 They maintain decentralized credit operations to support sales units whenever

possible. The benefits of proximity to the sales unit, informal relationships and faster
decisions have to be balanced with the quality and productivity gains of specialization.
Banks can reap significant efficiency gains from segmentation, process optimization,
scale economies and the management and steering of credit processes. Depending on a
bank's specific situation, gains can be as high as 40 percent of current operating costs.
In addition, making the credit process clearer and more consistent reduces credit risk.

Lesson Three: Use Risk Transfer Selectively

More sophisticated banks transfer risk on a regular but very selective basis through portfolio
management in order to improve risk-adjusted return in their credit business. Our
quantitative survey showed that hedging activity focused on the buy-and-hold portfolio—or
loan positions held for more than one year and until maturity—which usually accounted for
80 percent of the overall corporate portfolio's nominal volume and economic capital. The
overall annual transfer of credit risk was relatively low at about 1.5 percent in 2004 for
experienced corporate banks because of hedging costs. There was essentially no hedging
among less experienced corporate banks. The major hedging instruments are
derivatives and loans sales. Banks, of course, generally use syndication for single-event
transfers, which can be substantial. Hedging focuses largely on higher-risk clients, resulting
in more than 95 percent of bank hedging activity that targets ratings between B– and BBB+,
with most below investment grade. About half of a bank's corporate portfolio is typically
in these rating categories.
Hedging affects a bank's financial situation on several dimensions, and costs have to be
allocated to different units. We found the three following overarching principles. First, if
credit risk management advises an active credit portfolio hedge, then credit risk
management will bear the cost of the hedge. By contrast, if credit portfolio
management on the origination side proposes hedging activity, then origination will have
to bear the cost for that specific client. Second, a growing hedging portfolio increases
theto be evaluated on a mark-to-market basis. Third, in speculative credit-derivatives
markets, hedging costs are often higher than the expected benefits.

Lesson Four: Employing Advanced Models Pays off

Leading corporate banks apply advanced economic capital models and standard risk
calculations. As we have noted, expected losses and the required return on capital are the key
cost drivers in the credit business for large and mid-size companies. Best practice players
therefore apply advanced credit portfolio models using the advanced internal rating (AIR)
approach and integrate credit and market risk into their models.
As a result, leading banks have significantly lower capital requirements than their peers.
Whereas less sophisticated banks can reduce their capital requirements to 80 percent of
the regulatory level, leading banks can cut their capital allocation to 45 percent of
regulatory requirements. This is possible thanks to advanced modeling, which generally
causes modified origination activity in the credit business.
Sophisticated banks are granular in their approach to standard risk costs because of their
potential effects on sales and origination decisions. They align standard risk costs with the
business cycle and smooth discontinuities across rating categories. In all banks, economic
capital requirements and standard risk costs are the responsibility of credit portfolio
management. These metrics are also included in the sales-side performance assessment in
all banks. Sophisticated banks differentiate themselves by applying economic capital models
down to individual loans and salespeople, employing superior budgeting and steering
mechanisms and managing poor performance effectively.

