach.  Calculating risk-adjusted discounted values of after-tax cash flows within an asset portfolio is usually just “nice to have”.  Rank ordering available projects by their net benefits is the next greatest source of value.

The Pareto Principle says that 80% of net benefits are delivered by 20% of activities.  Mathematically, with any reasonable range of costs and benefits, this relationship holds true.  In simplest terms, the Pareto Principle says “cut off the tail”.  It also focuses on the concept of relative value.  We want to compare the ratio of benefits to costs, investments or activity. 

This applies to time management, where a log of time for one month reveals 10% of activities that should be eliminated.  The bottom 10% of products, product categories, stores, bank and library branches face the same indication that they are not cost justified.  Customers, divisions and business units face the same reality.  Some make money, while others do not.  Activity based costing calculations indicate that the lowest performers cost the firm more than was apparent.  Even individual performance can/should be considered on a rank-ordered basis.  The bottom 5-10% should be identified annually and considered for performance improvement plans in every group of 10 or more employees.

In emergency situations, triage must be applied.  Limited resources must be applied ONLY to the activities that can benefit and survive.  Those which will fail receive no investment.  Those which will succeed anyway, receive no investment.

At times, a two-dimensional grid should be used to determine activities which will deliver benefits.  In the classic Boston Consulting Group approach, business units are categorized by high and low growth and margin potential.  The top right units with high growth and margin potential get all of the investments and high-powered managers’ attention.  Low growth and margin businesses face divestiture.  High margin, low growth businesses become the proverbial “cash cows”, generating cash flows to feed other units.

Opportunity cost is a fundamental concept in prioritizing opportunities.  There is no absolute scale of expected returns.  There is only the “next best alternative”.  Even when business units have poor prospects, they must be compared with the realistic opportunity costs of doing nothing or divestiture.

Prioritization does not apply just to eliminating the negative end of expected business results.  Investments should be made in those activities with the greatest potential.  The Gallup Strengthsfinder approach applies this to human performance, demonstrating that natural talents provide the greatest relative return.  Firms should invest in those products and markets with the greatest potential.  They should also invest in facilities, equipment, IT projects, researchers and sales staff who deliver incremental value.  Many firms are inappropriately constrained by ratios and potential future change management costs.  Investment and product portfolio managers understand that there is value in starving losers and investing in winners.

The most sophisticated version of prioritization is employed in the principle of comparative advantage.  David Ricardo’s theory of international trade applies to countries, companies and units.  Comparative advantage says that relative benefit/cost ratios between countries, firms and units determine the best possible distribution of production.  ONLY those who are comparatively most productive should produce goods or services.  More than a century later Michael Porter applied this to companies, determining that those with true core competencies would succeed in the long run. Treacy and Wiersma’s book on “The Discipline of Market Leaders” indicates that firms can only have competitive advantages in one of the three areas of product innovation, customer intimacy and operational excellence.  Only the “best of the best” will prevail in the long run.  Outsourcing of non-essential functions is indicated.

Given the clear economic advantages of prioritization, why is this not universally applied?  Net benefits, the Pareto Principle and comparative advantage are beyond the comprehension of some economic actors.  Comprehensive, systematic calculations are applied only by a specialized subset of firms and functions. 

Perhaps more important is the personal cost-benefit calculation of individuals.  I could prioritize activities by relative benefit-cost, but I would be subject to criticism for eliminating the bottom 10%.  Perhaps it is better to not “rock the boat” and avoid the penalties of change management.

Some sophisticated managers follow the advice of Dr. Deming who highlighted the great risks of overreacting to random variations.  Managers should set an appropriate time-frame when using relative performance measures.

Dr. Deming also preached that managers need to “drive out fear”. For some employees, any rank ordering or evaluation of performance creates fear.  Some individuals believe that people should not be subjected to performance standards or rankings because this is not “fair”.  For most organizations, the essential competitive nature of employment and corporations is understood and accepted. Highly risk-averse individuals should not be employed by firms which face competitive pressures.

This does not contradict Maslow’s theory that security/safety is at the base of employee motivation.  Security oriented individuals should be guided to careers and positions which meet their needs.  The other 80% of employees should be counseled to understand the long-term competitive nature of labor markets.

