Greater Than the Sum of Its Parts
TD Canada Trust
In early 2000, TD Bank merged with Canada Trust (CT), the largest trust company in Canada, to form the new TD Bank Financial Group. Today, TDBFG is a leading Canadian financial institution with assets of $280 billion and revenues of $7.3 billion in fiscal 2002. TDBFGs businesses consists of TD Wealth Management, which includes discount broker TD Waterhouse as well as private clients, estate and trust, mutual funds, and asset management businesses; TD Securities Inc, which includes broker/ dealer and investment bank; and TD Canada Trust (TDCT), which is the retail personal and commercial bank.
Business Needs and Challenges
Prior to the integration of TD and CT, both organizations retail businesses were in the process of restructuring their business models. Both organizations had a branch focus, but were starting to explore the use of an internal-distribution-market business model. As a merged organization, TDCT operates on a fully integrated basis and has created product and channel groups. The bank, however, was lacking the measurement and management tools required to operate effectively in this new model.
TDCTs personal segment has three major business lines. The first two are the primary distribution channels: retail distribution, which includes approximately 1,400 retail and in-store branches across Canada; and eBank, the electronic bank that includes telephone banking, interactive voice response and call centers, automated banking machines, access cards, and Web banking. The third business line is the product group, which is responsible for managing TDs retail products, which include term and non-term deposit, consumer lending, credit cards, real estate secured lending, small business loans and deposits, and creditor insurance.
A New Business Model
Under the internal distribution market business model, each product and channel group is treated as a profit center and has P&L responsibilities. There is no double counting (shadowing), over-counting, or under-counting of results.
Within the model, product groups own the customer revenue, including net interest income and fees. Channels, on the other hand, are the groups that interact with customers.
The two channel groups, retail distribution and eBank, provide sales, service, and transaction support to TDCTs approximately 10 million retail customers. The product group is responsible for the development of products, including creating new products, pricing, and overall performance management of the individual product lines.
An internal transfer-pricing model is used to share revenues between manufacturers and distributors. The transfer-pricing model is based on market rates whereby the product group compensates the channels for sales at the equivalent of commissions paid to external brokers and agents, such as mortgage or insurance brokers. For service and customer transactions, the product group pays on a cost-plus-margin basis (using activity-based costing data). In addition, shelf-space decisions can adjust pricing up or down depending on the particular products that are of focus. The model is reviewed during the annual planning cycle to ensure it is reflective of TDCTs overall strategy.
Figure 1: TD Bank Financial Group Optimization Structure
The Integrated Product and Channel Profitability Model
Once TDCT had established the business paradigm, it needed a means by which to measure performance. During this period, Accenture was assisting TDCT with the integration effort, specifically with the finance department. Accenture was engaged to design a best-practice integrated product and channel profitability model (integrated profitability) and assist TDCT finance with the implementation of this model.
The purpose of the model was to measure the performance of products and channels and consisted of three primary components:
- Product profitability, which is measured on a fully costed basis to come
up with end-to-end profitability for each product within the retail bank.
Fully costed basis means that all costs within the retail bank are allocated
to the products using an activity-based costing methodology;
- Product by channel profitability to understand the relative profitability
of a product between the channels; and
- Channel by product to understand channel value efficiency within the channel and product contribution.
The audience for integrated profitability spans all levels within the retail bank. The reporting is used right up to the executive management level to assist them in making strategic business decisions and all the way down to the analyst for detailed analysis by product or channel.
Integrated profitability uses two fundamental concepts, multidimensional views, and drill-down along the views. With a multidimensional view, TDCT can look at profitability from various angles such as by product, by channel, across various financial statement lines, and by different reporting periods. The drill-down within the model allows analysis down to the lowest level along the product dimension.
Figure 2: Internal Distribution Market Business Model
Product profitability is used by senior management to assist in the structuring of products, including the pricing and overall product mix. Product by channel reporting is used by middle management to assist in products operational and tactical management. This reporting allows management to determine the cost-effectiveness of the channels in the selling and servicing of the products offered. It also aids in the product distribution strategy by better understanding the economics within the channels and how the bank can more profitability distribute products to customers. Product by channel is also key in the feedback loop on the internal revenue transfer pricing. By looking at the profitability of the various products in the channels, TDCT can better assess the reasonability of the transfer prices.
