Management of Financial Institutions

This article focuses on the management of financial institutions. It provides an overview of the main management strategies used in financial institutions, including activity-based costing, asset-liability management, profitability analysis, risk management, technology and information management, crisis management, and issues management. The management issues associated with federal and state regulation of financial institutions are addressed.

Keywords Activity-Based Costing; Asset-Liability Management; Credit Unions; Crisis Management; Financial Institutions; Financial Services; Information Management; Issues Management; Knowledge Management System; Management; Organization; Organizational Crisis; Profitability Analysis; Risk Management; Thrifts

Finance > Management of Financial Institutions

Overview

Financial institutions, which move money throughout society in both complex and simple financial transactions, include banks, credit unions, thrifts, savings associations, trust companies, offices of foreign banks, and issuers of travelers checks and money orders. The success and strength of financial institutions depends in large part on their effective management. Management refers to the work or act of directing and controlling a group of people within an organization for the purpose of accomplishing shared goals or objectives. Classic management, as defined by Henri Fayol and Frederick Taylor, consists of five main functions, roles, or actions: Planning, organizing, leading, coordinating, and controlling. Management theory, practice, and scholarship are characterized by a focus on issues of leadership, group dynamics, and employee motivation.

Managers in financial institutions must respond to new technologies, new organizational models, the economic forces of globalization, and increased diversity in the workforce. Modern financial institutions, responding to new technology, increased competition, and changes in trade regulations around the world, are transitioning from hierarchical and centralized forms to group-model and decentralized organizations. In response to the new forms of business organizations, such as large-scale financial institutions, high-tech companies and multinational corporations, management has evolved its skill set to include greater facility for managing change, information, and human differences.

Financial institutions face unique management concerns and challenges due to the degree of government regulation within the financial industry. The management of financial institutions is a complex process involving management sectors of accounting, investment, human resources, and risk assessment. Common management practices used in financial institutions include account-balance costing, asset-liability management, profitability analysis, information management, crisis management, issues management, technology and information management, and risk management. The management of financial institutions has changed significantly since the 1970s. Changes in the following areas have affected management practices in financial institutions: Regulation and deregulation, product diversification, and industry convergence (Kafafian, 2001).

• Regulation and deregulation: The financial industry has undergone significant periods of regulation and deregulation since the 1970s when interest rate limits and geographic quota restrictions were ended. The government regulatory agencies vie for control over regulatory issues such as consumer privacy, merchant banking, community reinvestment, and consumer disclosure.
• Product diversification: The diversification of financial products, particularly traditional banking products, began in the 1970s as a result of regulatory changes. The Gramm-Leach-Bliley Financial Modernization Act, passed in 1999, increased the financial products and services available to consumers in the areas of brokerage, trust, money management, insurance, credit cards, and securitization. The Gramm-Leach-Bliley Financial Modernization Act replaced earlier laws that had prohibited financial institutions from engaging in insurance and investment activities. The Gramm-Leach-Bliley Financial Modernization Act resulted in the creation of numerous commercial and full service banking and financial service institutions. Financial institutions are currently working to adapt the products and services they offer to the needs of their customers. Internet banking has expanded the products and services that financial institutions offer and consumers expect.
• Industry convergence: Financial institutions, such as banks, brokerage firms, money managers, insurance companies, insurance agencies, and data processing vendors, are consolidating their business domains. For example, there are fewer banks in operation than there were in the 1970s. The financial industry is in flux as once discrete businesses attempt to combine operations, product offerings, markets, customers, and internal employee cultures.

In the United States, and developed nations in general, financial institutions facilitate economic growth through lending, savings, and commerce. The early history of formal financial institutions in the United States established the pattern of connection between the health of financial institutions and the economy at large. In the 18th century, banks, life insurance companies, and trading companies were established in the United States. These financial institutions facilitated large-scale economic growth in the United States manufacturing industry, infrastructure, home ownership, business development, international trade, and market formation. Due to the importance of financial institutions for the economic and social health of the nation as a whole, the government actively regulates financial institutions. Clearly, the management practices of financial institutions, as well as the products and services offered by financial services, are scrupulously monitored and regulated by the government. The successful management of financial institutions has a significant impact and influence on the nation.

The following section provides an overview of the main management strategies used in financial institutions including activity-based costing, asset-liability management, profitability analysis, risk management, technology and information management, crisis management, and issues management. This section will serve as the foundation for later discussion of the ways in which management of federal institutions is influenced by state and federal regulations.

