All financial institutions share one key objective: to generate revenue in a way that supports and sustains profit. Yet all too often, banks focus on driving new deposits, loans and other volume-oriented measures of growth. The problem is this: Activities that create a positive effect on the balance sheet may not translate into sustainable profitability. And what good are high volumes without that?
Rather than evaluate the impact of risk on balance sheets alone, banks must also assess how risk impacts income statements. Financial institutions as a tradition emphasize the management of operational, credit, market and asset-liability risk. But profit risk represents one key area that banks frequently overlook—which can result in serious problems.
Fortunately, today’s financial institutions have access to a wealth of data that contains valuable insights. Properly unlocked, these insights will help navigate critical decisions and mitigate risk, including profit risk.
Profit risk explained
Simply put, profit risk centers on income statement concentrations—and serves as the focal point to layer relationships, markets, officers, branches, and products. The bigger the focal point the bigger the risk; in other words, a large focal point reveals that the bank’s income statement lacks diversity to highlight key profit risk drivers.
When banks minimize profit risk, they become less volatile and more viable: They sustain and grow income and capital. But those that ignore profit risk often over-rely on a singular product, relationship or market opportunity. This reflects a mindset that market/customer demands and interactions will remain the same. If and when the market shifts, though, it can threaten the bank’s profitability, as illustrated by the financial crisis of 2008. In the years leading up to the crisis, mortgages became the primary driver of the entire financial industry. When the housing market crashed, it proved detrimental to both the U.S. and global economies.
Profit risk calculated and evaluated
To calculate profit risk, banks can take the profit generated by the top ten percent of relationships and divide it by the total net income of the financial institution. When a very small percentage of relationships drive almost 100 percent of the bank’s profitability, profit risk is unhealthy for sustained earnings growth.
Financial institutions can address this by allocating income statements based on each account that each customer has with the institution. These include: types of transactions and the associated costs; specific fee income streams; and the value of each deposit and loan. From there, institutions can analyze income statements to evaluate harmful concentrations and threats.
When a risk is identified, the first instinct may be to emphasize the importance of cross-selling—with the assumption that selling more products creates a more profitable relationship. However, some products actually cost the bank money. Simply loading a customer up on additional products can, in reality, hurt the bank’s bottom line. To avoid this, banks must create the appropriate product combinations to engage with customers as they strive to maintain and grow profits.
Update data leverage
Banks also share two long-term marketing priorities: to increase wallet share and foster lasting customer relationships. But achieving this is difficult without a solid understanding of target customers. Ultimately, unlocking opportunities for sustained profitability demands a well-executed business intelligence strategy.
With access to massive amounts of customer and transactional data, banks should demonstrate to customers they understand their needs. However, data often remains underused--sitting in disparate databases, spreadsheets and repositories.
Instead, banks must begin to leverage data across the organization and consolidate the general ledger system into a single database. This allows banks to extract relevant insights about risks and opportunities. Leverage leads to the best and most accurate information about each individual, account, household, product, demographic, market, officer, segment, and channel. With increased visibility across the institution, banks can accurately identify the “next best product.” Product sequencing based on customer value bolsters profitability.
Once banks identify these opportunities, they can craft a well-timed marketing and communication plan that resonates with target customers. This adds up to a much-discussed and much-coveted goal: pinpointing the right product, for the right customer, at the right time, through the right channel—all while minimizing risk.
Long-term profitability rests on establishing a solid business intelligence strategy. Analytics allow institutions first to recognize which activities and relationships positively impact the institution’s bottom line; and second, identify which marketing channels and messages succeed for each customer interaction. From there, the bank can know with certainty how to profitably engage with customers in a way that resonates and deepens the relationship.
A high priority for profitability
Profit risk is not yet ingrained as a priority within the industry, but it should not be ignored. Mitigating profit risk should make up an integral part of a financial institution’s operations. What’s more, institutions should begin to transition from a sales culture to one created to sustain profits and growth. In doing so, bank employees can soundly identify opportunities to provide customers with products they need—and thus embrace a future that promises lower risks, higher profits and deeper relationships over longer periods.
Naseer Nasim, CEO of Baker Hill, is recognized as one of the leading technology executives in the financial software and solutions industry.