University of Southern California



FINANCIAL SERVICES AND FINANCIAL INSTITUTIONS:

VALUE CREATION IN THEORY AND PRACTICE

J. Kimball Dietrich

CHAPTER 24

Optimizing Financial Institution Performance

Introduction

Optimizing financial institution performance consists of getting financial service employees to work efficiently with each other and with the economic and financial resources with which they are entrusted. The topics considered in this chapter are broadly concerned with organizing and paying financial institution employees and are concerned with the following questions:

• What approaches and issues are associated with compensation in the financial services industry?

• What considerations enter into how financial service firms organize their activities and what are the connections between organizational form and value production?

• How do multidivisonal financial firms allocate costs and profits?

• What concerns should management of financial firms focus on as these firms grow and adapt to environmental changes?

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These topics have been addressed by economists as discussed below but are usually not central to economic analysis. These subjects are less susceptible to rigorous analysis than other topics we have addressed in this book but their overwhelming importance mandates that these issues be highlighted in this book for future managers of financial service firms.

24.1 Employee Compensation

The core of value creation in financial service firms is good people, workers who can communicate with customers, process and analyze complex information, negotiate deals and deliver quality products and services. Financial institutions are usually complex organizations -- multidivisional firms like Fifth Third Bancorporation or Country Wide Financial or often large holding companies like BancOne or Travellers with many separate corporate entities offering different financial services in different markets. How can workers' personal interests be brought into line with those of their employers in large organizations?

The problem of motivating workers can be viewed as a principal-agent problem as introduced in Chapter 6 and explored extensively in Part II which analyzed sources of value in providing financial services. In that discussion, principals and agents were typically financial service firms and their customers involved in some relationship like a credit arrangement or insurance policy. In discussing financial service firm workers, the financial service firm as employer is the principal and the worker is the agent whose actions can harm or help the firm. An extensive literature has evolved examining the workers' relations to employers[1].

Problems between financial service firm employers and their workers are similar in many ways to manufacturing firms and very different in others. In all firms, workers' interests are to have high pay and make a low level of effort. Their employers' desire to pay workers little and extract maximum effort. Employers cannot tell how much effort workers put out relative to their capacity. Economic analysis of employment contracts examines compensation schemes which minimize the cost to employers of their inability to control or perfectly monitor their workers' efforts because of information asymmetries.

In analysis of the simplest case[2], workers are characterized as being like tenant farmers who can vary their effort in working the land and their resulting output is observable. The question addressed is how the employer or landlord owning the land and the worker or tenant-farmer can enter an efficient compensation scheme in the sense that workers put out maximum effort. Analysis of this simple case demonstrates that the optimal compensation arrangement is for the landlord to charge the farmer a fixed rent and allow the farmer to keep all the production from the land. Since the worker or tenant farmer claims all output above a fixed amount, the worker is a residual claimant on production. Workers have the incentive to maximize effort and expected income equal to expected production minus the rent. In the simple case, employers pay workers the value of their output above a fixed amount.

Incentive contracts between principals and agents in the employment context must be altered to accommodate variations from the simplest case. One important potential difference between workers and employers are risk preferences reflected in differing tolerance to variations in income. Workers supporting families and depending exclusively on labor income to live may be more risk averse than employers who are wealthy owners or managers of corporations owned by diversified investors not exposed to firm specific risk. Efficient compensation contracts when employee are risk averse typically include risk sharing by the employer in exchange for increased income security for workers. In the case of the tenant farmer, the landlord shares output variations with tenant farmers, becoming residual claimants to output like the farmer. Workers do not receive all the value of their output above a fixed amount. This compensation arrangement causes an efficiency loss since the farmer shares the benefits of effort with the landlord and will be less willing to put out maximum effort in production.

Other complications arise when the worker (or tenant farmer) cannot be perfectly monitored or when there are information asymmetries. Imperfect monitoring occurs when output or factors like weather cannot be observed and related to production, becoming confused with the effect of the worker's efforts. Information assymmetries occur when workers know more about production conditions as when farmers know more than landlords about growing conditions and the productivity of land. As in the case of risk aversion, in these departures from the simplest case optimal compensation arrangements for workers involve sharing output and distributing the risk of output variations between worker and employers.

This discussion demonstrates than in departures from the assumptions of the simplest case, optimal compensation requires sharing output or profits and distributing risks of output variation between workers and employers. While sharing output reduces workers' incentives to put out maximum effort because they gain only part of the payoff, these contracts are the most efficient arrangements and align the interests of employers and workers as much as possible. In view of apparent risk aversion among workers in financial services and the likelihood of imperfect monitoring and output measurement by employers, it is surprising how few compensation arrangements at lower levels of financial service firms are characterized by sharing value of production or profits. Most financial service workers are paid by the hour or on an annual salary.

Given the labor intensivity and the value of human capital in financial services, compensation arrangements are vitally important to induce optimal performance of workers in financial service firms. Optimal employee compensation is at the heart of value production in the future evolution of this industry. Nonetheless, compensation of financial service firms differ widely among industry segments. Some firms are creative and innovative in paying workers while others cling to standard employer-employee arrangements. Compensation specialists are in great demand in the financial service industry.

To place employee compensation into a framework, we list and define standard compensation schemes observed in the financial services and other industries. We then characterize some distinguishing characteristics of financial service employment and assess the importance of the uniqueness of value creation in this industry in determing optimal employee compensation arrangements.

Workers' pay can be determined seven different ways: (1) straight time (typically hourly); (2) salary (usually annual); (3) piece work; (4) participation contracts; (5) bonus systems; (6) tournaments; and, finally, (7) equity participation. These compensation schemes are briefly defined and illustrated in Table 24-1. We will use this breakdown in analyzing compensation in financial services in the following discussion.

Each of the payment schemes shown in Table 24-1 is used in some segments of the financial services industry for some jobs. Often hybrid payment systems are used, for example combining salary and bonus systems. However, straight time and salary compensation schemes dominate worker pay in most financial service firms. In view of the simple standard analysis discussed above, straight time and salary compensation methods may be the least desirable compensation schemes from the viewpoint of economic efficiency in financial services. These pay methods do not address principal-agent problems associated with employees of financial service firms.

