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System Dynamics Simulations for the
Management of a Commercial Bank
by
Andre Finkenwirth and Georg Doll
University of Mannheim
Federal Republic of Germany
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System Dynamics simulations
for the management of a commercial bank
Abstract
Bank institutions occupy a special position in the
economy as they have to guarantee a frictionless money
movement. Compared with industrial companies, banks do
not produce concrete products but provide abstract
services with money as their output object. These ser-
vices - when they are included in balance sheet - are
reflected in the accounts as sales relations. Therefore
a balance sheet model is applied in order to reflect
general decisions in banking and to show how these
decisions affect banking business in terms of volume
and profit.
The analysed bank is the London branch of a Continental
bank, The branch acts on the markets as a commercial
bank, These kind of representations are the most common
ones in the financial center of London
The branch offers four different kind of products
Traditional, specialized, contingent and treasury
products. These products determine the statement of
asset and liabilities and in addition are also the
income earners of the branch
The behaviour of the branch is determined by decision
rules, market developments, the juristical position and
internal restrictions. This behaviour is tested by
adopting different scenarios
The System Dynamics bank model is adaptable to indivi-
dual circumstances of other banks and therefore it
offers practical support for the management of finan-
cial institutions
The model of the commercial bank
The model represents a commercial bank acting in the
financial center of London. This bank deals with four
products:
Product traditional (trad.). It includes products of
the corporate banking (short and medium term loans,
guarantees, tax-based and other products ), the trade
finance (short term export and import financing and
forfeiting) and the commodities divisions (letters of
credit, advances/acceptances and others) as long as
they are non-specialised products or lease arrangements
or non-standard products;
mois
Product specialized (spec.). It reflects products of
the Merchant Banking division (investing in non-listed
developing companies, management buy-outs and arranging
mergers and acquisitions) as long as assets are invol-
ved and specialized products offered by other Credit
and Marketing divisions;
Product contingent. It represents all eventual assets
and liabilities;
Product treasury. It includes trading of deposits with
banks as well as deposits taken from banks, both traded
in the interbank markets.
Fundamentally the model is divided into three sectors
(see figure 1).
Strategy Sector
——
Head
Balance Sheet Sector Office
Basic em Re-
stric-
> < tions
Trad. | Spec. Contin-| Treas-
gent | ury
Trad. Spec. Treasury
_ Profit Center Sectors amen
Markets
Fig. 1: The simplified structure of the model
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Strategy Sector
Within this sector decisions about desired volumes of
the different products are made, taking into consi-
deration risk readiness of the bank, substitution
wishes and profitability. In addition staff planning
decisions and employee costs are taken into consider-
ation in this sector.
Balance Sheet Sector
This sector is subdivided into four business areas
which are stated in the balance sheet of the examined
bank (see figure 2).
Assets Liabilities
Traditional
Product
Commercial
Loans
Specialized
Product
Treasury Deposits
Product
Liability
Treasury
Product
Deposits Asset
Contingent Contingent
Product Product
Fig. 2: Model's balance sheet
As the bank refinances itself by deposits taken with
banks and as this deposit business depends on asset
business, liabilities are not included in the balance
sheet sector. Nevertheless, deposits are included in
the profit and loss accounts
Profit Center Sector
There are three profit centers within the bank. They
are profit center traditional product, specialized
product and treasury product. In this sector emphasis
is placed on profit generating of the mentioned pro-
ducts as well as on pricing policy of the bank ma-
nagement
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Another model assumptions is that the loan portfolio in
its currency and area structure will not change during
Passing of time and that exchange rates are fixed
The loop structure of the model
Traditional product loops. Volume of the traditional
sector depends on the elements
- supply of traditional product;
- demand of the market for this product and
- maturity and selling off of traditional product
Fig. 3: Traditional product volume loops
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Specialized product loops. Volume of the specialized
Product also depends on supply, ‘demand and maturity and
selling off of specialized product. While demand, matu-
rity and selling off loops in the specialized product
sector are the same as the demand loops mentioned
above, supply loops are different.
Fig. 4: Supply specialized product volume loops
Contingent product loops. Contingent product volume has
to be viewed in conjunction with expected profitability
of the whole bank. The higher the expected profitabili-
ty the higher the contingent product volume. Contingent
product is viewed by the management as a substitution
possibility of traditional and specialized product. The
reason for that is that contingent product is not asset
binding and therefore total profitability of the bank
is rising if contingent product volume increases as
contingent product is generating income
Fra, & ¢ Contingent product loop I
=7l=
A second loop is implemented instead of the one men-
tioned above from the start of 1987 as a result of law
changes which from then on effect the business of the
bank. These law changes (new bank act) claim that 50%
of contingent product. volume has to be included in the
balance sheet as assets
+
Income
gent
c6
Fig. 6: Contingent product.loop II (after law changes
come into force)
Treasury product loop. Deposits are influenced by pro-
fitability comparison. The higher the profitability of
the treasury product compared to commercial loans pro-
fitability the greater is the desire of the management
to increase deposit volume
Fig. 7 : Treasury product volume loop
Figure 8 shows the simulated behaviour of the balance
sheet elements and of out of balance sheet business
(accumulated values).
