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The Challenge of Profitability Measurement
BY KENNETH CLINE
Banks have made progress in measuring profitability at the corporate level, roundtable participants say, but challenges remain in calculating customer profitability and non-interest expense.
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SYNOPSIS | Banks have generally done a good job, our roundtable says, in standardizing accounting practices for measuring net interest income on the corporate level. But problems persist in standardizing non-interest expense measurement. Panelists also cited difficulties in calculating customer profitability and providing simplified, actionable data to business line managers.
Banking is becoming undeniably more complex. Companies are getting larger, business lines more diverse and the regulatory burden heavier. In this context, the measurement and analysis of performance and profitability ? by business line and across the corporation ? has never been more important.
To assess how banking is meeting these challenges, BAI?s Banking Strategies assembled a panel of top experts to discuss these issues in depth. The group highlighted the critical need for more accurate measurement of customer profitability, noting the difficulty of pull-ing together the relevant data from diverse business lines. ?I don?t think we?ve really leveraged the information across the lines (of business),? says Frank McKeon, senior vice president, director of profitability measurement, with Tulsa, Okla.-based BOK Financial Corp.
Lack of standardization in calculating non-interest expense was another concern, as was the general need to simplify data and make it actionable for business line managers. “Where people can get in trouble is when they’ve designed a methodology or performance measurement process that’s disconnected from the types of decisions people are trying to make,” says Charlie Rozes, senior vice president with Charlotte, N.C.-based Bank of America Corp.
“You may end up building complexity for the sake of complexity and losing your internal customers in the process.”
Q: Why does banking still lag manufacturing or retailing in terms of measuring cost and profitability?
Rozes: I believe banking is more difficult to measure. Given the breadth of the products and myriad distribution channels, regulatory requirements, etc., there’s a natural complexity in banking that I don’t think you find in other industries, including manufacturing. And the business itself has just gotten much more complex.
Pierone: Part of it may be the difference between a service organization and a manufacturer. A service organization is more challenging, given that individuals are often supporting multiple activities. You’re in essence apportioning people to multiple functions.
Determining profitability at the net interest margin level, through funds transfer pricing, is fairly well defined and best practices are somewhat established. But below margin — or service transfer pricing — which includes the back office support and so on is far more subjective. That subjectivity handicaps how quickly an organization can move forward.
McKeon: I would follow up on what Peri said. Look at non-interest expense accounting in banking. If you were to poll the top 100 banks, I’ll guarantee you none of them are accounting for non-interest expenses in the same way, which is the below-margin area.
The non-interest expense accounting side is very volatile when you compare one institution to another.
Q: What will it take, or what will be required, to improve banking in those areas? Are there any developments on the horizon?
McKeon: We all understand best practices, but there are no rules of the game from a measurement perspective that are standardized across the industry. So, without that, it leads to us measuring things differently. Some of these areas are just nuances, but others can be significantly different, which makes benchmarking more difficult.
Rozes: I would say that there is some reasonable consistency with profitability measurement methodologies on the balance sheet, on the revenue items and on economic capital itself. But you do get a lot of localization on the non-interest expense side.
Many management teams want to know how they stack up relative to other players in the industry, large or small. Without having at least a de facto standard on how to think about and calculate expense and costs, including business process definition, our industry is at a bit of a disadvantage.
As far as what’s going to be the catalyst to make standardization happen, maybe we’ll take some inspiration from outside the industry. Along with companies such as Boeing and IBM, Bank of America is a sponsor of the Consortium of Advanced Management, International (CAM-I). One of the collaborative work groups that we have underway right now is defining a set of standards around cost measurement practices, such as activity-based costing (ABC). We want to develop a framework that can be used cross-industry as a way for companies, including banks, to assess competence and maturity in this area of performance measurement.
So, I think there’s some activity out there, across industries, to try to come up with standards. But it’s still elusive within financial services.
Pierone: Part of the issue is that the ongoing investment needed to support how costing ought to be done is not really sustainable for a lot of organizations. Organizations often make a significant investment but fail to realize the ongoing support and re-tuning that is required. Consequently, the assumptions and results can become stale, even erroneous. Costing processes and assumptions must be dynamically updated as the organization changes due to new products, new channels, acquisitions, etc.