Straight time pay means simply punching a clock and being paid for the time spent at the place of employment. Straight time compensation is common for part-time workers and other clerical personnel important in back-office operations of financial institutions. Most hourly workers are not highly paid and workers and employers share the benefits of flexibility in staffing size and hours worked. Straight time workers rarely develop a sense of commitment to their employers and often quit as their skills reach desirable levels, especially in the operation of equipment like check-encoding (proof) machines.

Salaried workers earn a set amount of money over a fixed time period, say a week or a year. They are expected to show up on time and do pretty much as told in the organization. Straight salaried workers have a larger fixed commitment from their employers in terms of length of time commitment and more to lose in terms of future income committed by the employer by quitting.

While the effort levels demanded of salaried workers fluctuate with demand for their services, the fixed commitment from the employer has the benefit of reducing uncertainty about future income. Most salaried jobs involve periodic (often annual) evaluation and reviews by management. Salaried jobs offer workers some incentive to improve skills to order to maximize their chances of retention and salary increases.

Piece work is the simplest pay scheme where workers are paid per unit of output. A few financial institutions use piece work compensation to pay workers for simple jobs like opening new accounts or completing money changing transactions. The problem with piece work is that if quality is a factor, workers will sacrifice quality for quantity of output. For example, if tellers are not responsible for cash errors, piece work would encourage sloppy cash controls.

Piece work compensation schemes are probably underutilized in the more routine and less quality sensitive areas of financial service firms, like back offices. In many cases financial service firms are reluctant to offer such payment schemes because of uncertainty about costs or revenues with output upon which piece work schemes could be based. We discussed cost and output measurement problems in the previous chapter. Dangers of production based incentive schemes is that workers will go to extremes to earn money producing unprofitable goods or services. The need to optimize employee performance is yet another motivation for studying costs and measuring output better as discussed in the previous chapter.

In sales activities, like loan agents obtaining mortgage loan applications, insurance agents selling policies, or securities brokers selling stocks and bonds, workers tend to minimize work effort unless compensation is related to production. Simple output sharing compensation arrangements discussed above are reflected in worker pay in selling of financial services like mortgage loans, insurance policies, or trading activity. Many mortgage lenders pay sales agents commissions based on loan production. Insurance agents often keep a major portion of the first year's insurance premium. Most securities firms compensate brokers by splitting commissions on trades. In many cases, these employees are guaranteed a minimum salary or "draw" over some time period. These arrangements are similar to the tenant farmer sharing risk with the landlord because of the minimum pay and commissions related to loan volume, insurance sales, or stock trading.

When commissions or other pay schemes similar to piece work are used, most evidence suggests that workers respond energetically. This may cause financial firms problems. Insurance agents are accused of being "replacement artists" causing insurance customers to buy new policies unnecessarily replacing economically valuable existing policies. Mortgage sale agents are accused of helping unqualified borrowers obtain mortgages. Brokers are accused of generating excessive trading activity by "churning" their customers' accounts to inflate commission income, potentially harming their employer's reputation and making them liable to lawsuits. This is a danger of piece work compensation when quality of service matters to the employer. More sophisticated compensation arrangements might improve on these pay methods, as discussed below.

Participation contracts make employee pay a function of some unit or division profits or other performance measures. For example, employees of securities trading firms are often compensated based on the profits of their specialized unit, such as a Treasury trading department. Managers of branches of banks and other financial service firms are often paid on the basis of their branch "profits." Paying workers based on performance aligns their interest with the performance of the division of the firm where they work. This can produce employee performance in line with the firm's goals if maximum profit center earnings are in line with maximization of the firm's overall value.

Participation pay based on unit profits introduces problems in calculations of profit center earnings, a point we discuss below in conjunction with transfer pricing. Profit participation in units where profitability is hard to assess because of difficulty in setting transfer prices or poor control systems can lead to unchecked employee performance harming the firm. For example, Joseph Jett was a Kidder Peabody bond trader who falsely inflated trading profits $350 million (while covering losses of $100 million) to obtain multimillion pay in 1992[3].

Bonus systems are usually combined with low salaries and compensate employees on the basis of exceeding some target levels of production or performance. For example, a life insurance district sales manager might be paid a $5,000 bonus for every ten percent increase in policy sales over the preceding year's sales. Bonus systems can be thought of as modified piece work pay with bonuses determined by bracketed amount of production. Bonus systems are common with managers responsible for groups or teams of workers and provide managers incentives to urge increased productivity of subordinates.

Targets or quotas used in paying bonuses are often negotiated by the employee and the manager. While information asymmetries may make target setting subject to principal-agent problems, well designed bonus systems may develop information concerning expected future activity levels useful in organization planning efforts. Bonus systems based purely on volume, like piece work pay, can distort the quality of products sold.

A "tournament" is jargon describing employee compensation and job responsibilities based on a contest with other workers. A worker's performance evaluated as superior to other workers wins the promotion or job assignment or large pay increase. The evaluation scheme may be clearly based on quantitative objectives, like producing the highest profits or sales, or it may be based on less well defined qualitative criteria, for example demonstrating superior management skills by turning around a failing division rather than simply managing an untroubled division acceptably. Tournaments have the benefit of inducing competition and high levels of effort if the prize is big enough. Losing the tournament may reduce morale for other workers who may leave or shirk even though they performed nearly as well as the winner.

Finally, many executives receive pay in the form of stock or stock options. Stock ownership aligns top management's interest with those of shareholders and the same is true for stock options at conversion prices reasonably expected to be surpassed by market values under good management. The highest paid executive in Fortune executive compensation survey of 200 companies in 1993 was Sanford Weill of Travelers, Incorporated, the insurance and brokerage (Smith Barney Shearson) firm. His total pay was $45.6 million, of which $41.4 million was in the form of long-term incentives and stock grants. Other bankers and financial service executives in survey also received generous stock option plans, often valued at more than salaries.

Typical compensation schemes described above can be used in combinations to solve some principal-agent problems between financial firm employers and their workers. Other problems may require more complicated or non-standard compensation schemes. Economists have studied a wide range of problems involving information asymmetries and imperfect monitoring of workers' activity and found that solutions can involve complex compensation contracts based on a number of indicators in addition to production or time, for example the average performance of other workers or production of similar products.

Some principal-agent problems can be resolved by workers choosing among a menu of compensation agreements which induce them to reveal information about themselves or signal assessments of important market information or information concerning production conditions. Offering workers a choice of compensation schemes is rare in financial service firms. Financial service firms in general have not been sophisticated in developing compensation schemes.