Channel by product reporting allows the channel to make operational and tactical management decisions. It will also allow them to better assess the efficiency of the channel and to deal with issues such as capacity management. This type of reporting also assesses the feedback loop with respect to transfer prices. All of the individual views relate back to one another and are fully balanced.
Figure 3: Components of Integrated Profitability Model
The Building Blocks of the Integrated Profitability Model
The integrated profitability model consists of five fundamental building blocks: funds transfer pricing, revenue transfer pricing (referred to above as internal transfer pricing), expected loss methodology, activity-based costing, and economic capital.
Figure 4: Building Blocks of Integrated Profitability Model
Funds Transfer Pricing
Funds transfer pricing allows for net interest income (NII) to be measured accurately on a product-by-product basis, whereas traditional accounting-based NII measures are a net between interest income on loans and interest expense on deposits.
NII is calculated at the certificate level (e.g., individual mortgage contract) using TDCTs funds transfer pricing system. For asset products, such as a loan, NII is defined as the interest received from the customer less the transfer pricing charged by treasury for providing the funds to the business to lend to their customers (treasury acts as the banks bank). For liability products, such as a deposit, NII is defined as the transfer pricing earned from treasury less the interest paid to customers.
Revenue Transfer Pricing
As described previously, product groups pay channels a market rate for sales, service, and transactions. This allows revenues to be assigned to product groups and channel groups without double counting.
Expected Loss Methodology (ELM)
TD Canada Trust is incorporating an ELM to calculate loan losses. ELM is a method of estimating loan losses and assigning them to specific credit products that is more predictive than the provision for credit loss approach under traditional generally accepted accounting principles accounting. Under ELM both portfolio seasoning and seasonality impacts are eliminated from the P&L. ELM also ensures that there is always a reserve in place to cover future losses.
Activity-Based Costing (ABC)
Activity-based costing allows expenses to be allocated to products by channel using business drivers such as customer channel-usage behaviors that are more meaningful to and manageable by the business than traditional expense-allocation methodologies. TDCTs ABC methodology is based on standard costing. Therefore, ABC rates are fixed (e.g., during a fiscal year) and the main variable is the level of business activity (e.g., number of sales by channel, number of deposit transactions by channel, etc). This allows for a more understandable link between business drivers and profitability outcomes.
Economic Capital
TDCT has introduced risk-adjusted return on risk-adjusted capital (RAROC), which is a risk-based approach to allocating capital to products and channels. This is a superior way of measuring return of allocated capital (compared with measuring traditional return on equity or ROE), measuring economic profit, and linking profitability to shareholder value.
Implementation Challenges
Integrated profitability was one of the few strategic projects undertaken during the integration environment. The project successfully navigated through many unique challenges.
Condensed Implementation Timeline
Normally a two-year initiative, integrated profitability was successfully implemented in 18 months. Multiple, phased implementations allowed the project to deliver complete profitability reporting solutions by business area on an accelerated basis where new areas were brought online every quarter.
Dynamic Work Environment
The integrated profitability model was developed to seamlessly and transparently support the transition of the underlying, pre-integration CT and TD financial infrastructures to the new TDCT end-state architecture. Throughout the transition, a comparatively small project team delivered consistent and meaningful profitability reporting. The project implemented innovative solutions that addressed significant challenges that included freezes to core product system changes, alignment of TDs custom activity-based costing model to CTs branch network, and summarized data that did not satisfy the detailed product profitability reporting required by the business.
Benefits of Integrated Profitability
TDCT has seen many benefits from the model and expects to see much more in the future. The bank has been able to use the model to establish return on allocated capital by individual product and determine shareholder value added by product. This analysis is now used to quantify the impact of each products performance and allows better alignment between strategy and the financial targets and plans.
The information has also been very useful for the product groups to be able to analyze all costs associated with the products to get an end-to-end costing view of their products for strategic business decisions.
The branch network is planning to use the model to help them in making branch investment/disinvestment decisions. The model will allow retail distribution to review the profitability of each branch so that proper investment decisions can be made.