Applications

Management Strategies in Financial Institutions

Management of financial institutions is a multifaceted endeavor involving the oversight and direction of human resources, accounting, investment, resource-allocation, production, research and design, and finance areas. Common management practices used in financial institutions include activity-based costing, asset-liability management, profitability analysis, risk management, technology and information management, crisis management, and issues management.

Activity-Based Costing

Activity-based costing is an accounting or finance-based management tool used in management accounting. Managers use activity based accounting to identify, describe, assign costs to, and report on operations. Activity-based costing is used in three main ways: a tool to aid strategic decision-making; a lens into the decision-making process; and a resource allocation mechanism. Activity-based costing facilitates strategic decision-making and cost reduction. It allows management to make decisions from an informed and objective basis (Rafiq & Garg, 2002).

Asset-Liability Management

Asset-liability management refers to a risk management practice used to make investment or disinvestment decisions and maintain the credit service ratio. The asset-liability management process generates graphical analysis, data analysis, and interest rate simulation for use in the budget making process. Asset liability management includes the important area of gap analysis. Gap analysis, a tool for comparing actual and potential performance, helps managers answer the following questions: Where are the fundamental mismatches of cash flows and maturities on the balance sheet? Does the institution have a positive or negative gap between actual and potential performance? What is the effect of interest rate changes on the profitability, viability, and safety and soundness of the corporation? Federal regulators require financial institutions to create and distribute a formal asset-liability management report for investors.

Profitability Analysis

Profitability analysis, often part of a larger project of cost-volume profitability analysis, is an analytical tool which compares the inner workings and profitability of a financial institution. Profitability analysis, which has applicability and uses in all areas of a financial institution, examines fund transfer pricing, capital assignment, and costing techniques to predict annual profitability by lines of business, organizational units, products, and customers. Federal regulators, lead by the Financial Accounting Standards Board, require financial institutions to create and distribute a formal profitability analysis report for investors which analyzes profit by categories such as business, geographies, product lines, and customers.

Risk Management

Risk management, which refers to the process of evaluating, classifying, and reducing risks to a level acceptable by stakeholders, is an established practice in financial institutions. Federal regulators require that financial institutions prepare and distribute comprehensive risk management reports to investors. Federal regulators have created risk category checklists which financial institutions can use to create risk management plans. For example, the Office of the Comptroller of the Currency (OCC) includes the following risk categories in their checklist: Credit, liquidity, interest rate, price, reputation, strategic, transaction, foreign exchange, and compliance risk. The Federal Reserve Bank (FRB) includes the following risk categories in their checklist: Credit, market, liquidity, reputation, legal, and operational risk (Kafafian, 2001).

Technology & Information Management

Technology and information management has changed significantly since the 1970s. The main areas of change include: Core technology of accounting and application systems; internal systems such as fax machines, e-mail, Internet access, local networks, remote accessibility, and technology training; external technologies including banking systems, ATMs, telephone banking, call centers, and Internet banking; and management information systems such as budgeting and planning; and data mining and mapping; and product, service and demographic analysis (Kafafian, 2001). Managers in financial institutions are responsible for information and knowledge management. Managers in modern organizations are increasingly applying information technologies (IT) to the problems and challenges of knowledge management (KM). Information technology helps organizations create knowledge management systems (KMS) that structure information storage, use, and distribution within an organization. Organizational knowledge management systems include elements such as data mining, learning tools, intranets, email, telecommunication and video-conferencing technologies, knowledge directories, decision support tools, expert systems, workflow systems, social network analysis tools, and knowledge codification tools. Knowledge management systems create searchable document repositories to support the digital storage, retrieval, and distribution of an organization's explicitly documented knowledge and information (Butler & Murphy, 2007).

Crisis Management

Financial institutions are vulnerable to organizational crisis, such as extortion, hostile takeover, product tampering, copyright infringement, security breach, bribery, information sabotage, sexual harassment, plant explosion, counterfeiting, and boycott. Organizational crisis refer to a low-probability, high-impact event that threatens the viability of the organization and is characterized by ambiguity of cause, effect, and means of resolution, as well as by a belief that decisions must be made swiftly. Organizational crisis management refers to a systematic attempt by organizational members with external stakeholders to avert crises or effectively manage those that do occur. An organization's crisis management framework or model for analyzing often includes the 4C frame of causes, consequences, caution, and coping.

• Causes refer to the immediate failures that triggered the crisis.
• Consequences refer to the immediate and long-term impacts.
• Caution refers to the measures taken to prevent or minimize the impact of a potential crisis.
• Coping refers to the measures taken to respond to a crisis that has already occurred.