Several dimensions of financial services discussed in Part II of this book differentiate production of financial services from manufacturing or other service production. The many activities in the value chain required to produce financial services mean the value produced by employees may not be effectively be measured by a single output measure. The difference between financial services and other production or sales environments is undoubtedly relevant to the design of optimal compensation schemes for workers in the financial services industry. Optimal compensation of financial service employees may not be easily captured by a relation to a single measure, for example the number of loans, insurance policies, or trades sold per period.

Analyses of compensation in production contexts focus on production over short time intervals, like the growing season in our simple tenant farmer example. Financial services like credit services or asset management services take place over long periods of time. These financial services are part of a long-term relationship possibly involving a number of products or services not fixed at the outset of the relationship. Financial firms' reputations are often important to their success in attracting new business.

Because of long-term committments, variable level of demand for services by customers, and the importance of reputation, officials of financial service firms must sustain a level of customer satisfaction and trust sufficient to optimize the value of customer relationships. Piece work or commission based pay based on transactions can result in workers overlooking the benefits of long-term relations where future business may be infrequent but profitable. Many firms consider their employees' relations to their customers to be among their most important assets, a source of value in view of future business from financial service demands in the future and from referrals.

The time horizon over which financial services take place also means that future performance under financial service agreements impacts the value of the relationship. Employees must monitor customers to assure that the relation works as expected, for example in credit arrangements or insurance contracts. One way to induce employee engagement in long term performance of customer relationships is to have workers take a quasi-equity position in the profits from customers, as in a portfolio of customer loans. If the worker's pay depends not only on the making of the loan but the future performance of the loan, as it would if the worker "owned" a share of the profits from customers, incentives of employees and financial firms could be more effectively aligned.

Another complexity of financial relationships is that there is often more than one service or product. Bank calling officers are concerned primarily with their business customers' deposits and credit needs, but other products, like trust services and securities trading services, are also available. Compensation schemes must be tailored to induce financial service firm representatives to sell the whole range of products available or to induce referrals to other parts of the financial firm organization. For example, home mortgage sales people paid on a commission will neglect selling automatic deposit deductions or other services unless explicitly motivated to do so. Cross-selling may take time and effort by workers to communicate complex information remote from their main sales activity. Unless rewarded, these employees find their time used more profitably to sell familiar products.

Sometimes financial service products are so different that the same compensation scheme for sales cannot be applied to them. For example, brokers expect immediate income from securities trades of their customers and brokers will make as many trades as they can, praying for period of heavy trading volume. Insurance salesman take a long time to explain and sell insurance policies to their customers, usually receiving a large commission upon sale of the policy, often the first year's premium. For life insurance agents, a few sales can be a year's income. The differing sales problems for brokerage and insurance means optimal compensation schemes and sales culture must differ. The difference in insurance and securities sales is one explanation offered for Merrill Lynch's lack of success in selling insurance through brokerage offices.

Many financial services require a team effort. Motivating workers to function effectively in teams may require compensation contracts which include not only an individual worker's performance but also assessment by team members or a participation contract based on team performance. For example, investment banking fees generated by a team presentation to a corporate client could the basis for individuals' pay. The total compensation could be linked to the number of relevant investment banking services sold so that teams would be motivated to sell a wider range of products that just those of interest to the team members.

Finally, employees of financial service firms must be creative and innovate. New financial products and services is where the highest profitability will be found in the future. Pay schemes which encourage innovation and risk taking in product development or new customer services are essential in the financial services industry of the future. Compensation arrangements for employees expected to innovate must tolerate unsuccessful efforts at innovation if a large number of ideas is required to identify valuable new products. Financial service firm workers must be willing to take the risks of experimentation and failed ideas at the same time as they are motivated to innovate. For example, employees could receive time off to develop new ideas with pay and be given participation in new product profits or other inducements to come up with new ideas. Compensation arrangements like this are rare in financial service firms today.

24.2 Financial Service Firm Organizations

Human resources are a critical input into the provision of financial services. How can these resources best be organized in order to motivate workers to provide these services effectively and responsibly? Given the complexity of many tasks in this industry, how can workers' performance be monitored? The legal form of business organization--corporation, partnership, sole proprietorship, or mutual--has a role in assigning responsibility and allocating rewards in complex organizations of individuals. Grouping of workers into divisions or other firm units with reporting relationship and performance responsibilities influences how efficiently workers interact to achieve the firms' objectives. We discuss the legal structure and forms of organization in turn.

Legal Form of Financial Firms

Regulation and taxation explain many legal aspects of organizational forma and complexity of financial service firms. For example, until 1994 banks in the United States had to have a separately incorporated bank subsidiary in every state where it wished to take deposits. Insurance companies often have many subsidiaries to do business in different states. Credit unions must be mutually owned. Holding company structures are widely used to evade restrictions on activities of regulated financial service firms, like banks, thrifts, and insurance companies. Legal and regulatory considerations explain some, but not all, of the legal structure of financial service firms.

Business firms of all types can be considered as a system of agreements and contracts binding a variety of parties together in producing goods or services -- suppliers, workers, managers, customers, creditors and investors. All these parties will have differing interests and desires. Each party works naturally enough to maximize his or her own welfare, leading to conflicts of interest. Resolution of these conflicts are studied using principal-agent analysis as in the previous section.

A solution to conflicts affecting the efficiency and reliability of an organization may depend which is the best legal structure for the tasks performed by the organization. According the analysis of Fama and Jensen (1983a, 1983b) presented in Chapter 3, the corporate form of organization developed historically to undertake large, complex investments, spread risks, and limit liability to initial investments. Their argument is that corporate structure is favored by corporations like commercial banks requiring skilled professional management to work with complex nonmarketable assets like commercial loans. Owners of corporations claim income left over after paying all other parties with claims on the firm, like workers and creditors. Owners of corporations elect a board of directors with the power to fire management to oversee their interests.

Fama and Jensen note that the partnership form of organization requires that partners share liability and income with professional colleagues, in contrast to corporations. Fama and Jensen argue that partnerships can be effective organizations when firms provide professional services like investment banking. Shared liability bonds partners to the highest level of performance because each partner's performance places the firm and its reputation and future business at risk. Investment banks and brokers are frequently organized as partnerships.

