Case 13-5

Chemical Bank

Chemical Bank is a classic case on management control in a commercial bank. One of the key issues is: should branches be set up as profit centers? Discussion: Goals. Although the goals for a branch are described in paragraph 3 of the case, these are probably not a good statement of the goals for the bank as a whole. Although I am sure that the bank as a whole wants to earn satisfactory profits, and to grow in deposits and loans, both of these objectives are really a function of another factor which is an explicit goal of many banks; service to their community. The economic rationale of this high-sounding goal is straightforward; banks make a profit by loaning out the funds entrusted to them by depositors. An increase in loans requires a preceding increase in deposits. But in order to get an increase in deposits, the bank must perform a useful service to businessmen and residents of the community. One of the most important differences between a bank and a manufacturing company are the opportunities for product differentiation. Money is about the most homogeneous product imaginable and, in fact, money is not the banks product at all. Its product is service to depositors and borrowers, and it must find imaginative and efficient ways to render better services than its competitors. Organizational structure. Nominally at least, Chemical Bank is decentralized in the operation of its branch banks. Branch managers are told that they are responsible for the profits of their branch as though it were an independent bank. In fact, because each branch is a part of a much larger institution, the authority of the branch manger is severely limited. He cannot control the price that he pays for deposits, either in terms of the interest rate on savings accounts or the types of services to be offered on regular checking accounts. Given the risk preferences of bankers generally, plus whatever additional criteria Chemical Banks top management has laid down, the branch manager operates within a very narrow range of discretion concerning the interest rate, that he can charge on loans. The most critical operating variable for his branch, its location, has already been determined. And the most important element of operating costs, payroll, cannot be altered substantially without careful justification at headquarters. What, then, can the branch manager do? Is he really profit responsible, or is the system described here merely an artificial control device for motivating him? What does top management want an individual branch manager to do? My view of his role is to cultivate the banking potential of the geographical area in the vicinity of his office. This really means that he is the deliverer of the banks services to depositors and borrowers; the branch managers responsibility for efficient internal operations of his branch is of clearly secondary importance. Other than being a personable, intelligent representative of the institution, how can the branch manger go about performing his main job in an efficient and effective manner? What kinds of decisions does the branch manager have to make? I think that the most important, continuing decision is how to allocate the use of his main resource, his time, and the time of other officers located in his branch. An aggressive (to the extent appropriate) bank is one in which the officers are continually attempting to develop new business (new depositors and/or new borrowers) through broadening their circle of contacts. To the extent that it is possible for a bank officer to direct his efforts toward (1) the development of new depositors, or (2) the development of new borrowers, then an individual branch manager has an important job. Trade-off decisions must be made between the allocation of time to one activity or the other and these decisions must be based on (1) the particular environment in which the branch is located, i.e., the relative difficulty of acquiring deposits versus acquiring loans, and (2) the overall balance of loans and deposits for the bank as a whole. If this analysis is correct, then I think that the profit center system used by Chemical Bank is most appropriate. The transfer price on excess or borrowed funds tells the branch manager tells the branch manager what the position of the total bank is regarding the relative value of loans and deposits. Against this transfer price, the branch manager can then decide for his specific location whether his resources may be better employed in trying to acquire deposits to earn the transfer rate, or whether he should be borrowing from the central bank and using his efforts to make

loans at rates above the transfer rate. He is, implicitly, told to make these continuing resource allocation decisions against the objective of improving the overall profitability of his particular branch. Developing this line of reasoning in a class discussion is never as straightforward as I have tried to set it forth above. Sometimes this rationale for the system does not come out until very late in the class, but I think it follows most directly from the discussion of what the branch managers job is, and I try to develop it at this point in the discussion if it can be done without forcing the students too much. Key variables. Given these objectives and the organizational structure for accomplishing them, what are the key variables to be used for control purposes both at the branch and at headquarters? For a particular branch, I think the answer to this question depends importantly on its size. A large branch, with several officer personnel, will need formal control system for the branch manager than a one-officer branch will require. Any branch manager, however, will be searching for measurements of (1) evidences of satisfaction with banking services among his existing customers, and (2) the extent and effectiveness of efforts to develop new business for his branch., At the headquarters level, however, I suspect that the problem is quite different. Although top management is also interested in both of the measurements just listed, they have the important additional problem of putting those measurements into a locational context in order to evaluate the performance of a particular branch manager. Branch profitability, therefore, may be a useful key variable at the headquarters level even though, as a general rule, profitability is not specific enough to service as a useful key variable for operating management. At the headquarters level, the real control branch performance lies in the selection of the branch manager. Profits, particularly in relation to a carefully prepared budget, reflect the branch managers success in developing the potential of his location. Headquarters personnel should concentrate their efforts on those locations which seem to be falling short of their potential so that branch profitability really acts as a screen in helping to identify the branches that need help. A great many other, not-so-key variables are reported in the branch earnings statement and the branch Office Report and its supplement. The statistical data are note news to the branch manager, and I suspect that they are used primarily at headquarters to facilitate the beginning analysis of a branch that appears to be in trouble as identified by a variance in its earnings statement. Question 2. This question is useful for two purposes: (1) if the discussion of Question 1 has not already raised the issue of whether a branch should be a profit center or a cost center, then the issue is easy to raise here because the earnings statement implies a profit center while the branch office report implies a cost center control system; and (2) even if the profit center concept for branches is validated, the publication of a statistical report, such as Exhibits 8 and 9, raises an interesting question because of the conflicting signals that it gives to the branch manager. On the one hand, he is told that he is responsible for the profits of his branch, yet at the same time, he knows that headquarters personnel are receiving a great deal of detailed data that are really encompassed in his branch earnings statement. One of the important values of a management control system is as a device for defining the job responsibilities of the unit on which the report is prepared. It is difficult to tell a man exactly what his job is, particularly if there is much breadth to his responsibilities. Just how difficult this is in Chemical Bank, and the degree of success that they have had, is illustrated by the data collected by Dr. Paik and reproduced in Appendix A. Although it takes 15 minutes or more, I have had a great deal of fun in class by putting Dr. Paiks exhibits on the blackboard, line by line. Interpreting these data is not easy. The students first reaction is that this is ironclad evidence of confusion, poor communication, and perhaps management. Obviously, branch managers, and headquarters personnel would have a consistent ranking of goals in a well-run bank. Then, some student would usually point out that it might be very appropriate for an individual branch to have a different ordering of goals that reflect the characteristics of its particular location. About all that is accomplished by this little side discussion is to emphasize how difficult it must be for headquarters personnel to communicate the legitimacy of a shifting order of goals for a different branch managers, but I think that thats an important point to make. Question 3. Dealing with this question of the use of a return on investment yardstick for branch performance measurement really requires more knowledge of the banking business than the students are able to glean from the case. Theoretically, it seems to me that it would be possible to develop such a measurement by calculating the amount of capital, surplus and undivided profits (i.e., equity) that branch would need in order to support its level of