Organizational crisis management effectiveness is demonstrated when potential crises are averted or when the major stakeholders of an organization believe that the success outcomes of short-term impacts outweigh the failure outcomes. Crisis management outcomes are often evaluated on a success-failure continuum based on the idea that all organizational crisis results in degrees of success and failure (Pearson & Clair, 1998).

Issues Management

Managers in financial institutions often face ethical issues that arise in the workings of their institution. Issues managers are responsible for integrating business decisions and ethical decisions. Strategies for handling ethical dilemmas in organizations involves the identification of issues, research, analysis, and the creation of responsive organization-wide policies. Issues management provides a framework for analysis of ethical dilemmas and situations that arise in the workplace. One of the main challenges of ethical issues management involves practical implementation of strategies and policies. Issues managers must match the degree of ethics formality to the style of organization. Issues managers may strengthen their ethical issues-management process by adopting a formal code of ethics for the organization and conducting issues-management meetings. Ethics statements articulate the values with which employees should make work-related decisions. In addition to an ethics code, issues managers may work with employees to evaluate work-related decision prior to making definitive and final decisions. This decision-making model is a less formal approach to ethical decision-making than an ethics code (Bowen, 2005).

Issues

Regulation of Financial Institution Management

The regulation of management practices in financial institutions occurs at the state and federal levels. State governments regulate financial institutions, and their management, as a means of ensuring a stable and growing economy. For example, in 2006, the Tennessee Department of Financial Institutions, which is a representative example of the state financial institutions office, was responsible for regulating 160 state-chartered banks, eight trust companies, three business and industrial development corporations, 118 credit unions, 849 industrial loan and thrift offices, 75 insurance premium finance companies, 1,591 mortgage companies, 573 check cashers, 1,484 deferred presentment services companies, 703 title pledge lenders and 57 money transmitters, and thousands of mortgage loan originators. The Tennessee Department of Financial Institutions oversees the state banking system, processes all financial institution related consumer complaints, offers education and outreach programs and generates state-level bank-related legislation.

There are six federal regulatory agencies that oversee the management of financial institutions: the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS). The Consumer Financial Protection Bureau (CFPB) was opened in 2010 in response to the 2008 financial crisis that resulted from reckless practices by lending and investing institutions.

• The Federal Reserve Board: The Federal Reserve Board is the central bank of the United States created, by Congress in 1913, to strengthen the nation's monetary and financial system. The Federal Reserve regulates state member banks, bank holding companies, subsidiaries of bank holding companies, edge and agreement corporations, branches and agencies of foreign banking organizations operating in the United States and their parent banks, and institution-affiliated parties. The Federal Reserve Board has four self-described responsibilities: Conduct the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices; supervise and regulate banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers; maintain the stability of the financial system and containing systemic risk that may arise in financial markets; and provide financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions.
• The Federal Deposit Insurance Corporation: The Federal Deposit Insurance Corporation, created in 1933 in response to national financial instability of the 1920s and 1930s, regulates state non-member banks and insured branches of foreign banks. The Federal Deposit Insurance Corporation insures deposits in banks and thrift institutions for at least $100,000; identifies, monitors, and addresses risks to the deposit insurance funds; and limits the effect on the economy and the financial system when a bank or thrift institution fails. The Federal Deposit Insurance Corporation, which has an insurance fund of approximately $49 billion, insures more than $3 trillion of deposits in U.S. banks and thrifts. The Federal Deposit Insurance Corporation is the primary federal regulator of banks that are chartered by the states that do not join the Federal Reserve System.
• The National Credit Union Administration: The National Credit Union Administration regulates and supervises credit unions. Credit unions are non-profit financial institutions that are owned and operated entirely by its members and provide financial services for their members including savings and lending. The Federal Credit Union Act, passed in 1934, established the National Credit Union Administration and federally chartered credit unions in all states. The not-for-profit credit unions were originally established to promote savings and limit the potential for profit from profit-motivated lending arrangements.
• The Office of Thrift Supervision: The Office of Thrift Supervision is the federal agency responsible for chartering and supervising the thrift industry. Thrift associations refer to savings and loan associations, credit unions, or savings banks. The Office of Supervisory Operations, and The Office of Thrift Supervision as a whole, analyzes the financial marketplace to see how federal regulation affects the thrift industry. The Office of Thrift Supervision advises Congress on regulatory policies.
• The Office of the Comptroller of the Currency: The Office of the Comptroller of the Currency, established in 1863, charters, regulates, and supervises all national banks including national banks, federally chartered branches, and agencies of foreign banks. The Office of the Comptroller of the Currency performs the following functions: Examines the banks; approves or denies applications for new charters, and branches; takes supervisory actions against banks that do not comply with laws and regulations; removes officers and directors, negotiates agreements to change banking practices, and issues cease and desist orders as well as civil money penalties; and issue rules and regulations governing bank investments and lending. The Office of the Comptroller of the Currency is directed by the Comptroller, a presidentially-appointed position, for a five-year appointment.
• The Consumer Financial Protection Bureau (CFPB) Created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Consumer Financial Protection Bureau (CFPB) has broad authority. The CFPB issues regulations under a number of consumer protection laws and has supervisory and enforcement authority over financial institutions with assets over $10 billion, including banks, savings associations, credit unions, consumer mortgage companies, payday lenders, and private college loan servicers (Mogilnicki & Malpass, 2013).

