Written with Mahendra Madhavan for a case study in our Global Financial Management course.
Citibank must answer questions regarding its purpose within Indonesia. Bank headquarters has requested higher net incomes, augmenting a currently aggressive budget. Citibank’s quest for higher profits could negatively affect the bank’s long-term leadership in Southeast Asia.
Citibank expanded into Indonesia in 1968. By 1983, the local Citibank official in Indonesia, Mr. Mistri, maintained a profitable division which tracks the growth of the country. Attaining the profit growth correlation with the Indonesian economy was an original reason for expansion into Indonesia. The government of Indonesia had requested international banks to make the foreign direct investment to increase human and financial capital. In 1983, Citibank corporate managers increased the Indonesia’s after-tax profit goal by $500,000 to $1,000,000. In pursuit of these goals, the local Indonesia Bank officials based decisions on diverse risks, regulatory restrictions, local growth and competition, and personal compensation.
Due to corporate business controls, local bank officials are allowed maximum exposure to a country, but may exercise an ability to stay lower than maximum. These controls are set by collaboration between corporate and local bank officials. While the acceptable sovereign risk derived with the budgets, the risk limits are available prior to the budget process. By fixing acceptable sovereign risk prior the budgets, the probably income can be setup dependant on risk, and risk independent of desired income. However, if the risk review was not complete prior to the budget, the company risked an adjustment game of tweaking budget and risk levels instead of making solid analysis.
In 1983, when corporate bank officials pushed down an increase in net income, they did not provide any guidance for increasing risk, nor make adjustments to the weighted average cost of capital. A CAP model states an increase of reward is accompanied by an increase in risk. When corporate officials increased budgeted income arbitrarily without respect to risk, they degraded the previously accepted budgeting process. Citibank corporate officials should provide a dialog for corporate and local officials with regards to the desired risk and return characteristics from the region.
Citibank had achieved one of its major goals in Indonesia of sharing in the growth of the Indonesian economy. Between 1968 and 1983, nominal GDP averaged 27% growth. However, real GDP growth only achieved 7%. If purchasing power parity held with respect to translation rates, Citibank should have achieved 7% over the same period. Assuming the original, aggressive budget was in line with expected real GDP growth, any addition to the net income would defer from original business strategy in Indonesia.
Due to Indonesia’s natural resources, expectations were negative because of short-term, falling oil prices. The GDP of the country for the coming year was uncertain. An increase in sovereign exposure during uncertainty gives Citibank less certain outcomes, but could mean exceptional growth if the country does perform well. If Citibank presses increased profits from Indonesia, it will increase its risk in relation to the local economy, and may not achieve profits.
Competition & Conflict of Interests
Citibank has provided increased training for human capital within the banking sector. An increase in capabilities has increased the knowledge of the entire sector, and increased competition. Higher degree of banking sector knowledge and skill calls for higher compensation packages which decrease profits. Competition for staff with local banks also pushes up compensation. Furthermore, a cultural flight from being trained at Citibank to employment at a local bank creates a political dilemma for the transnational bank. The increased competition pushes costs higher, and revenues lower. All the while, the Indonesian government has very defined roles for the foreign bank.
Bank compensation and bonuses are derived from budget versus performance measures. Since local bank officials wish to maintain bonus levels and the future is uncertain, there is a propensity to set the budget bar low. Mr. Mistri set a slight increase in revenue and a drop in profits. He considered this budget “aggressive,” but other facts from the case would call his budget “soft.” Competition could cause higher costs and lower revenues, but not to an extent to lower profits. Citibank’s Indonesian income, which correlates with the GDP, should not be negative unless real GDP is negative. Mr. Mistri appears to have set a low watermark that is easy to achieve, and will maximize his bonus.
Since Citibank is a foreign bank, it lacks ability lobby the government. Furthermore, since Indonesian banking is still developing, the government imposed strong restrictions on foreign banks to prevent them from creating a tilted balance of payments. These regulatory restrictions and expectations of foreign banks limits Citibank’s expansion. It must conform to the government’s expectation, and remain within the confines of Jakarta.
Reduce / Eliminate Prime Government & Corporate Loans Mr. Mistri could accept the budget changes and make changes to the investment allocation. By removing portions of the prime government and corporate loan portfolio, the bank could make riskier loans which should increase profits. Any move to reduce this portfolio would be outside the expectations of the Indonesian government, and could cause political backlash.
Increase Principal Invested / Value-at-risk in prime loans Citibank could increase the principal investments of prime loans and increase notional interest earned. Internal controls support this action because the bank currently invests less than the acceptable sovereign risk in Indonesia. These actions would lower target return on assets and return on equity for Citibank within the country, because prime loans would achieve less than 1.25% and 20% respectively. Political risks also accompany this decision: an increase of capital inflow would negatively affect the balance of payments, which Indonesian government had been working hard to stabilize.
Search for New Sources of Revenue Citibank could search for new sources of income. Developing a new market for current products would increase sovereign risk. Finding new ventures and establishing relationships would increase costs, and could provide limited results. Regulation has limited Citibank’s expansion possibilities, and any expansion would be limited to Jakarta proper. Since the bank has operated in Jakarta, it would have to take riskier loans to provide sources of revenue.
Change Nothing Mr. Mistri could make no changes to operating procedures. Such action would increase risk to Mr. Mistri within Citibank. By accepting changes to the budget, yet not making changes to the operating plan, his employment is tied to a recovery of the Indonesian economy.
Resist Changes to Budget Lastly, Mr. Mistri could resist changes to the budget. During his tenure at Citibank, he has established sweat equity and gained promotions. He has established himself as a leader, and has been rewarded for it. He could resist changes to the budget, and provide an insightful rebuttal outlining the flaws of the increased budget requirement: any increase in the net income expectations should be accompanied with a dialogue regarding expected risk.