Prioritization is an effective and essential business strategy in all business conditions.

Building an Integrated Planning and Control System

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In the process revolution since WWII, we have seen every business function discover that input-process-output descriptions of activities followed by a “say what you do, do what you say, be able to tell the difference” feedback structure are the key to long-run success.  Firms need to evaluate and consolidate these planning and control systems into a single fully integrated system, since they are all attempting to reach the same goals using the same tools.  There are at least five different sets of systems independently active in most firms today.

Strategic planning systems operate at the highest organizational level, attempting to evaluate the situation, set direction, identify critical success factors, define strategies and key performance indicators, and approve major investments and projects.  More evolved frameworks, like the balanced scorecard, attempt to link strategic goals to operational performance.  Many firms have learned to link strategy to measures and projects.

Modern financial planning and control systems have evolved for more than 100 years.  Strategic plans are translated into long-term financial plans to guide borrowing, investment, operations and risk analysis decisions.  The financial plan is translated into a negotiated annual budget.   A financial performance management system evaluates managers against business unit, department, product, customer and project goals.  The key transaction processes are defined and monitored.

Risk management has evolved to become a separate discipline apart from classic P&L management.  Regulatory compliance and external financial reporting have become more technical and legal.  Internal controls have moved to secondary and tertiary levels of safety with an emphasis on “defensible positions”.  Emergency preparedness and disaster recovery have developed into new disciplines.  Risk management tools have evolved from insurance policies to include hedges, contracts and outsourcing.

Human resources systems have grown to become parallel factors.  The regulatory side has greatly increased the emphasis on compliance and risk reduction.  HR performance management systems have become linked to business performance through SMART goals.  HR has been charged with helping managers professionally address frequent change management issues.  HR has also become a senior management partner in attempting to create cultural alignment.

The process or quality systems approach has been the greatest innovator.  At the highest level, a management or total quality management system attempts to incorporate all activities.  The quality approach requires clearly defined customer goals.  All processes must be defined and documented at the staff and system level.  Operations measures are defined to provide simple and direct feedback.  Quality goals are set and quality improvement is defined as a separate goal.  Processes are defined within the generic framework of product, sales and delivery.  IT systems are positioned as facilitators, requiring technical and user documentation.  Individual application systems become more complex, incorporating best practices, but allowing many exceptions.  Change management becomes a sub-discipline, with growing project management expertise.  Process changes are driven by re-engineering, kaizen and continuous process improvement efforts.

Ideally, a firm defines and operates a single planning and control system which integrates the strategic, financial, risk, human resources and quality management dimensions.  Failure to integrate these components leads to added costs, political conflicts, waste and missed opportunities.  A performance management cross-team with representatives from sales, product management, finance, HR and operations is needed to coordinate this effort.

There ARE many components.  We need to overcome the desire to have a fully integrated system that encompasses all possible components as exhibited by the US military in their Afghanistan plans.

http://www.nytimes.com/2010/04/27/world/27powerpoint.html

Goals of an Integrated Planning and Control System

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The proliferation of planning and control systems has led to a large number of goals.  Fortunately, they can be consolidated and categorized to facilitate the development of an understandable consolidated system.  The essential goals are eternal, but the growing complexities of the business environment and processes have increased the number of goals worth monitoring.  On the planning side, firms need to prioritize, clarify, align, communicate and prepare. 

In spite of the countervailing winds of entrepreneurship and empowerment, in a dynamic world with greater value at stake, firms need to set key priorities at the top for direction, values, strategies, investments, projects, critical success factors and key performance indicators.  Without them, even in the best conditions, managers and staff will ineffectively make decisions “as well as they can”.  Clear priorities and expectations can significantly reduce the zero-sum game of internal politics.  Senior management needs to proactively clarify the priorities, trade-offs and commitments made to all stakeholders, including investors, customers, suppliers and internal departments. 

A well-designed strategic plan and its related structures effectively align the decentralized, specialized, outsourced, matrixed and virtual resources of today’s firm.  Intentions, decisions, opportunities, authorities and best practices are clearly communicated.  The well-defined expected and desired future state allows individual functions to optimize within their frameworks.  Long-term commitments are made and managed, allowing business units and functions to flex within the context and pursue immediate opportunities.  Commitments are made at every level at the right time, with confidence.  Scarce resources are devoted to priority objectives and secondary projects consume no resources.