In addition to the regulatory efforts and powers of individual agencies, there are interagency commissions that oversee the management of financial institutions. The regulatory agencies come together in formal and informal ways to coordinate their policies and approaches. The Federal Financial Institutions Examination Council (FFIEC) established in 1979, is an example of a formal collaboration. The Federal Financial Institutions Examination Council is a formal interagency body with the power to develop uniform principles, standards, and report forms for the federal examination of financial institutions by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. In addition, the Federal Financial Institutions Examination Council is empowered to make recommendations to promote uniformity in the supervision of financial institutions.

Conclusion

In the final analysis, management consists of five main functions, roles, or actions: Planning, organizing, leading, coordinating, and controlling.

• Planning refers to management forecasting, strategizing, and deciding what needs to happen in the future.
• Organizing involves making efficient use of human and material resources.
• Leading refers to motivating, commanding and exhibiting skills to inspire and lead employees.
• Coordinating refers to unifying and harmonizing all organizational activity and effort.
• Controlling involves monitoring and checking employee performance for conformity and uniformity.

The management of financial institutions involves these five management functions as well as additional management functions specific to financial institutions. The management of financial institutions differs from the management of other types of institutions in the degree of government oversight and regulation. Financial institutions operate under a high degree of risk due to the effect that their operations have on the health and strength of the economy in general. Managers of financial institutions use a variety of management approaches and practices, including activity-based costing, asset-liability management, profitability analysis, risk management, technology and information management, crisis management, and issues management, to promote stability and growth in their institutions and the economy at large.

Terms & Concepts

Activity-Based Costing: An accounting or finance-based management tool used in management accounting.

Asset-Liability Management: A risk management practice used to make investment or disinvestment decisions and maintain a credit service ratio.

Credit Unions: A non-profit financial institution which is owned and operated by its members and provides financial services such as savings and lending.

Financial Institutions: Institutions that provide financial services.

Financial Services: The products and services offered by financial institutions to facilitate loans, insurance, commerce, investment, money management, and stock transactions.

Crisis Management: A systematic attempt by organizational members with external stakeholders to avert crises or effectively manage those that do occur.

Information Management: The systematic and explicit management of vital information in an organization.

Issues Management: The executive function of strategic public relations that deals with problem solving, organizational policy, long-range planning, and management strategy as well as communication of that strategy internally and externally.

Knowledge Management System: Ways of structuring information storage, use, and distribution within an organization.

Management: The work or act of directing and controlling a group of people within an organization for the purpose of accomplishing shared goals or objectives.

Organization: A formal arrangement of people committed to shared goals and objectives.

Organizational Crisis: A low-probability, high-impact event that threatens the viability of the organization and is characterized by ambiguity of cause, effect, and means of resolution, as well as by a belief that decisions must be made swiftly.

Profitability Analysis: An analytical tool which compares the inner workings and profitability of a financial institution.

Risk Management: The process of evaluating, classifying, and reducing risks to a level acceptable by stakeholders.

Thrifts: Savings and loan associations, credit unions, or savings banks.

Bibliography

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Rafiq, A. & Garg, A. (2002). Activity based costing and financial institutions: Old wine in new bottles or corporate panacea? The Journal of Bank Cost & Management Accounting, 15, 12-30.

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Suggested Reading

Preble, J. (1993). Crisis management of financial institutions. American Business Review, 11, 72. Retrieved September 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5632288&site=ehost-live

Robb, S. (1998). The effect of analysts' forecasts on earnings management in financial institutions. Journal of Financial Research, 21, 315. Retrieved September 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=1178402&site=ehost-live

Wee, L., & Lee, J. (2000). Seven challenges to implementing shareholder value management. Bank Accounting & Finance (Euromoney Publications PLC), 13, 7. Retrieved September 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=3185550&site=ehost-live