Royal Bank of Canada. - Ahead of the Rest: Deploying Value Based Management

 John Shaw. Vice-President and Corporate Controller, Royal Bank Financial Group,

Royal Bank Financial Group (RBFG) uses Value Based Management (VBM) to influence all levels of its staff to make decisions and take actions that will deliver superior performance. Those who judge them, customers, shareholders and employees, find the results agreeable. They are impressive. The bank has increased economic profit [1] (EP) more than fivefold from 1996 to recently reported fiscal 2000 results.

The approach taken by RBFG goes beyond the financial measures that are typically associated with VBM. RBFG places financial measures within the context of a holistic measurement and management process.  In this process, disciplined strategic and operational analytical and planning methodologies are performed in an aligned and integrated manner. 

Introduction

In 1994, the scene at the annual budget review meeting was typical of many organizations.  The executive team was seated around the conference room as the budget numbers for each operating unit were presented.  The rationale for each plan was carefully explained, discussed, thought through and agreed upon.  After the presentations were done, the Chairman and C.O.O turned to the Corporate Controller and asked “Well, how do we look in total versus last year?”.  The answer given was familiar.  “Revenue is up, but expenses are up even more, so we have an earnings reduction year over year”.  At that point, the mood of meeting became more somber as the executives began the difficult task of deciding how to reduce expenses in order to get the numbers in line. The task was painful because there was no clear yardstick against which to assess relative merits of any particular spending program. 

 At RBFG, finding investment dollars to undertake new initiatives, while achieving profit goals, was of critical concern, because legislative and competitive challenges were changing the face of Canadian and global financial services markets.  To prosper in the future, RBFG needed to diversify from its traditional banking business into a variety of businesses such as insurance and wealth management.  Shifting from a monolithic business, with a variety of service offerings, to a number of business units, which would compete in highly differentiated markets with new services, required a new way of thinking and behaving.

Most executives will relate to the situation that was experienced by RBFG. In many organizations, budget processes often become a top-down assertion of desired corporate performance and a bottoms-up consolidated shortfall. These views attest to the apparent day-to-day realities of business operations.  Apart from the obvious gap between the top-down/bottom-up views, there is the cross business unit competition for funds.  An executive who is responsible for the performance of a large and successful traditional business unit might question the merits of significant re-assignment of funds to a more risky, younger, untried business unit.  Although the participants are usually bright and accomplished people, making choices between apparently competing objectives is still difficult. Decision making is almost always influenced by the internal reward system, which tends to create competition between managers with insufficient emphasis on external competition.  RBFG recognized that there was a problem with their measurement and reward system.  If the purpose of measurement is to influence human behavior, then the management team needed to be re-focused on the real competitors, those outside the organization.

Finding Value

To address the planning, management and resource allocation issues, RBFG initiated three major changes in the way the corporation functioned.  The first change was to organize differently, separating corporate and functional groups (systems/technology, legal, etc.) from the operating businesses.  The second shift was to change the way in which each business would be assessed, in order to drive desired human performance.  Finally, the third change was to streamline the planning and budgeting process itself, in order to align strategic/competitive objectives with operating goals and requisite financial performance.  RBFG initiated a process that would fundamentally change the corporate culture.

In 1995, RBFG re-organized its management team and business structure from the previously centralized, hierarchical organization to a flat, market-focused structure featuring five main business groups, each led by a Vice Chairman.  Each group included 4 to 6 separate lines of business with their own management team.  The Vice-Chairmen were set up to guide the businesses with a mandate to focus the organization on customer service, employee development, strategy and long range planning, with a particular responsibility for broad market segments. An important aspect of the new organization was for each business unit to make use of centralized corporate services, thus obtaining consistency and, hopefully, economies of scale.

Accountability for performance became the new mantra.  Each of the Business Unit (BU) heads became responsible for performance of their units.  The challenge facing the organization was to know what goals to establish.  There were two major components to changing the yardsticks, the first dealing with establishing a set of financial data for each unit as if they were independent businesses, the second was to redefine the way in which goals were established.