An effective planning process prepares the firm to face the unknown.  Participants at all levels have devoted time to organization level thinking about direction, situation, gaps and solutions.  If simulations, sensitivity analysis and emergency preparedness work has been done, some level of preplanned formal responses and tools has been defined, providing a base and confidence for managing the challenges that were not expected.

On the controls side, the system needs to deliver results while managing assets and risks.

“What gets measured gets done”.  Objectives that are measured and reported receive priority management and staff attention.  Today’s digital dashboards expand the number of goals to be pursued and more clearly communicate their status to everyone in real-time.  This greatly increases the motivation by staff to improve their real performance (and sometimes beat the system).  The quality revolution attempts to move this feedback loop to a higher level, with staff understanding customer needs, defining their own goals, measuring performance and developing quantum leap improvements to serve easily understood definitions of success.

The accounting staff has always been charged with safeguarding the firm’s assets.  In the analog world, this was straightforward.  Today, it requires a deeper understanding of intangible assets such as patents, supplier relations and brand value.  In spite of the loss of firm loyalty, it is apparent today that employees are the most valuable assets for most firms.  Employees need to feel valued for their skills and contributions, and be given opportunities to build their skills and apply their talents.  The human resources management system (job descriptions, evaluations, compensation) needs to be effectively integrated into the overall planning system.  An effective process system also builds the knowledge management value of the firm by documenting processes, accumulating knowledge and improving the rate of knowledge transfer through training and sharing.

In the post-Enron, Sarbanes-Oxley informed world, risk management has become an important board level topic (because board members have new responsibilities).  Developing basic and advanced internal controls to prevent and detect theft is a classic controller responsibility.  Administrative policies and procedures have long been used in large and small firms to increase the degree of compliance with management’s expectations by managers and staff.  Most firms have been subject to some level of regulatory oversight, audit and compliance.  All firms have reported financial results to external stakeholders within generally accepted accounting practices and tax laws.  Firms have always thought about the risks of natural disasters, but today’s decentralized and electronically supported worlds require much more attention to a variety of 10%, 1% and 0.1% risks.  Firms have used insurance policies for basic risks for centuries, but today they must evaluate and guard against a much wider variety and degree of business risks.  Finally, complex and decentralized firms are subject to Murphy’s Law and the role of the weakest link.  The sheer number and impact of risks has caused them to make openness and transparency a top value.

An integrated planning and control system needs to address all of these goals.  Planning must prioritize, clarify, align, communicate and prepare.  Reporting must deliver results while managing assets and risks.

The Knee Bone’s Connected to the Shin Bone

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In simplest terms, the mortgage lending industry collects deposits to make loans possible.  As mortgage lending has grown increasingly complex, the checks and balances of a simpler time have been lost.  Like the proverbial frog boiled as the water temperature rose, bankers did not perceive the changes in systemic risks.  Like the subjects in Hofstadter’s “Escher, Gödel and Bach”, a strange loop has been formed that could not be predicted from its components.

http://en.wikipedia.org/wiki/G%C3%B6del,_Escher,_Bach

In place of the original triplet of depositor, banker and borrower, today we have no less than 14 actors to consider: borrower, mortgage broker, mortgage product, mortgage broker firm, mortgage lender, guarantor, consolidator, mortgage-backed security, securitized asset, credit default swap, credit rating agency, investment banker, investors, regulators and auditors.

In 1776, Adam Smith provided scientific, philosophical, ethical and political support for free markets of independent buyers and sellers. Academic economists from Alfred Marshall through the Chicago School provided sophisticated theoretical, historical and statistical support for free markets.  Ronald Reagan and Margaret Thatcher consolidated political support for free markets.  NONE of them had a 14 step conga line in mind.

http://www.youtube.com/watch?v=RKtPrOiMj3o

At every step, we have the risks of self-interest creating failure rather than an efficient market with optimal social welfare.

Borrowers have an incentive to lie to mortgage brokers about their income.