Traditional product volume decreases during the whole
simulation by 83% and at the end of the simulation in
1991 represents 2% of total balance sheet sum (22% at
January 1983). This decrease is a result of both, lower
extension of loans than matured ones and heavy selling
off of traditional product volume in the first month of
1987.
Up to the end of 1986 specialized product volume is
gaining more and more importance in terms of contribu-
tion to total assets but as this product is sold heavi-
ly in 1987 at the end of the simulation specialized
volume represents only 10% of total assets (8% at
January 1983). The development of specialized product
volume is determined during the simulation by supply
which fluctuated during the whole simulation
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TOTAL
ASSET
1800.0T
TREASURY
VOLUME
1
1
'
'
'
o
v
'
1000,.0T
SPECIALIZED
CONTINGENT
—_—o INCLUDED
1
rf mes spre COMMERCT AL
LOAN YOLUME
a SON TRADITIONAL
! VOLUME
q
T
Srcotrncent
T EXCLUDED
200.07
-600.0T
1983 1984 «1985 1984 1987 1988 1989 1990
Fig. 8: Balances sheet structure - base run
Contingent product volume which is not included as
asset increases in the simulation up to January 1987
when it reaches its maximum level of 584 million
Pounds. Then, in the first three months of 1987, it
decreases due to law changes coming into force at the
start of 1987 as half of contingent product volume is
to be included in the balance sheet. Nevertheless from
then onwards it increases and at the end of the si-
mulation non asset contingent product has a volume of
390 million Pounds. The part of contingents, which are
included in the balance sheet as assets in 1987, also
increases and at the end of the simulation contingent
product volume declared as asset is 390 million Pounds
The increase of contingent product business is mainly
the result of the fact that this area generates the
highest profitability. Therefore supply of this product
exceeds demand by far so that the development of con-
tingent product is determined by demand
Treasury product volume stays relatively stable during
the simulation. An exception of this development is the
negative trading of treasury product in 1987. These
trading activities are the result of deteriorating mar-
ket conditions leading to low profitability. At the end
of the simulation treasury's contribution to balance
sheet sum is 63% (71% in January 1983).
The result of the explained asset movements reflects
the development of the balance sheet sum. Balance sheet
sum increases in the first three years of simulation
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Due to the heavy selling off of traditional, specia-
lized and contingent volume and the negative trading of
treasury product, which exceed contingent product vo-
lume declared as assets, balance sheet sum decreases in
1987, Nevertheless, the inclusion of contingent as
assets and the increase of treasury product volume lead
to an increase of the balance sheet sum in the follo-
wing years. At the end of the simulation in 1991 bala-
nee sheet sum is 1,594 million Pounds (1,024 million
Pounds at January 1983).
Profitability loop. The profitability loops apply to
both, the traditional as well as to the specialized
Product sector. Profitability depends on volume and
profit which the involved assets generate. Higher
profits result in higher profitability, but an increase
of volume leads to profitability decrease. Profit is
measured in net income before operating expenses. There
are three sources of income:
- interest and fee income, both generated by tradi-
tional and specialized product;
- fee income generated by. contingents and
- interest income from treasury
Fig. 9: Profitability loop
Figure 10 shows the development of the total income the
bank generates during the passage of time as. well as
the development of the different sources of income
(accumulated values). At the beginning of the simula-
tion income generated by traditional product represents
21% of total income (124,570 Pounds per month). It
decreases slightly and at the end of the simulation
income of traditional product represents about 1% of
total income (15,730 Pounds per month). This decrease
reflects the decrease of traditional product volume.