Regular financial statements were developed for each business unit involving separate P&L and Balance Sheets.  Transfer pricing was used to value loans and deposits as well as to distribute the cost of shared services in such a way that each business unit paid for services consumed as if it used a competitive external supplier. This was done in such a way as to ensure the organization maintained control of its centralized processes and took advantage of economies of scale.  Activity based costing principles were used for the purpose of establishing transfer prices.

Now came the task of driving each BU as if it were a completely stand-alone business, accountable to shareholders in the open market. Each business is required to perform and compete with defined peer groups of competitors in the same segment. The relationship with Royal Bank provides a differentiating advantage (distribution, customer relationships, basket of services offered) rather than a crutch. The theory being that the sum of a series of strong performers would be greater than the performance of a monolithic whole business. 

Having distributed profit and loss accountability, in order to focus BU’s on value contribution, it became necessary to attribute capital funds to the BU proportionate with risks assumed. This was a significant undertaking, which required innovative thinking, and led to the use of a Risk-Weighted Capital Assignment (RWCA).  RWCA requires RBFG managers to define and measure risk to determine changes in capital utilization and to evaluate risk-return trade-offs when making choices about business mix and other decisions.  The resulting assignment of capital became a key input to the calculation of shareholder value, and to the overall decision-making process.

To establish priorities, allocate resources and measure performance, management needed a common currency or financial standard.  To be effective in the competitive marketplace would mean balancing the interests of multiple stakeholders – customers, employees and shareholders.  Royal Bank adopted shareholder value growth as a governing objective, and the metric of “value” or “value-added” for making strategic decisions, for acquisitions, to evaluate BU strategies, in product pricing, marketing and sales planning, or in day-to-day customer offer alternatives.

RBFG introduced economic measures of performance and economic-based goals.  Economic Profit (EP), which incorporates capital usage and its cost, was introduced to overcome the deficiencies of Return on Equity, which does not incorporate the cost of capital.  Management adopted an EP focus to increase shareholder value growth by:

• Increasing Net Income without tying up more capital

• Increasing value by investing in projects with positive net present value;

• Improving efficiency of invested capital by re-allocation capital employed; and

• Improving risk-return profile.

However, Economic Profit is a one-period measure that does not integrate the growth component of value creation.  Reliance on this measure alone could mean maximizing short-term results at the expense of long-term performance. 

For this reason, RBFG developed and implemented a comprehensive Shareholder Value Model (SVM) in 1998.  The SVM is an effective tool for linking strategic and financial planning.  The model translates activity-related business driver objectives into projections for future financial performance, and is used for a variety of purposes:

• To provide summary financial plans (5 year projections);

• To develop shareholder return goals for RBFG;

• To estimate BU contributions to total market capitalization;

• To align Business Group and Business Unit goals with overall RBFG financial goals;

• To evaluate alternative Unit and Business strategies; and

• To assist Group Management Committee in making portfolio management choices.

This is based on the principle that “creating shareholder value requires intense focus on delivering benefits to customers in the most efficient way, hiring and retaining a motivated workforce, maintaining excellent supplier relationships and being a good corporate citizen in each of the company’s local communities. When wealth is created all stakeholders win.”[2]  Indeed, in the Royal Bank’s 2000 Annual Report the company states its vision to be:

 “Our Vision is to be Canada’s premier financial services provider, with committed people working as a team to create customer and shareholder value.”

“Our Focus is on improving performance in each of our businesses to achieve consistent and superior returns for our shareholders."

Each BU undertakes comparative analysis of the performance of competing organizations, in terms of market position, rates of return, growth and market valuation. The Shareholder Value Model is used to develop shareholder return goals to estimate (current and pro-forma) the contributions of the BU’s to total Royal Bank market capitalization, and to set BU value creation goals congruent with corporate goals.

From there BU managers analyze the drivers of value (e.g. revenue growth, operating ratio [margin/return] and risk) to determine how they will achieve performance in the top quartile of their BU peer group. Value drivers are high-level metrics that represent performance of non-financial dimensions of the business; for example, increasing market share and customer satisfaction drive revenue growth.  Performance of internal processes to be low cost, timely and accurate relative to competitors drives the operating ratio.

Source: Internal RBFG Document.