Mortgage brokers have an incentive to process as many successful mortgages as possible, coaching borrowers and appraisers.

Mortgage lenders and firms have an incentive to devise mortgage products that are most attractive to borrowers, including no money down, variable interest rates and negative amortization beauties. 

Mortgage broker firms have an incentive to generate volume, without regard to the risks that will be born by the lenders or investors.

Mortgage lenders have an incentive to book as much volume as possible; locking in profit spreads for 30 years.

Fannie Mae and Freddie Mac serve a pivotal role, consolidating and guaranteeing individual loans and collections of loans in support of the American ideal of home ownership.  As quasi-government agencies, they have an incentive to capture congressional support through campaign contributions.

http://www.diffen.com/difference/Fannie_Mae_vs_Freddie_Mac

Mortgage backed securities provide the key gap in the chain of responsibilities.  They allow the mortgage brokers and lenders to transfer liability for mortgage defaults to investors.  Theoretically, these financial instruments greatly increase the sources of funds and through the portfolio effect reduce risks for everyone.

http://en.wikipedia.org/wiki/Mortgage-backed_security

The most sophisticated financial engineering is used to transform a portfolio of mortgages into a new set of securities that separate risks into layers, theoretically allowing some investors to have low risks and returns while others assume moderate and higher risks and returns.  This financial alchemy also increases the pool of potential investors and fine-tunes the risks assumed.

http://en.wikipedia.org/wiki/Securitization

Investors in mortgaged backed securities and their derivatives are not fools.  They understand that risks accompay these innovative instruments and that there are inherent underlying risks.  As sophisticated investors, familiar with derivatives of all flavors, they seek ways to limit their risks.  Credit default swaps were created to provide them with additional security about the risks involved in investing in securitized mortgage based securities.

http://en.wikipedia.org/wiki/Credit_default_swap

Credit default swaps and mortgage-backed securities are evaluated by credit rating agencies.  The growing complexity of financial instruments greatly increased their business volume and relations with investment banks.  They provided overly positive ratings historically.  They were paid by the firms that created the securities.  No one should be surprised by the results.

http://en.wikipedia.org/wiki/Credit_rating_agency

Investment bankers have played a key role in the growth of the securitized mortgage industry. They collect fees as advisors in the creation of products and as advisors to mortgage brokers, mortgage lenders,  guarantors,  consolidators and investors.In their banking role, they have invested directly in these securities, provided funds for others to invest and developed derivatives to allow bets against the securities.  Investment bankers have supported both political parties.

The securitization of mortgages has allowed a wide variety of individuals and firms to invest in these assets, including banks and investment banks as part of their overall portfolios.

Regulators have tried to keep pace with these innovations, but failed.

Auditors have invested their resources complying with the details of the Sarbanes-Oxley legislation, but missed the change in risks in this complex system.

The mortgage world has become very complex in the last 30 years.  The proponents of “financial reform” in both parties need to closely review the reality of a 14 actor system.  There is a trade-off between the benefits of financial innovation and the regulatory costs of financial complexity.  We have clearly crossed the line where the costs of complexity (regulatory and risk) have exceeded the benefits of innovations (funding and reduced risks).

Banking in Bedford Falls

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As the Great Recession moves along into its third calendar year, the focus in Washington is on “Financial Reform”.   The backlash at Democrats and Republicans alike over the “bank bailout” continues to grow.  The politicians are posturing to allocate credit for the so-called reforms, but seem destined to “give the people what they want”.  It might help the politicians and the people if there was a shared understanding of the inherent factors universally at play in the home lending market.

I propose that everyone take an evening off and watch the classic 1946 film “It’s a Wonderful Life”, starring James Stewart as George Bailey, the initially reluctant but eventually heroic, manager of the Bailey Building & Loan Association in Bedford Falls.

http://en.wikipedia.org/wiki/It’s_a_Wonderful_Life

The essentials of banking are exhibited in this film.  Bedford Falls is the whole universe.  All of the actors know one another.  The cast is composed of depositors, owners, board members, bankers, borrowers, regulators and landlords. 