In the Fama-Jensen argument, mutual organizations are efficient when assets are simply evaluated or readily marketable. Mutual organizations can be efficient ways of organizing activity when agency problems are not caused by asset or service complexity. Mutual fund shares sold to investors and deposit-taking institutions organized as mutuals, like thrifts and credit unions, survive because their assets are marketable or relatively simple and mutual shareholders or members can enforce management discipline by threatening to withdraw funds.

Other arguments have been made for the mutual form of organization relative to stock companies. Rasmussen (1988) uses an agency argument to show that investors may trust mutual organizations to invest in safer assets than stock companies. The reason for the trust is that the mutual company managers will lose their jobs if the firm goes bankrupt from risky investments they have made. Since there are no shareholders in a mutual who could benefit from risky investments with potentially large payoffs (and only limited losses due to limited liability), managers have no incentive to take risks. Mutuals will be safer places to place savings and hence are an efficient form of savings for risk averse individuals.

Another explanation for the existence of mutuals, made in this case in the context of the insurance industry, has been advanced by Mayers and Smith (1986). These authors argue that in insurance it may be more costly to resolve the conflicts between creditors and owners than between customers and managers of firms. They argue that it may be more efficient to have only customer as owners, that is, a mutual form of organization. If policyholders are simultaneously owners of the corporation, the need for costly monitoring of stockholders to prevent expropriations of wealth from customer/creditors is eliminated. Customer owners may concentrate on overcoming conflicts between customer needs and management interests.

Another argument explaining the existence of mutual firms, more popular than academic, is that these organizations are run for the benefit of management. According to this view, managers take control of mutual firms and pay themselves large salaries and provide themselves with desirable perquisites. For example, the Wall Street Journal reported on large pay raises at mutual insurance companies in 1982 as follows:

The widespread increases, disclosed in reports filed with state insurance regulators, add to the questions about who really controls mutual insurers. The companies are owned by their millions of policyholders rather than by stockholders. But critics say they are often run for the benefit of entrenched managements, which leads to inefficiency and cronyism. [May 14, 1982, p. 27]

Rasmussen, cited above, provides evidence of the low participation of mutual deposit-taking institution depositors at annual meetings, and suggests that management really does control most mutuals.

An argument that mutual firms exist because of management greed and demands for perquisites does not explain why mutuals develop in the first place. Management exploitation arguments do not explain how inefficient high-cost mutuals survive competition from corporate organizations in the same business which can underprice and defeat inefficient competitors in the market for financial services.

Other arguments for existence of mutual organizations in financial services are first in many observers' minds -- the tax treatment of mutuals. Many mutuals are tax exempt or tax advantaged. Credit unions do not pay taxes. Mutual funds do not pay taxes if they pass their income through to owners. Other mutuals are taxed, but usually income is only taxed to the extent that the income is attributable to owners. The partnership form is also tax advantaged in that partners pay taxes as individuals only once on their share of the partnerships income. Corporations pay corporate income taxes and owners pay taxes on salaries from the corporation and dividends.

Tax rules discussed Chapter 17 make mutual versus corporate or partnership organization important economically in terms of tax treatment. Nonetheless, economic arguments based on agency and management issues is probably more important in explaining the long history of the joint existence of many forms of organizations providing financial services. Mutual and corporate forms have coexisted in periods predating the corporate and personal income taxes and have survived innumerable changes in the tax code.

Organizational Structure

A wide variety of organizational structures are observed among financial service firms. Sizable organizations must be broken down into coherent units. These units may be the basis of profit centers used in motivating workers and monitoring performance. Organizational structure can be a means of lowering costs through improved coordination and communciation or focusing effort and increasing revenues as part of an firm's strategy. The underlying idea of designing organizations is coordinating the efforts of many workers to foster efficiency and smooth flows of information and resources within the organization to accomplish goals of the firm.

An important aspect of an organization is the degree of centralization desired by managers or investors. Centralized organizations use organizational structure to control and monitor implementation of policies. Decision making in centralized organizations tends to be top down, with business initiatives generated by top management and performance at lower levels reviewed and approved in terms of organization objectives.

Decentralized organization structures encourage initiatives at lower levels of the organization. Decentralized management emphasizes coordination rather than control of individual units. Decentralized structure fosters flexible responses to local situations. Performance of decentralized units is in terms of broad organizational targets rather than implementation of specified business plans developed by the firm.

The tradeoff between tightly centralized organizations which monitor and control performance versus decentralized business units with the ability to respond quickly to local business opportunities will be the crux of financial institutions organizational development in the future. Changes in communications and computing technology and competition are changing dramatically the economics of coordinating, monitoring, reporting and controlling diverse business units in both centralized and decentralized systems. Centralized and decentralized organizations may be best under differing competitive and technological circumstances.

Examples of centralized and decentralized organizations can currently be observed in two United States banking corporations. NationsBank, an outgrowth of North Carolina National Bank (NCNB) is highly centralized under its chairman High L. McColl, Jr., and controls its subordinate divisions tightly. A merger of a banking unit into NationsBank is followed by installation of managers from headquarters and standardization of systems. BancOne of Ohio, on the other hand, is highly decentralized under its chairman John B. McCoy. BancOne keeps local management in place following mergers and encourages local initiatives. Both organizations install financial control systems after mergers but NationsBank integrates subordinate units into a tightly controlled system while BankOne standardizes reporting to enable local managers to compare and evaluate their performance.

Three ways of organizing business organization are commonly observed in financial services: (1) customer or regional groupings; (2) product divisions; and (3) functional areas. The value creation matrix of Chapter 2, repeated here as Table 24-2, can be useful in understanding these organizing principles for workers and resources within either centralized or decentralized financial institutions. Product divisions in financial service can be visualized in Table 24-2 as grouping employees participating vertically into business units, for example transaction based services. Functional organization corresponds to organization or workers horizontally in the table according to the activity they perform in the value chain, for example grouping employees with responsibility for communication and marketing in several product lines into business units. Most organizations use combinations of the three organizational principles to group resources and workers.