Rozes: I agree with Peri — if you can’t maintain it and keep it up to date, then there’s not much value in building it to begin with. I think there’s probably some misconception about what really goes into building and maintaining an ABC program, the system, the data, etc. Although investment is required, the perception that ABC requires armies of cost accountants and specialized, expensive systems is not correct, yet that probably scares a lot of people off.
For the most part, ABC is not a financial exercise focused on your general ledger — it should be a mirror of your operations, leveraging existing operational data used by management to run the business. Some of this operational data includes staffing and capacity models. The focus should be on your business processes, not on your cost centers and organization structure.
Maintainability is certainly a key element, and it may be one of the reasons banks haven’t moved ahead more in this space. I also think there may be the lingering perception that ABC is only relevant to manufacturing companies, which is also not true.
McKeon: The smaller financial institutions, say $5 billion and less, may not necessarily commit the resources to maintain that type of information so that it’s fresh and it’s changing as their business evolves. Some of the smaller institutions just don’t have finance groups big enough to maintain an ABC program on an ongoing basis and thus depend on outside consultants to assist with doing a one-time exercise that can become outdated.
I think most of the larger financial institutions actually are committing the resources to do the job and deliver good information to their business users. There is no doubt that an ABC program can provide significant business value and far exceed the cost of the resources required to support the program.
Rozes: I think it’s always important to bring it back to the business decisions that you’re trying to support. Where people can get in trouble is when they’ve designed a methodology or performance measurement process that’s disconnected from the types of decisions people are trying to make. You may end up building complexity for the sake of complexity and losing your internal customers in the process.
There is a point of diminishing returns beyond which you’re not really going to make any better business decision just because you, for example, have a deeper level of product detail, or more frequent refresh of the source data, or more sophisticated funds transfer pricing or cost methodology. You need to bring it back to the types of decisions that you’re trying to make about products, customers and channels and ask, what is the information required to support those decisions? It’s easy to get lost in the data.
There needs to be a continued vigilance on the basic blocking and tackling: the collection of data, the presentation and the accessibility of information. Ask yourself: Do I have the basics ironed out or not? Am I really on the same page with management, as far as what they want, the decisions they’re making? Is the information really finely tuned for that? Or are we producing information that’s superfluous? We shouldn’t get away from some of the critical fundamentals for the sake of chasing sophistication and detail.
Several years ago when I was in consulting I had a client — a CFO at a large U.S. bank — who told me that, if you gave him Tiger Woods’ golf clubs, his game would still be terrible. His point was that it’s not so much having the “best” methodologies and systems as it is knowing what to do with the information.
Pierone: With regard to complexity, every institution has its own idiosyncrasies and its own culture. I had lunch with executives from a $700 million financial institution and was talking to them about their planning process. They have 1,700 lines in their budget. It was unbelievable to me the time they spent building out detail. Then, I talked with another institution, a $50 billion West Coast regional bank doing quarterly forecasts, and they’re down to 150 to 200 lines. It’s about leadership and culture in a lot of places, learning to major on the majors and minor on the minors.
So I don’t know that there is a uniform message on complexity. I find people that are buried in minutia. But then I find others who are getting much more value from the timeliness of relevant or key information.
Q: What can banks do to make the information they have more useful? To other people in the organization, to investors, etc.?
McKeon: At BOK Financial, before we even decided on how we were going to provide enhanced management information, we conducted an information needs assessment with all of our business line managers. Questions regarding current information they receive as well as addressing new information needs to provide a clearer understanding of their business drivers. What do they like? What is usable? What’s not? What else are they craving or need?
Different pockets of the organization are going to have different needs. We’ve got to partner with them and deliver what they need.
Q: I’ve often heard bankers complain that they’re inundated with too many reports ...
Pierone: Lots of data and not much actionable information. Part of this issue goes back to an inadequate amount of time determining the key measures that truly provide insight into the performance of the business.
We are engaged with a super regional bank that is focused on providing more meaningful information. They have a monthly report which shows by bank, region, loan center and loan officer — and ultimately the customer —the profitability of loans originated in the prior month. Their analysis is inclusive of funds transfer pricing, costing and capital allocation to truly understand the incremental risk/return profitability of a prior period.
From this, they can reward people more effectively, understand who is performing and who isn’t, identify key trends by region, etc. This sort of incremental analysis is very helpful.
Q: What can bankers learn from other industries, like retailing or manufacturing? Is there anything that you’ve seen that you’d like to import to your organization?