There are inherent conflicts between the roles.  Depositors don’t really trust the bank as shown by the bank run.  Landlords would like to see lending restricted to boost rents.  The owners are motivated by self-interest (enlightened or not) and set policy accordingly.  The board seeks a trustworthy banker to be its agent, and provides incentives to attract and retain him.  The banker has fiduciary and personal motives.  The regulators enforce the laws, unaware of all key facts.  The borrowers want loans, even if they can not afford them, in order to escape the costs of the landlords.  People act out of self-interest.  They respond to incentives.  There are trade-offs to be evaluated and decisions to be made.

A bank fills a valuable social role, attracting deposits in order to lend money.  A bank profits by the spread.  A bank is in business to lend money whenever it sees a profitable opportunity, irrespective of the moral concerns of owners, depositors or borrowers.  Banking is subject to real risks such as bank runs.  Banks are subject to poor decisions by bankers, mistakes by employees and fraud by anyone involved in any transaction. 

Historically, banks have operated by the 4 C’s of credit: capacity/cash flow, capital/collateral, conditions and character.  This is especially effective in a small town such as Bedford Falls.  Although George and the audience might hope that every citizen should qualify for a loan, some may not have the earnings to cover the principle, interest, insurance and maintenance of a home.  Some may not be able to save for a down payment to create adequate collateral.  As business conditions change, the income of the citizens is at risk and the ability of the bank to manage its affairs fluctuates.  A banker with a long-term perspective and proper incentives adjusts lending accordingly.  Finally, character counts.  Past financial and personal performance are good predictors of future performance.  Character is part objective and part subjective.

Even in this simplified setting, risks abound.  Public pressure for universal home ownership can result in too many loans.  Regulators can enforce laws mechanically while missing larger problems.  Institutional knowledge can be lost through staff turnover.  A single fraudulent act can threaten a bank.  Changing external business conditions can disrupt the bank.  Lending policies can be too loose or too tight.  Business judgments can be wrong.

The film delivers an escapist, idealist, overly simplistic view of life.  Mr. Potter is the evil bank owner and plotting, fraudulent landlord.  George Bailey is the selfless hero.  Yet, behind the scenes, we have a social institution performing a social function.  We need banks to provide the social function of collecting deposits, allocating credit and collecting from borrowers.  In spite of the vastly more complex institutional structures today, the role of a “building & loan association” is essentially the same.  As a society, we allow these institutions to connect savers and borrowers across varied time frames because this is a necessary function.  Our laws and regulations should be based on this real-world understanding, not upon the simplistic dualism of “good and evil”.

The Financial Paradigm

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The financial decision-making paradigm was developed in the 19th century by the “marginal” school of economics and refined into modern financial tools by the 1950’s.  In essence, it says that by comparing incremental benefits with incremental costs, that rational decisions can and should be made.  While academic economists refined the exact conditions under which this is logically true, practical business professionals have simply just adopted these tools.  Business students learned to choose the greatest net benefits.  Some also learned to calculate the risk-adjusted, interest-rate discounted incremental after-tax cash flows.

In practice, finance professionals and business decision-makers have seen limitations in the theory, but adapted it to make “rational” decisions.  If qualitative factors exist, they are ignored, translated into numbers or considered separately.  If key numbers are unknown, they are estimated, modeled or limited.  If factors are interrelated, a simulation model is run or lesser factors omitted.  Cash flows 30 years out are ignored due to their low present value.  Rules of thumb are used as simple linear relations.  The whole is defined as the sum of the parts.  The principle of diminishing marginal returns is used to eliminate inconvenient, minor or detailed items.

For short-term or long-term decisions, the standard financial decision making tools are adapted to meet most situations.  With experience and business judgment, decisions are made with a high degree of confidence using this single approach.

In addition to the common “adjustments” accepted by financial analysts in practice, there are deeper criticisms regarding the financial paradigm.  It is inconsistent with the historical, accrual cost approach required in public accounting.  Managers are unable to estimate factors, so they are constructed by analysts.  For major investments or decisions, the inherently qualitative factors may be most important.  Fully-loaded costs are used throughout most financial systems, so decisions are guided by “the numbers”. Purely financial incentive systems lead to padding, managed numbers and missed opportunities.   Focusing on financial results alone leads to neglect of the asset, operations and customer levels of the balanced scorecard.  Accounting systems are not structured to monitor key decisions, but to eventually report historical costs.  The financial decision making paradigm does not directly help managers to solve problems or serve customers, but it can create an adversarial relation between line managers and the financial staff.