Customer groups are used by many financial firms to organize activities. The goal is to be more effective in dealing with market segments, for example retail customers, by grouping experienced and trained personnel with similar market focus together. Many firms rely on geographical breakdowns of organizations to maximize efficiency in gathering local area market information and communicating effectively with financial services customers with similar needs. Financial institution branches in different geographical regions can be focused on particular market segments, like retiree household depositors in Florida and mortgage borrowers in Utah and Arizona or middle market commercial borrowers in the Silicon Valley. Commercial banks and thrifts often use branches or groups of branches as business units. Many financial institutions have representative offices in large cities or different regions.

Product divisions are another common organizational form. For example, employees responsible for specific casualty insurance lines may be grouped together in a unit of a diversified insurance company. Trust services and corporate lending, representing asset management and wholesale credit services on Table 24-2, are organizational units in many banks. The advantage of product organization is improved communication and shared experience of workers specialized in performing all activities in the value chain for similar products. The disadvantage of product organization is a narrow focus possibly insulating employees from developments in other markets. For example, an organization focused on deposit taking and transaction processing may not see asset management services like mutual funds as a possible substitute and competitive threat. Product organization can also obscure potential synergies from joint production of activities in the value chain for several financial services, for example by cross selling products as part of marketing and communication with customers.

Organizations can also be grouped by functions. Functions used to organize employees might be finance or marketing areas, funding and investing and communications and marketing in terms of the rows of Table 24-2. An advantage of functional organization is to pool employees with special expertise and experience, like marketing research. Functional organization may focus effort effectively but runs the danger of separating activities which are produced jointly in offering financial services, like production and delivery and marketing and communication of retail services through branches. Functional organization often works best in centralized organizations with a narrow product line where controls between organizational units can be imposed from above without obscuring important product or market relationships.

In setting up or changing organizational structure, the major focus of financial service firms should be to maximize the productivity of employees. The organization must reflect the most important information flows and cost synergies from shared efforts in performing the activities in the value chain necessary to offer financial products and services. The structure should induce desired levels of communication and team work, whether in servicing customers, developing new products, or in implementing new procedures. Factors like team identification and esprit de corp are important considerations in organizing activity.

24.3 Transfer Pricing

Multidivisional financial organizations are linked by a shared interest in many resources and personnel working in related areas. For example, commercial banks and thrifts lend money raised from depositors. If the depositors are household customers serviced by a retail banking division and lending is to the wholesale market in the corporate lending division, resources must flow between organizational entities. The prices or rates which are used to account for resource transfers within organizations are called transfer prices. These prices may be important in determining the reported profitability of profit centers in different divisions of complex organizations.

The importance of transfer pricing can be demonstrated with a simple example based on real problems facing many banks and thrifts. There are two profit centers in the example, retail deposits and corporate lending. Balance sheets and income statements for the two divisions are presented in Table 24-2. The retail division has more deposits than it can lend to borrowers so it makes funds available to the corporate division which can lend more money than it can raise in deposits[4]. The interest rate on loans is 6 percent. In the example, the transfer price on the funds between divisions is 5 percent. Clearly the profitability of the two divisions depends on the transfer price. At five percent, the retail division is more profitable. At a transfer price of four percent, the corporate division would be more profitable.

The importance of transfer prices is based on several factors. These factors are: (1) the effect of transfer prices on the allocation of resources in the firm and maximization of value for the entire firm; (2) the effect of transfer prices on the incentives and compensation of managers based on divison profits; and (3) the production of information concerning the relative efficiency of divisions and internal sources of the organization's competitive advantage relative to market competitors. We discuss each in turn.

Firms are formed to reduce transaction costs of doing business[5]. More efficient information flows and efficiency from better coordination of activities and economies of scope can be realized within organizations reducing the costs of transacting business having different components or stages in production. In large, multidivisional organizations, specialization by customers, products, or function discussed in the previous section results in resource transfers between divisions.

If transfer prices are not correct, division managers may overproduce products or services using undervalued inputs. They may produce the wrong products by responding to transfer prices which are too high, increasing profit center performance but reducing the firm's profits overall. If transfer prices for activities produced within the firm are set too high, profits may be lower than those possible using external suppliers in producing products or services. If transfer prices are set too low, the firm may not realize maximum profits from demand or technological dependencies linking production of products or services.

Most current of the current discussion of transfer pricing currently in the United States concerns the role of transfer prices in shifting income tax liabilities across international borders. Transfer prices for goods shipped internationally can be used to shift profits of multinational corporations. In the United States, section 482 regulations of the Internal Revenue Service (IRS) outlines acceptable methods for transfer prices used in filing company taxes when resources are shipped across international tax boundaries. In our above example, imagine that retail deposits are from an United States subsidiary and loans are in a low-income tax foreign country subsidiary of a multinational bank. Lowering the credit on deposits would move profits to the foreign subsidiary.

IRS rules provide methods to benchmark acceptable transfer prices. These methods are difficult to apply and lead to a great deal of conflict and litigation. In 1987, for example, Nissan and Toyota automobile companies from Japan paid the IRS $604 million in taxes on income reduced by high transfer prices on autos shipped to the United States[6].

The focus in this chapter is on the economic incentive effects of transfer prices although many of the issues are the same as in international tax disputes. The example of the deposit- taking firm reveals the importance of transfer pricing to the assignment of taxable profits earned in multidivisional corporations. When management compensation or performance evaluation is based on divisional profits, managers' pay or promotions in some divisions will be increased and others decreased by changes in transfer prices, just as tax liabilities are changed across international borders with transfer price adjustments. In many financial institutions, the fixing of transfer prices like the cost of funds in our example is a serious political problem because of repercussions on management compensation.

Hirshleifer (1956) presents an economic analysis of the effects of transfer pricing within multidivisional firms where there are no important management incentive effects. The emphasis of Hirshleifer's analysis is multidivisional firm managers who maximize profits of their divisions and make decisions based on transfer prices for intermediate goods. Our discussion assumes that a central management sets transfer prices to maximize profits of a firm facing external markets and internal production conditions. Hirschleifer stresses that either final or intermediate good division managers motivated to maximize firm (rather than divisional) profits would make the same transfer price decisions. Table 24-4 summarizes the results of Hirshleifer's analysis we discuss in the following.