McKeon: If you look at other industries, and how they go about forecasting and planning, it’s on a more frequent basis. Most banks go through their annual budget process and probably do quarterly or monthly forecasting, but even the forecasting frequency and organization level it is completed at can vary quite a bit from bank to bank.
Sometimes, we look in the rearview mirror more than we should. I believe we need to improve our forecasting and gain a better understanding of where our business is going. Other industries, such as retail, focus more attention and resources and update forecasts sometimes weekly to support their business information needs.
Pierone: Yes, I would concur. Retail seems to live and die on the comparative or “comp store” analysis. If growth is largely sourced from new stores, then it suggests an aging or maturity of the core business, which must be addressed. Bankers could definitely benefit from this sort of analysis — and some are.
Q: Comp store branch growth seems to be attracting more interest in banking lately. Is that interest being translated into action by companies?
Pierone: I see some traction, but I don’t think it’s a generally accepted practice. It is not pervasive in annual reports. I don’t think you hear about it in quarterly earnings announcements to the Street ...
Rozes: It does not appear to be a consistent practice across the industry. Complexity of data may be part of the problem. You have the deposit system, the loan system, the mortgage system, the card system, etc. There is a need to potentially address at least half a dozen major sets of products, each with their own disparate platforms, with data that has to be brought together in a consistent, timely and repeatable manner to look at same-store branch sales.
Many banks have also started to utilize other channels such as e-commerce, ATM and call centers within their overall, integrated sales strategies, so the branch may not play the same exclusive role as it did in the past or in other industries such as retail. For larger institutions with a full, diverse range of products and services, this metric really only reflects the consumer portion of the business, so although it may have some value to that particular line of business, it does not have the same utility for corporate or investment banking, or at a company-wide level.
Q: Where does banking stand in terms of measuring customer profitability?
McKeon: That’s one of the biggest challenges we have. It’s a hot topic; everybody wants it. One of the biggest challenges is to define who the customer is. We can define the customer in a lot of ways, by individual, households, market segment, etc. You need to define these terms so as to not confuse your business managers as to what is being measured.
One of the issues we’re trying to get our arms around is, how much value is there? And our major challenge is, how do we link those DDA and trust accounts, etc.? And once you do that, who owns the customer? How do you use that information? What is it telling you?
I don’t think many banks have been able, across business lines, to truly get all that pulled together. It’s certainly a challenge, not just doing it from a mechanical perspective, but once we’ve got it, what do we do with it? I don’t think we’ve really leveraged the information across the lines.
However, I do believe we’ve been able to understand and effectively use customer profitability information within major business lines, such as mortgage, commercial lending, retail banking, etc. The main reason is that each business line uses independent source application systems that contain customer information specific to that business. This allows us to understand customers within major business lines, define them and appropriately measure them.
But due to the lack of data integration amongst these application systems, it creates a major challenge to define the full customer relationship. It is difficult to link customer accounts such as commercial loan, deposit accounts and investment management accounts that reside on different systems.
Many banks are consolidating these disparate systems data into data marts or warehouses to address this issue.
Rozes: I agree that customer profitability measurement is an imperative. You could argue that the customer is the only true profit center in any company. Products in and of themselves aren’t profit centers. Geographies and lines of business are not profit centers.
If you say that you are a customer-centric company, then it’s logical that you would understand and manage the profitability of those customers and their full relationship with the bank. We need to understand what the needs of the customer are, whether in a client managed or so-called “mass retail” space, how they transact with the bank, and measure the contribution and value of that customer if we’re going to grow the business in a sustainable and profitable manner.
In addition to what Frank described, even some of the basics around customer profitability measurement can be a challenge, such as householding and domiciling the full customer base. Banks without a high quality process to capture and manage their customer reference data consistently across all lines of business, through all contact points, will struggle with customer profitability. The range of financial and non-financial data, often coming from legacy “stovepipe” systems, adds to the challenge. Data or lack thereof is often the most limiting factor to comprehensive customer profitability measurement.
I think most companies are in a have/have-not situation — some of their lines of business have a customer profitability measurement capability while others do not. And for those lines of business that do, their methodologies and results may not be comparable. From discussions with my peers at other banks, it seems that very few have a consistent, company-wide view of customer profitability. Bank of America, however, has this company-wide view and we derive significant value from it.
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