Over the past two decades, banks have spent millions of dollars to segment customers based on profitability and to differentiate the service and pricing offered to these customer segments. A typical bank ends up with a relationship profitability “cliff chart” (see chart, “Falling Off the Cliff”) that ranks customer profitability and shows the cumulative effect of customer profitability.
At most banks, approximately 20% of customer relationships are extremely profitable, 75% of customer relationships do not have a material impact on profitability while the remaining 5% of customer relationships are extremely unprofitable. Royal Bank of Canada, for example, found that 17% of its customers accounted for 93% of the bank’s profits, according to a recent book by Larry Selden and Geoffrey Colvin.
With all the turmoil and changes sweeping the banking industry in the last few years, many banks may find themselves with inaccurate cliff charts because the customer profitability figures behind them are out-of-date. This leads to unfortunate consequences, such as highly profitable customers not receiving the attention they deserve; marginally profitable customers receiving more attention than they warrant (both positive and negative); and extremely unprofitable customers not being appropriately addressed (by measures such as re-pricing). The result is suboptimal pricing, inefficient customer service and, most importantly, lost profit.
During these difficult economic times, recognizing highly profitable and extremely unprofitable relationships and differentiating their treatment has never been more important. In today’s “bounce along the bottom” economy, accurate profitability information can mean the difference between being an acquirer and becoming the acquired. It is imperative for all banks to update their costing and profitability systems at least annually.
Where to Look
The industry changes over the past five years have been overwhelming and many have impacted the underlying service costs. Bankers need to look at the following four categories when deciding which parts of their profitability models to update:
Acquisitions. Have you revised unit costs to reflect new economies of scale? Even some costs classified as “variable” may actually scale. Do the assumed behaviors of the newly acquired customers match the expectations? Any costs that are not based on specific, account-level behaviors should be re-examined. Are there material cost differences between the acquired customers and the legacy customers? Costs to serve a new metro market may be significantly different than the costs to serve the legacy market.
New product/channel costs, such as those associated with Remote Deposit Capture (RDC), are dramatically different from generic, branch-based deposit-per-item costs. An RDC customer’s deposit-related costs are a fraction of the costs of a branch depositing customer. Does your profitability system reflect these types of differences?
Teller capture, branch capture and image exchange (including same-day clearing) have all contributed to a cost reduction for deposited items. Does your profitability system reflect the true balance sheet impact of these new processes? For example, many banks undervalue the float impact of these process changes by assigning overnight rates (Fed Funds). However, ongoing or “permanent” process changes should not be valued at overnight rates. At a minimum, these float reductions are as valuable as short-term deposits (usually 3- to 5-year rates). The value of these process changes is much more equivalent to the value of short-term demand deposit account deposits (3-5 year money).
And finally, consider regulatory and assessment changes. What will the repeal of Reg Q do to the duration of your business deposits? How is “unlimited” deposit insurance cost assigned? Should it be assigned to individual customers or is it a corporate-wide “tax” on all profits?
Also, as the Federal Deposit Insurance Corp. (FDIC) changes its deposit insurance assessment from a deposit-based assessment to an asset-based assessment, will the cost assignments to loans increase or will it remain a deposit cost? What if the FDIC changes to risk-based asset assessment? Similarly, the growing mountain of reporting requirements on lending has resulted in significant staff increases in the loan origination and servicing process. Are the new rules considered in the profitability system?
Properly maintained, the profitability system is a tremendous tool for product managers and the marketing department. If these two groups are not using the profitability data, it may be a sign the data is outdated. Hold quarterly meetings with product managers, marketing, operations and costing management to identify improvements to the profitability system as a result of the four environmental changes listed above. The costing group should develop and test improvements throughout the year and implement the improvements as part of the annual planning cycle.
Mr. Bahnub is senior vice president and director of business intelligence at Buffalo, N.Y.-based First Niagara Bank and author of Activity-Based Management for Financial Institutions: Driving Bottom-Line Results. He can be reached at firstname.lastname@example.org.
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