The 1980’s “quality revolution” lead to a time when there was significant support for a variation on Shakespeare’s maxim: “first, let’s kill all of the accountants”.   Since then, finance and accounting professionals have fine-tuned their models, linked to the balanced scorecard framework, enhanced allocations through activity based costing, simplified ROI models, learned quality paradigms and deliver a mixed dashboard of financial and operations measures.

 The financial decision-making paradigm remains at the core of modern business decision-making because it does a good job of organizing the key factors, determining the level of detail needed to make good decisions and communicating those decisions to others in a consistent fashion.  No paradigm is perfect, but the marginal cost-benefit approach is doing very well moving through its second century.

Production Strategy

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Financial success often depends upon making wise strategic and structural decisions.  The Pareto Principle or ABC rule says that 20% of a firm’s products will deliver 80% of its volume or profit.  For most organizations, on a purely mathematical basis, some version of the Pareto Principle will hold true.  It may be 10% or 33% of the products accounting for most of the results, but this clustering is nearly universal.  Focusing on those activities that provide the greatest “bang for the buck” is a good strategic and tactical approach to business.

Production methods (including services) can also be classified into ABC categories.  The oldest method: custom or handicraft production can be labeled C.  The big breakthrough of standardized parts and mass production can be labeled A.  The hybrid products delivered by modular stages as in an assembly line can be labeled B.  Again, most organizations find themselves with a combination of mass (A), modular (B) and custom (C) produced goods. 

Since mass production has inherent advantages and is the lowest cost approach, firms should add modular products when the incremental benefits outweigh the costs.  Moving to the custom level involves the same benefit/cost comparison.  The incremental percentage margin is set by the marketplace and tends to decline through time as competitors add similar products, better features and benefits are offered and processes are refined and costs removed.   Sales and product managers will usually overestimate the margin benefits, while finance and production managers will underestimate them.  On the marginal cost side, the roles will often be reversed. 

The relative benefits and costs will vary from case to case, but the general structure and decisions will always need to be addressed.  In order to generate higher margins, firms need to offer products which appear to have greater custom appeal and this requires additional costs.  Firms which neglect to evaluate these trade-offs or which allow case by case negotiations often find that they have too many custom products and too little profit — or too few value-added products and too few customers.

There are four strategic approaches to this inherent trade-off.  First, firms can be disciplined and choose just one of the 3 production types.  They can deliver goods in a narrow range (A), using focused factory techniques.  As Henry Ford said, “any color you want as long as it’s black”.  They can adopt an operational excellence strategy and reduce costs through time.  Or, they can develop a modular strategy with well-defined processes for production, product development and marketing (B).  By leveraging the efficiencies of a set of highly effective modular processes, they can deliver new products and services at moderate volume with higher margins.  A product innovation strategy can be delivered this way.  Finally, they can choose a customized production strategy (C) and deliver highest margin niche products to specialized users.  This approach can attempt to leverage mass or modular production, but the real focus is on developing or adapting products to meet specialized needs.  This fits best with the customer intimacy strategy.

Unfortunately, the explosion of product choices in the 1970’s and 1980’s resulted in most firms delivering some messy, unintended combination of A, B and C products.  The mass production world moved from 90% A and a little B to 50% A, 40% B and 10% C in many cases.  Some firms even found one-third each as their production profile.  A second overall strategy has been to outsource the production of A level mass production items to the lowest cost source: in a focused factory, to a market leader, as an import, as a drop ship or through a partner.  A third strategy is to develop a truly modular production line ala Dell and move all production through a single highly refined process.  A fourth strategy is to outsource the customized work to partner firms, IT implementation shops, other engineering firms or to repackaging firms.

It is possible to combine mass, modular and custom product deliver flows within a single firm, but it is not easy.  At a minimum, firms need to make decisions in these terms, monitor the results and adapt to ensure that the marginal benefits justify the marginal costs.