According to Hirshleifer's analysis, intermediate good transfer prices in general should be set equal to marginal costs of the intermediate good at the firm profit maximizing production level. Considering retail deposits to be an intermediate good from our example, transfer prices should be set at the marginal cost of funds which maximizes the deposit-taking firm's total profits. The third column of Table 24-4 provides interpretations of Hirschleifer's analysis in terms of our deposit-taking financial firm example. In case (1), loan deposit ratios are fixed and in case (3) the market for deposits is upward sloping meaning the deposit-taking firm has market power in its deposit market. In both these cases, the optimal transfer price for the deposit division is where the marginal cost of deposits equals the marginal revenue from loans. In case (2), the deposit market is competitive and the optimal transfer price is the market rate on deposits. Since interest rates are fixed by competitive conditions in case (2), marginal deposit costs for the firm are equal to market rates. Therefore for cases (1) through (3), marginal cost transfer prices are optimal.

In cases where there is dependence between the intermediate good and final good demand, for example when deposit taking is not independent of loan demand, transfer pricing is more complicated. This is case (4) in Table 24-4. The effect of the deposit division's actions on the profitability of lending must be considered in the setting of transfer prices. If deposit-taking tends to increase the demand for loans, perhaps by expanding customer contacts, optimal transfer prices will be between market rates and the marginal cost of funds. In the deposit-taking firm example, the credit rate on deposits should be above the marginal cost of funds to induce managers to increase the supply of deposits to levels maximizing joint profits from deposits and lending.

Hirschleifer's analysis stresses the importance of using marginal or incremental costs in setting tranfer prices under competitive conditions where intermediate and final products are independent technologically and have no market dependencies, cases (1) to (3) in the table. Hirshleifer raises an important point concerning long-run effects of transfer prices when fixed costs are considered in addition to variable costs. Divisional profits including allocations for fixed costs may be negative using transfer prices based on marginal costs which maximize total firm profits. It cannot be determined whether divisions reporting losses when fixed costs are included should be closed without looking at the total firm profit picture including fixed costs for other divisions. Losses from one division may subsidize larger profits in other divisions. This could meant that divisions reporting losses when fixed costs are counted contribute to overall firm profitability in the long-run. Optimal transfer pricing may not produce division income statements useful in identifying firm wide competitive advantages.

In cases (1) to (3) in Table 24-4 analysed by Hirshleifer, marginal cost transfer pricing is a robust approach for optimizing short-run decisions (ignoring costs) with transfer prices. Technological and demand interdependencies complicate analysis of optimal transfer pricing. Hirschleifer's analysis also ignores incentive effects on divisional managers who must expend costly effort to produce in response to transfer pricing signals from central decision makers in the organization. Marginal cost or market pricing may not be optimal when accounting for these effects, as in case (4) of Table 24-4.

In an economic analysis of divisional managers responding to transfer pricing in producing intermediate inputs to a final output for a firm, Besanko and Sibley (1991) show why division profits should be calculated using transfer prices departing from market prices or marginal costs. Their analysis focuses on the principal-agent problem caused by managers compensated by profit-sharing within the firm who are buying inputs from the external market and producing outputs for the firm. The analysis is interesting because it shows the effects of technological dependencies between intermediate and final goods and management incentives on optimal transfer prices. Differences in transfer pricing from market prices are necessary to make the incentives of the manager responsible for producing the intermediate input align with those of the organization as a whole.

The Besanko and Sibley analysis demonstrates how transfer prices induce managers of divisions to expend optimal effort while accounting for technological interdependencies between outputs for various divisions. For example, in our deposit-taking firm example, assume that managers of deposit-taking divisions stimulate loan demand for the lending division in the process of gathering deposits. By providing good service and calling on deposit customers, loan demand from the institution is increased. This causes a technological or market dependence between deposit and lending divisions. In this case, the deposit-taking division should receive higher transfer rate than market rates or marginal costs to reflect the positive effect of deposit services on loan profitability. By paying higher rates on deposits, managers in the deposit division have greater incentives to increase their efforts. This is similar to case (4) in Table 24-4.

Transfer pricing is clearly important in all financial services. We can consider interdivisional transfers between deposit services and credit services as in our example as transfer prices between columns of the value creation matrix in Table 24-2. Additional examples are transfer prices on funds provided by insurance reserves used by credit service or asset management service divisions of insurance companies and transfer prices assigned to transaction processing costs associated with securities trading services offered by brokerage firms. Many other financial service firm examples of transfers between columns of Table 24-2 are possible.

The importance of transfer pricing in financial services will continue to increase as financial services respond to competitive and technological developments. If we view separating the performance of activities listed in the rows of Table 24-1 by different firms or divisions as unbundling financial services, costs and transfer prices between rows of the table become important in determining competitive advantages in value chain. For example, decisions to produce internally or outsource activities require knowledge of optimal transfer prices for activities produced within a firm and market prices for activities produces by external suppliers and reasons for departures of internal transfer prices from marginal costs, for example demand or technological dependencies.

Compensation of workers efficiently providing activities in the value chain necessary to offer financial services will depend on profit centers using optimal transfer prices. Synergies or technological and demand interdependencies can be the basis of value creating strategies if they can be identified, if costs measured adequately, and if workers can be motivated to perform as required. Use of optimal or at least good transfer prices are central to accomplishment of value creation in strategies based on transfers or resources between the rows or columns of the value matrix.

Transfer Prices in Practice

How are transfer prices set in multidivisonal organizations? There are three practical ways to arrive at prices or rates between divisions of large organizations[7]: (1) market benchmarks; (2) political negotiations; and (3) cost estimates. We discuss the advantages and disadvantages of each of these methods in financial service firms. These three methods may be compared to criteria applied by the IRS to transfer prices used by multinational firms. The IRS guidelines are attempts to determine whether transfer prices used in international transactions are legitimate results of one of the three methods listed or are set arbitrarily to minimize global tax liabilities. In assessing transfer prices reported on tax returns, the IRS also looks at return on asset and return on equity calculations and market prices and markups for other firms. The IRS is not concerned about optimal or efficient organization of activity.

The advantage of market based transfer prices is that they represent objective measures of alternatives to internal production of intermediate resources. Even if market measures are not used in transfer pricing problems, managers at all levels of organizations should be aware of the prices of substitutes available from the market. Knowledge of market alternatives can prevent negotiated prices from distorting allocation of resources too much and provide a useful benchmark for cost based estimates. Managers can use market prices in negotiations effectively by simply using the argument that they could obtain resources, like funds or computer power, from outside vendors at quoted values.