fe
Income generated by the specialized product reflects 9%
of total monthly income at January 1983. Up to the
first months of 1986 it becomes more and more important
especially as total income decreases heavily between
the middle of 1985 and the first months of 1987 (32% of
total income at January 1986). Later on its importance
decreases and at the end of the simulation income of
specialized product represents 6% of total income
(71,610 Pounds per month). The development of income
generated by specialized product partly reflects dete-
riorating market conditions during 1987 to 1989 and the
decrease of specialized product volume especially in
1987 and 1989
2
g oa oa “1 “1 “1 bose
a 1 t 1 1 1 TOTAL
7 i i ; ‘ INCOME
1 ' ' 1 1
' 1 1 1
3 ' 1 1 1 TREASURY
3 “ft ay “1 “1 INCOME
EF] ' 1 f \
1 : 1
. Lp CONTINGENT
1) INCOME
400.0
1 COMMERCIAL
LOAN INCOME
SPECIALIZED
TRADITIONAL f
~ INCOME
INCOME
0.0
1983 1984 1985 1986 1987 1988 1989 1990
Fig.10: Income structure - base run
Income generated by contingents is only of little im-
portance at the beginning of the simulation represen-
ting 13,600 Pounds per month reflecting 2% of total
income. During the passage of time it becomes of ever
increasing importance in terms of the proportion of
total income contribution and at the end of the simu-
lation income generated by contingent product stands at
429,360 Pounds per month (37% of total income). The
development of income earned by contingent product
represents increasing fee margins and volume during the
simulation
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In January 1983 treasury product income represents 68%
of total income. Between 1985 and 1986 it looses
significance in terms of total income contribution. The
reason for this is the fact that market conditions are
very difficult and therefore fee margins are extremely
low. Nevertheless, in the following years interest
income generated by treasury area again becomes impor-
tant by contributing to total profit and in January
1991 treasury product income represents 55% of total
income.
Interest income generated by the treasury product is
essential for the development of total income during
the passage of time. The high fluctuations of treasury
product income result in fluctuations of total income.
Summary of the results of the model experiments
Three model experiments are applied
Model experiment I represents the model's behaviour
after a juristical change, i.e all contingents have to
be declared as assets from 1987 onwards
Model experiment II reflects the model's behaviour due
to market changes by assuming that due to higher
competition the market conditions for contingent
product deteriorate, i.e. fee margin for contingent
product is lower than in the base run.
Model experiment III states the behaviour of the model
by changing the policy of head office, i.e. the credit
availability amount for one customer is increased
The following summary in tabular form (see table 1)
reflects the comparison of figures of the base run with
figures of each of the three scenarios. Here it is
distinguished between the first four years of the
simulation ("1st"= 1983-1986) and the following years
C"2nd"= 1987-1991)
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Model experiment 5 Ir IIr
Elements 1st 2nd 1st 2nd ist 2nd
Traditional volume & = < < < =
Specialized volume = «<< « >> > »>
Contingent volume 2 “<< > «< «<< =
Treasury volume = . < < = >
Balance sheet sum = >: « < = >
Traditional income = = = < > ba
Specialized income = « = > 39 »>
Contingent income = “<< < «< < >
Treasury income cs = s i = =
Total income = “<< « “< > »>
Total ROA = coon < “< > >
>> remarkably higher than the figures in the base run
higher
3s” similar to " . ec « "
% Lower than " ” noon ” «
Rig remarkably lower " " " " "
Tab. 1: Tabulated summary of the results of the model
experiments
Final observation
The base run and the model experiments show that the
profit of the branch depends on the development of
market conditions. The managements adaptability towards
changing market conditions is not fast enough, in
either, to compensate quickly a potential resulting
decrease of income and to use improved conditions to
increase profitability. This inadequate adaptability is
not only the result of management decisions but of
strong reglementations set by head office
An improvement of the mentioned adaptability would be
to increase flexibility of management by:
(1) Shortening official channels (especially the
existing ones with head office) in terms of time
required to obtain the approval for a deal
Increasing lending volume per customer
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(2) Increasing the percentage of possible maximum
contingent product volume in budgeted business
volume. There is no reason for the fact that
management restricts contingent product volume to a
maximum of 50% of budgeted business volume.
(3) No constant increase of budgeted business volume.
The. possiblity of a lower budget than in the last
period could generally lead to a shrinking of bus-
siness towards higher profitability and toa
specialication.
The managements main aim is maximizing proceeds. The
question has to be asked if the strive after this aim
is sufficient to guarantee profitability especially as
expenses are not taken into consideration by manage-
ment. A result of the non attention towards expenses
could be a substance consumption of the branches
(parent supervisors) equity if losses are made. In this
respect it seems to be richer in meaning for the ma-
nagement to adopt the aim of net profit maximizing in
its decision process especially as then the expense
sinking potential would be considered.
To guarantee higher profitability certain changes have
to be made:
(1) Establishing an effective cost accounting center.
The higher the precision of cost accounting is, the
more accurate is the profit contribution figure of
each product or customer resulting in higher effi-
ciency of the branch as products or customers which
generate the highest net operating income can be
advanced
(2) Strengthening the treasury division. Income of
commercial loans including contingent income covers
only in the first four years of the simulation
expenses while in the following years this income
stagnates and is exceeded by steadily increasing
operating expenses. Therefore in the long term it
is necessary to smooth income fluctuations of the
market with which treasury operates. This can be
achieved by bringing up to date the electronical
equipment of treasury and by recruiting highly
capable people with experience in money and capital
markets experience
(3) Development of a customer group orientated organi-
sation structure. This structure enables the branch
to cooperate better with customers as only one or
two employees advise a customer (instead of five or
even more).
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