BU strategies are evaluated at the corporate level, in terms of their net impact on overall Royal Bank revenue growth, returns and capital utilization leading to long-term business value.  Once the total shareholder return for the Group is established and the BU strategies are endorsed, their contributions are locked in and are translated into specific economic profit targets.

Having established BU performance goals, the next challenge was for managers to align the behavior of all of the people in the organization with BU goals.  This was accomplished by creating performance measures for functions within each BU. Managers have to:

• Understand cause and effect relationships
• Link BU strategy with organization actions and performance evaluations
• Implement individual performance plans and metrics around four perspectives (customer satisfaction, employee satisfaction, business performance and learning)
• Agree on performance standards with internal (and external) service providers.

Consequently, creation of measurement logic linked to financial performance led to simulation modeling techniques to assess the potential impact of a variety of management choices. These decision support models translate activity-related business drivers into projections of prospective financial performance.

Planning and Budgeting and Reporting

The third significant step in transforming the RBFG measurement and management process was to change the way in which Planning and Budgeting was accomplished.  The old way of doing a strategic plan, operating plan and budget in a cycle that would take the best part of a year was clearly inadequate.  What was needed was a highly streamlined process, which would establish competitive goals, endorse broad business strategies and then readily transform the data into budgets and operating objectives. To quote a 1998 Fortune article, ‘…strategy is the result of a process’.  It is not a plan imposed, but a pattern inferred from the outcome of hundreds, even thousands, of analyses and decisions made at the smallest possible level of detail.”[3]

Since 1994, RBFG has implemented a new approach to planning and budgeting.  It is known as the “Strategic Performance Management Process (SPMP).  SPMP is designed to complete the planning cycle, from strategic review and update to detailed BU budgets in fourteen weeks.  This is followed by creation of individual performance plans, so that everyone in the organization knows exactly what is expected of them.

The primary steps in developing SPMP each year are:

1. The Group Office reviews and updates Royal Bank Group’s strategic direction and communicates it to all levels of the organization
2. Group Office and BU management teams establish VBM goals for each unit and for RBFG in total
3. BU mangers develop strategies and specific actions with which to achieve strategic goals
4. BU develops 2 year implementation plans, detailed budgets, balance sheet projections and non financial measures.  These plans target value drivers that will deliver the established goals.

Source: Internal RBFG Document. 

Having established plans and budgets, BU’s SPMP moves on to creation of individual performance plans, tracking and management reporting.  Each employee defines a specific set of measurable actions they will accomplish in the ensuing period in support of the BU objectives.  Consequently, a performance contract is established which becomes the basis on which managers assess the performance of each individual. This assessment is linked to employee performance based compensation payout at the end of each year.

Conclusion

If the purpose of measurement is to influence human behavior, then the approach, focus (external vs. internal) and the alignment of all participants towards common goals is critical. At RBFG, these issues have been addressed through a combination of structure, process, policies and tools, which enable innovation, speed and performance by linking organization strategy with actions taken by individual employees. RBFG has created a performance management and measurement framework that directly links the actions and performance of every employee to the success of their BU and consequently to the total organization.  

90% of the 58,000 Royal Bank employees are participants in the share purchase plan, giving them a direct stake in the value creation process.  Each and every one of them has the opportunity to influence their future in a substantive and meaningful way.  This they will accomplish by satisfying the needs of their customers, while operating efficient and effective processes and by delivering superior financial returns to their stockholders.

Customers and shareholders will continue to benefit as services are enhanced and financial returns continue to be competitive.

Paul A. Sharman, ACMA, is a member of the Journal’s  board of advisers.  He is president of Focused Management Inc., specialists in the implementation of Value Based Management and Performance Measurement and Management applications and can be reached at psharman@focusedmanagement.com.  Sharman leads a group of writers who contribute to this column, which appears three times annually.

As Vice-President and Corporate Controller, Royal Bank Financial Group, John Shaw is responsible, with other members of the Finance team, for executing strategic planning, forecasting and management reporting processes. His unit is responsible for developing and implementing Group-wide financial, management reporting and economic capital policies. He is a graduate of Wharton (MBA) and McGill