Market benchmarks have two disadvantages. First, in line with the discussion above, market based transfer prices may not induce optimal effort and production in multidivisional organizations. Second, many transfers between divisions do not have perfect substitutes in the market. Many firms adjust transfer prices to account for market phenomena, for example by adjusting internal deposit transfers for differences in maturity using adjustments from the term structure of interest rates. Comparisons of internal transfers and adjustments to market quotations may not adequately capture the economics of internal resources. For example, retail transaction deposits may be cheap because core deposits have low turnover despite their availability on demand.

Negotiated transfer prices have the advantage of accounting for special situations in the organization. Negotiations can in fact replicate internal markets where the unique economic tradeoffs of the organization are explicitly reflected in transfer prices. In many instances, for example in pricing computer services or technical advice, transfer prices may effectively signal development of corporate strategy, say by computerizing diverse operations. To the extent that internal users are competing for divisional resources and transfer prices reflect internal demand, management can determine the efficiency of relying on internal units to perform activities instead of using market substitutes available externally.

The biggest problem with negotiated transfer prices is that they are subject to political manipulation. Most retail bankers complain that their operating units are not given sufficient credit for resources because of transfer prices fixed to benefit more powerful and entrenced management in areas like corporate lending or investment banking services. Political transfer prices can blunt management incentives to provide intermediate resources efficiently.

Cost based transfer prices are subject to all the problems of cost measurement discussed in the previous chapter. The rule for cost based transfer prices is[8]:

[pic] 24-1

In terms of our cost measurement discussion, both elements of this equation are difficult. The rule includes as a first element variable costs. While variable costs avoid problems of overhead allocations included in average cost methods, variable costs are still difficult to measure as discussed in the previous chapter. The opportunity cost component of transfer prices is the most difficult problem. Opportunity costs are defined as what the organization as a whole gives up or gains by using internal resources. This component will include the incentive and demand and technological interdependencies discussed above. Estimates of this component will be very difficult for financial service firms but are essential in setting optimal transfer prices.

Transfer pricing is at the core of efficient operation of multidivisional financial firms. None of the three methods of establishing transfer prices can be relied on to produce efficient allocation of effort in all instances. Pragmatic managers will be aware of the effect of transfer prices on decision making and compensation and derive estimates from all three methods. Transfer prices will be reviewed and evaluated constantly as changing market environment and competition affect the competitive advantage of financial firms.

1. Growth and Change

This book began by discussing the many changes taking place in financial services. It must end by emphasizing the importance of flexibility and adaptability of firms and their managers and employees in the dynamic environment of the future. Financial firms must be organized to change. Change can mean growth, shrinkage, broadening or narrowing focus. The importance of organization is that information concerning competitive advantages or ephemeral market opportunities must be communicated and acted upon quickly. Experimentation, failure, and false starts will all be necessary to find the most effective strategies.

How can firms organize effectively to accomplish the agility necessary to respond to rapid market developments? There is no single answer. Decentralized organizations can be responsive to local market developments but foster rogue behavior and inefficiences from poor coordination or monitoring. Centralized organizations can be unresponsive and slow to process developments into market responses. There is no single best answer. Intelligent managers must be constantly weigh these tradeoffs as they organize effort.

Three basic characteristics of successful organizations appear to be important in the future: (1) employee incentives and compensation based on developments they can control in their markets or product areas; (2) good systems review identifying poor or disastrous performance relative to winning efforts; and (3) an atmosphere encouraging experimentation and risk-taking. New products must be encouraged both in operating divisions and research divisions. Communication between parts of the organization must be free and candid.

Most observers of the financial services industry believe that the future will be characterized by the consolidation of many small financial firms. These consolidations are economically justified by synergies gained from larger organizations. Many financial institutions identify strategic planning with acquisitions. Acquisitions within markets and across international boundaries will be an even more common phenomenon in the future.

The underlying issue is growth. The presumption is that growth is good despite this book's emphasis on return on investment. Growth is only good when it increases return on investments or maintains excessive returns. Growth can be realized internally and externally. In any case, growth should be built on a strategy of building on strengths and shedding areas of weakness where the criterion of performance is return on owners' investments.

Mergers and acquisitions have been common in financial services in the last decades. We began the book with some of the more notorious examples. Mergers and Acquisitions magazine has ranked commercial banking in the top three industries in the United States by number of mergers in each of the last ten years.

What has been the result of these mergers? As discussed in the final section of the previous chapter, there is little evidence to support the argument that investors gain by mergers producing larger banking institutions. Problems from integrating management and workers into new organizations such that incentives and skills of merged firm employees maximize efficiency of the organization are enormous.

We conclude our analysis of the financial services industry with a challenge to future managers. Survival and success in the future can only be based on management decisions creating value through increased revenues or reduced costs. All decisions by good managers must identify and justify gains from consolidations. Managers proposing growth strategies must show explicitly the synergies to be obtained by mergers or internally funded growth. Not only must these synergies not be left as vague assurances of the benefits of size or diversification but the synergies must be explicitly related to reasonable revenue increases or cost reductions. Future managers are challenged to demonstrate convincingly the impact of their decisions on return on investment. Simple arguments based on economies of scale and scope are not a sufficient justification for internal or external growth.

This book is intended to provide future managers with a framework for developing arguments providing economic justification for financial service strategies in the future. Managers must be able to argue persuasively the value of growth or diversification from potential demand or production intedependencies between and within the rows and columns of the value matrix in Table 24-2. With labor and human capital intensive activities dominating the value chain in financial services, with the role of information distribution and analysis in the face of the technological developments favoring inexpensive information distribution and powerful local information processing power, managers must show the advantages of larger scale operations concretely. The best managers can and will be able to use the value matrix and the analytical tools provided in this book to show the gains from growth and/or change policies they advocate in terms of return on investment.

Summary

Value produced by financial service firms comes largely from the skills and coordinated activities of workers. Motivating workers with incentive based pay can be very important even though creative compensation schemexs are currently infrequent in financial services. Organizational structures affect the ability of good people to work and communicate in firms. Organization is important to foster a spirit of innovation and experimentation required by the further evolution of the financial services industry. Transfer pricing within large scale organizations is a way to communicate top management objectives, to provide incentives to workers, and to identify competitive advantages of financial service firms. Given the importance of pay, organizations, and performance accounting in financial firms, strategies for growth and change must be carefully formulated in terms of synergies in the value matrix to be successful. The most successful firms, those with the highest return on investment, will not be built on hunches and hopes.

