The Grand Mishandling of Strategic Projections
After nineteen years in financial services, I am finally witnessing the tide turn in bank and credit union strategic planning. What once was an annual budgeting exercise, is now beginning to take the more productive path of identifying and paving the way to the financial institution (FI) of the future. The one that makes clear either-or choices to ensure future relevance for their customers, employees, communities, and shareholders (if stock owned).
But the fate of strategic plan projections, for the most part, remains mired in the old-school budgeting process. When asking senior leaders what success would look like if they executed their plan well, the answer is all-too-frequently what leaders reasonably think they can achieve. In other words, success looks like next year’s budget.
In February, I proposed that FIs evaluate strategic alternatives as a regular part of the strategic planning process. To use the present value of future earnings streams to determine if the strategy is actually adding value. Developing strategic projections so you have an extremely high likelihood of achieving them may not yield the answer you want. What if your Board expects senior management to increase the value of the FI by 10% per year, and you project a 5% increase in earnings because you feel comfortable you can succeed? You will erode the value of the franchise.
The Board may decide to turn the keys over to someone capable of increasing franchise value. See the chart below for the decrease in the present value of tangible book value per share versus the nominal increase in tangible book. If you were a Board member of this franchise, what would you do?
In my opinion, FI strategic plans should have three scenarios:
Scenario 1: Stretch. These projections should depict “what success should look like” in executing your strategy. I am not proposing creating projections that cannot be achieved, a risk that an investment banker told me often happens when FIs evaluate their strategic alternatives. If I were to handicap these projections, I would give senior leaders at least a 40% likelihood of achieving them. The more strategic leaders gain credibility with the Board and their shareholders (if publicly owned) at achieving stretch goals, the greater the likelihood the FI earns its independence. Creating overly optimistic or “hockey stick” projections only erodes credibility with your constituencies. “Stretch” are the projections that should be discounted to determine the present value of the strategy.
Scenario 2: Base. These projections take more the form of budgets. They are estimates of what senior leaders reasonably believe they can attain. As mentioned, present valuing these projections may not yield the answer you want. But in setting Board and regulator expectations, these projections are likely to be around 70% achievable.
Scenario 3: Stress. These projections serve to identify the things that can go wrong, and their impact on your FIs balance sheet and capital ratios. FIs tend to do this within their ALCO process regarding swings in interest rates. But interest rate risk is only one form of risk that can pose significant challenges. By modeling the most likely stressors, senior leaders can develop contingencies in advance to improve their balance sheet and profitability.
In my experience, FIs tend to use scenario 2. Why? In my opinion it is because they want to manage expectations, and it is how it has always been done via budgets. Another reason may be the uncertainty in projecting out several years. Banking, unlike many other industries, has significant macro issues that are beyond bankers’ control which impact their balance sheets and income statements. Because of these uncertainties, we shy away from what our financials will look like in the future.
But if, through strategic planning, we set our sights on the bank we want to become, we should model what that would like like in our financial statements. Not doing so dilutes our credibility and accountability to our Board, our shareholders, and ourselves.
How does your FI use strategic projections?
Note: The above chart represents the actual tangible book value per share of a Northeast FI from 2005-2010. If the Board of this FI expected a 10% annual return, they were sorely disappointed.