Lesson Five: Investment Portfolio Strategies Add Value

Only the most sophisticated banks have separate investment portfolios based on best
practice credit portfolio models that outperform the market and provide useful
revenues. The investment portfolio is defined as the part of the credit portfolio that is held
for more than one year but is sold before maturity. For a sophisticated bank, this
portfolio ibetween 2.5 percent and 10 percent of the overall credit portfolio.
The investment portfolio typically shows the following composition: Corporate risk
represents 80 percent, with sovereign and bank risk and specialized lending
accounting for the remainder. The rating of the investment portfolio varies greatly
depending on the investment strategy followed:
n Strategy one. A revenue focus aims at generating additional income. The
bank therefore accepts lower credit-rating categories, with about two-thirds of
the portfolio rated below A. The resulting margin and economic-capital re-
quirements can lead to a return on risk-adjusted capital of between 25 percent and
35 percent in the investment portfolio itself.
n Strategy two. To maximize return, the bank invests in highly rated assets. The
corresponding very low economic capital requirements result in returns of more
than 35 percent.
Sophisticated banks' track records show the economic advantages that credit portfolio
management delivers. Increasing liquidity in secondary markets is likely to foster new
opportunities in the large- and mid-size–lending business. Indeed, active credit portfolio
management is far from being a technical or isolated issue for a few specialists. Rather,
it is an integral part of the daily credit business with substantial impact on
performance.
Behavioral Change: Overcoming Organizational and Cultural
Barriers to Profitable Growth
between 2.5 percent and 10 percent of the overall credit portfolio.
The investment portfolio typically shows the following composition: Corporate risk
represents 80 percent, with sovereign and bank risk and specialized lending
accounting for the remainder. The rating of the investment portfolio varies greatly
depending on the investment strategy followed:
n Strategy one. A revenue focus aims at generating additional income. The
bank therefore accepts lower credit-rating categories, with about two-thirds of
the portfolio rated below A. The resulting margin and economic-capital re-
quirements can lead to a return on risk-adjusted capital of between 25 percent and
35 percent in the investment portfolio itself.
n Strategy two. To maximize return, the bank invests in highly rated assets. The
corresponding very low economic capital requirements result in returns of more
than 35 percent.
Sophisticated banks' track records show the economic advantages that credit portfolio
management delivers. Increasing liquidity in secondary markets is likely to foster new
opportunities in the large- and mid-size–lending business. Indeed, active credit portfolio
management is far from being a technical or isolated issue for a few specialists. Rather,
it is an integral part of the daily credit business with substantial impact on
performance. tive position and accessibility on a professional and personal level—would
agree on actions to be taken in the following six months. When it actually came to
implementing these plans, however, the bank encountered numerous difficulties.
n RMs tried to push innovative and traditional products, only to learn that,
because of insufficient training, they could not answer clients' fundamental
questions about those products. This hurt the bank's credibility at a critical
juncture in the client development process and damaged the RMs' confidence.
n Product specialists used insights from the client relationship sessions to
approach clients directly. This often led to confusion on the part of clients because
the product specialist provided information that was inconsistent with—or even
contradicted—that provided by the RMs.
n Cross-selling opportunities were neglected. RMs and product specialists disagreed
about such opportunities, causing differences over pricing and other transaction
terms. Follow-up processes were not institutionalized, creating situations in which
both RMs and product specialists approached a client—sometimes even
individuals at different levels of the client organization.
n Even when RMs and product specialists successfully collaborated and executed
transactions, there were problems. Because of system constraints, more
complex products had to be fed manually into the RMs' performance-measure-
ment system. This resulted in a tremendous workload, prolonged
disagreements over revenue splits and cost allocations and eventually led to big
questions about the reliability of internal controls.

n Many employees regarded the financial rewards system as unfair. Since big-ticket
deals made up 40 percent of the corporate bank's profits, RMs wondered why their
product specialist counterparts could tap into bonus pools that were often several
times bigger than those for RMs. This did not create a good foundation for continuous
and effective cooperation.

So what went wrong? Given the importance of winning market battles profitably in
corporate banking, why were the obvious fixes not pursued to prevent such dysfunctional
behavior? In our experience, there are usually three core reasons.
First, senior management fails to provide a clear, shared view of objectives and the
accountabilities for achieving those goals. As a result, when the execution of strategy
creates tension, the commitment of senior-level executives to fixing the problem falters.
In the example cited above, there was no shared view of client profitability and no single
point of accountability for achieving client goals. This meant that the firm had no view
of how best to use its limited capital allocation per client or which products to prioritize.
The product specialists and RMs disagreed, but they failed to resolve their disagreements.
Each group complained up its respective reporting chain of command but found no
resolution at the top. If no one is responsible for achieving client goals, those goals will
not be achieved.

Second, the performance management process represents a real barrier to cross-selling.

Product specialists are highly motivated by the bonus payout system to push large
transactions—and only to a limited extent to develop and execute cross-selling client goals
in a team environment if those goals don't meet their bonus aspirations. This makes for
notoriously poor collaboration and likely results in a suboptimal relationship between the
client and the bank in the long run.

The most senior RMs—those most qualified to evaluate complex client needs, to match
those needs to products and to sell to "difficult" clients—are paradoxically the least
motivated to take on such challenges. Why? Because as they are promoted and move up
the ranks, their opportunity to cherry-pick the most attractive clients increases. The
needs of these clients are already widely known, and a steady history of product sales has
already been established. Moreover, both these factors are strongly linked to RMs'
compensation and reputation. Why risk introducing "new" product specialists?

Many executives are resigned to the following truism: The battle for talent is a battle for
bonuses, and in a star system we cannot afford to introduce new accountabilities and risk
losing top performers to the competition. But it takes more than new metrics and tools and
improved planning processes to move the dial on cross-selling: It takes leading a change in
the way employees in the field collaborate and driving cultural change. This cannot be
done by avoiding the issue of team accountability.