References

Besanko, David and David S. Sibley. 1991. "Compensation and Transfer Pricing in a Principal-Agent Model," International Economic Review, Vol. 32, No. 1 (February), pp. 55-68.

Coase, Ronald. 1937. "The Nature of the Firm," Economica, Volume 4, pp. 386-405.

Fama, Eugene F. 1980. "Banking in the Theory of Finance", Journal of Monetary Economics 6, pp. 39-57.

Fama, Eugene F. and Jensen, Michael C. 1983a. "Separation of Ownership and Control", Journal of Law and Economics (June), pp. 327-349.

Fama, Eugene F. and Jensen, Michael C. 1983b. "Agency Problems and Residual Claims", Journal of Law and Economics (June), pp. 327-349.

Granfield, Michael E. and J. Fred Weston. 1990. "Effective Section 482 Enformcement and the Japanese Auto Cases," Tax Notes, March 5, pp. 1187-1197.

Hirshleifer, Jack. 1956. "On the Economics of Transfer Pricing," Journal of Business, Volume 29, pp. 172-174.

Mayers, David and Smith, Clifford. 1986. "Ownership Structure and Control: The Mutualization of Stock Life Insurance Companies", Journal of Financial Economics 16, pp. 73-98.

Milgrom, Paul and John Roberts. 1992. Economics, Organizations, and Management. Prentice-Hall, Englewood Cliffs, New Jersey.

Rasmussen, Eric. 1988. "Mutual Banks and Stock Banks", Journal of Law and Economics (October), pp. 395-421.

Sappington, David E. M. 1991. "Incentives in Principal-Agent Relationships," Journal of Economic Perspectives, Volume, Number 2 (Spring), pp. 45-66.

Williamson, Oliver E. 1975. Markets and Hierarchies. The Free Press. New York.

Table 24-1

Compensation Arrangements

|Type of Compensation |Description |Where Observed |

|Straight time |Hourly or day payments when on the job |Part-time clerical workers, many back |

| | |office functions |

|Salary and review |Compensation fixed at all levels of output |Most full time jobs in financial service |

| | |firms excepts sales and trading |

|Piece work, commissions |Fixed payment per unit of production |Securities brokers, mortgage lenders, new |

| | |account personnel in banks |

|Performance participation |Formula relating compensation to |Trading departments of investment banking |

| |performance measure like divisional profits|firms |

|Bonus system |Bonus based on achieving specified targets |Managers of branch banks |

| |of performance | |

|Tournament |Several employees compete for promotion and|Managers and executives in all areas of |

| |raise |financial firms |

|Equity participation |Stock or stock options part of compensation|Top executives of most financial service |

| | |firms |

Table 24-2

Financial Services and Value Producing Activities

| Services/ | Credit | Securities | Insurance | Transaction | Information | Advising/ |

|Activities |Services |Services |Services |Processing |Services |Management |

| Pricing/ |Loan rates |Underwrit-ing fees | | | | |

|Term Setting | | | | | | |

| Information/ |Calling officers | | | | | |

|Marketing | | | | | | |

| Monitoring/ |Checking collateral | | | | | |

|Controlling | | | | | | |

| Production/ | | | | | On-Line | |

|Delivery | | | | |DataInquiry | |

| Funding/ | | | | | | |

|Investing | | | | | | |

| Risk Bearing/ | | | | | | |

|Sharing | | | | | | |

Table 24-3

Transfer Pricing Example

|RETAIL DIVISION |CORPORATE DIVISION |

|INCOME STATEMENT |INCOME STATEMENT |

|Interest on Loans |$ 60 |Interest on Loans |$300 |

|Earnings Credit (5%) |$200 |Interest Cost (3%) | $30 |

| | | | |

|Interest Cost (3%) |$150 |Earnings Charge (5%) |$200 |

|Profit |$110 |Profit |$70 |

|BALANCE SHEET |BALANCE SHEET |

|Loans $1,000 |Deposits $5,000 |Loans $5,000 |Deposits $1,000 |

|Claims on Wholesale Division $4,000 | | |Liability |

| | | |to Retail |

| | | |Division $4,000 |

Table 24-4

Transfer Pricing Rules from Hirshleifer (1956)

|Supply and Demand |Optimal Transfer |Example for Deposit-Taking Firm |

|Conditions |Price Rule | |

|(1) Single joint level of output for intermediate |Marginal cost of intermediate good |Determine where marginal revenue from loans|

|and final good | |equals marginal costs of deposits and use |

| | |transfer price for deposit funds equal to |

| | |that marginal cost. |

|(2) Intermediate and final goods produced and |Market price for intermediate good which |Price deposits at market prevailing rates. |

|marketed independently and intermediate good market |is equal to marginal cost of intermediate| |

|competitive |good | |

|(3) Downward sloping demand curve for intermediate |Transfer price is set where sum of net |Add marginal revenue from loans to marginal|

|good |marginal revenue from final good and |revenues from other uses of deposits and |

| |marginal revenue from intermediate market|set transfer price equal to marginal cost |

| |are equal to marginal cost of |of deposits at that rate. |

| |intermediate good | |

|(4) Demand dependence in that external intermediate |Transfer price between marginal cost and |Use of deposit to purchase securities |

|good sales reduce demand for final good |market price |reduces loan demand: set transfer price to |

| | |optimal rate for aggregate profits |

| | |somewhere between market rates and marginal|

| | |deposit costs. |

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    [1] See Sappington (1991) for a survey of compensation schemes or Milgrom and Roberts (1992) for a complete development of many of the issues in this chapter.

    [2] This treatment loosely follows Sappington (1991).

    [3] Michael Siconolfi, "Kidder Trade in Bond Options Dismissed," Wall Street Journal, July 12, 1994, p. A3.

    [4] The interest rate or service cost of deposits is assumed to be three percent for convenience.

    [5] These ideas stem from Coase (1937) and elaborated by Williamson (1985).

    [6] See Granfield and Weston (1990) for an review and analysis of IRS methods for reviewing transfer pricing. The Japanese tax agency refunded the $604 million to the auto companies.

    [7] See for example Horngren and Foster (1991), Chapter 27. Granfield and Weston (1990) detail IRS acceptable methods.

    [8] See Horngren and Foster (1991), p. 863.

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