deposits. Branch profits could then be computed as a percentage of the capital invested to arrive at the return on investment as it might be calculated for an independent bank. The desirability of calculating such a measurement is less clear, however. Its main advantage would be that it would provide a more useful figure for comparing one branch to another than the figure that is now presented on the branch earnings statement, the Net Earnings Ratio. This ratio, analogous to profits as a percentage of sales in a manufacturing company, is the ratio between net earnings before taxes and gross income for the branch. Obviously, this ratio varies significantly from one branch to another. A return on investment measurement would have much smaller variations but Im still not sure whether the variations would mean anything. The branch manager has no responsibility for the overall banks dividend policy nor for decisions to raise new equity capital. I believe that net earnings provides sufficient information for the branch manager to make his resource allocation decisions, and that he should not provided with (and perhaps confused by) a return on investment figure. Question 4. There are a great many noncontrollable and allocated costs that appear in the branch earnings statement. After the stage has been properly set by an earlier discussion of goals and organization, it is extremely worthwhile to discuss several of these cost items. The opening questions for each item is: How shall we handle this element of cost such that the branch manager will be motivated to act in a manner consistent with the overall goals of the bank? The allocation of costs for check clearing and other clerical functions is probably the most dramatic one to discuss, he should not be charged with the cost of them. What they really mean is that the branch manager cannot control the efficiency with which these activities are performed, but further thought leads to the discovery that he really is responsible for the incurrence of the activity. Or, at least the branch manager is getting credit for the income that results from servicing a customers checking account, even though he obviously cannot control the extent of the activity in the account. If the branch manager were not charged for the costs of servicing checking accounts, then the relative desirability of increasing the deposits in his branch would be higher, a new deposit would generate income for him at no cost. Failing to charge the branch manager with the costs of servicing accounts would, therefore, lead him to make erroneous decisions about the allocation of officer in soliciting deposits rather than loans. The counter-arguments on this item, as well as discussion of several other cost items, will be found in the student examination papers Appendix B. Question 5. My answer to the question as stated is yes because, as indicated earlier, I think a branch budget should be a careful attempt to predict the degree to which progress will be made in developing business in the branchs particular location, and I want to use budget variances as a measurement of the extent to which the branch manger is achieving the particular goals that have been agreed on in setting the budget. Therefore, noncontrollable rate variances on both interest costs and on allocated servicing costs should probably be broken out separately. There is another fascinating question that can be raised at this point. Exhibit 5 is a little difficulty for the students to understand, and once they do understand it, it comes as a revelation to many of them that the interest rate on excess or borrowed funds is really a transfer price between branches. The question then is: Should the transfer price be a cost based price as calculated in Exhibit 5, or should some other price be used? First, we must recognize that the transfer price is cost-based in the sense of the opportunity cost of funds in the regular investment pool, not the explicit cost of servicing depositors checking accounts. But we have seen that this transfer price is a key fact in the resource allocation decisions be made by branch mangers, and that increases or decreases in this price will have some effect on the way the branch mangers spend their time. The extent to which a small change in the rate will influence branch action depends, appropriately, on the particular environment in which the branch is operating; a change of a given magnitude might have no effect at all in many branches but would probably have some effect on some branches. Thus, the ability of top management to establish and change the transfer price is a major tool for controlling the activities of the branch managers. For example, if for some reason the top management wanted to increase the deposits of the bank as a whole, it could raise the interest rate paid on excess funds and thereby encourage the branch managers to allocate more time to seeking deposits (and less time to seeking loans). Why top management might want to do this, and whether it would be a good policy or not, are difficult questions to answer, but it does seem to me that this control system provides top management

with a useful tool for influencing the activities of branch officer personnel in a nicely subtle, decentralized manner. Summary As the above discussion indicates, this is an extremely rich case that can be sued as a vehicle to discuss a variety of topics. Although it is easy to structure the discussion in almost any desired direction, I find that, if time permits, the most effective utilization of this case is just to let the discussion run while the students develop and improve their understanding of the situation. Used in this way, the instructors main role is to keep signaling to the students that there may be additional levels of understanding for them to achieve in this case, and to occasionally take a few minutes to consolidate the gains that have been made.