Third, there isn't the right leadership to drive the change in culture that is necessary to
create market success. Legacy cultures still pit investment bankers against lenders. On both
sides, there is also often a reluctance to adapt to the need for more sophisticated
measurements. Such measurements are certainly necessary for defining capital
allocation targets and investment programs. Generating sustainable success requires far
more than just committing to action: Leadership needs to sponsor collaboration, enforce it,
reward it and monitor it with rigor when players neglect the bank's long-term interests.

So what can be done to overcome these considerable obstacles? Many corporate banks
often blame implementation failure on their culture and shrug it off, as if to say, "What
can we do?" That is an excuse. When banks do succeed, they address their culture head-
on, change it when it needs changing and achieve superior results.
Thus, we recommend that as new strategies are formulated, goals set and
implementation plans developed, a structured evaluation of the organization's
readiness to implement those strategies also be undertaken—with data generated
through surveys, interviews or workshops. This approach will produce clear
accountability for new initiatives and encourage the right behavioral changes. Man-
agement will have insight into how best to balance performance disciplines with
motivation. Managerial actions usually fall into five key areas.

n Aligning the structure. This should not be a superficial shift in personnel and
reporting structures at the top. Rather, the executive management team and its
respective business-line leaders should have clearly defined revenue and profit
goals for which there are single-point accountability and decision-making and veto
rights. It is surprising how many management teams lack such clarity in their
mandates.

n Improving the performance management process. This can be done only by

establishing transparent but robust key performance measurements (especially for
client and product profitability) and ensuring that there is real follow-up (and, thus,
real rewards and penalties) on the commitments made to meet those goals. In this
context, we have noted that high-profile promotions and firings can dramatically
accelerate changes in behavior.
Defining critical shared accountabilities. This ensures that when joint plans are made, all
parties are accountable for their execution. Don't reward prod uct specialists who move on
to client opportunities without management endorsement. Penalize them for not adhering
to their shared accountability, and let everyone know that you have done so.
n Working on key capabilities, infrastructure tools and people. These initiatives
may take time—new information systems and measurement tools may be required
—but postponing the investment is unwise given the fact that it is critical to achieve
transparency on results and facilitate clear, rapid decision making. Similarly,
investment in key personnel—through training, career development and compensation
—may be necessary to get the best people to perform or to bring in new people from
the outside.
n Ensuring that senior executives lead change. Executive teams need to understand
that the old model dies hard and that they have a direct responsibility to drive change
with determination. These leaders should realize that their behavior and their signals to
the organization are critical to successful implementation. That means displaying
completeagreement among the leadership:
Disagreements stay in the room and do not leave it; decisions are firm. People who are
aligned with the new direction are visibly acknowledged; those who fight it are visibly
called out.
Few institutions today create substantial value in corporate banking. But banks that get
it right will end up with the most profitable share of this critical business. Doing so will
give them a tremendous competitive advantage specially in a slow-growth
environment. Establishing strong, broad and profitable banking relationships with core
client segments is essential for success.

Note. This article is an excerpt and adaptation from a longer research report, Delivering Profitable Growth in a
Crowded Market: Global Corporate Banking 2005, by Juergen E. Schwarz, Kilian Berz, Frans Blom, Udo Broeskamp, Bruno de
Saint Florent, Nicholas Glenning, Klaus Kessler, Andreas Regnell, Michael Shanahan, Walter Sinn and Nick Viner.

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Chapter 3: Bank strategy

Article No. 17 Financial

Frontiers

This article looks at the strategy undertaken by Visa, regarding the new technology of
contactless payments.

Historically, the making of payments has been the basis for banking. The reduction of
the use of cash as a form of payment within economies has revolutionised this element
of banking. Developments made in payments technology have been particularly useful in
making large numbers of small payments, for example, those made for travel on trains
and buses.

The article looks at the introduction of such payments in Hong Kong, and the scope for
them in a number of European countries. There is an especially detailed look at the
amalgamation of Visa technology with the popular and widely used Oyster payment
card, as used in London to make payments for bus and tube journeys.

Existing contactless and similar systems in use in the US and several Asian countries
are reviewed, with the potential for Visa technology to be used in these countries
examined.

The possibility for the new technology to evolve into one global system is appraised. A specific suggestion
is made to develop the technology into a software based system, so that it can be embedded in mobile
phones (thus greatly extending the scope of mobile internet based banking). Also appraised are the
developments in the area of security, with the potential use of fingerprints or iris recognition proposed, to
improve security of transactions.