Bankers continue to see pressure on net income and many are attempting to improve results by reducing expenses and maximizing fee income. In doing so, they are being reminded of just how hard it is to squeeze more net income out of current period revenue.
The traditional assumption is that improving profitability means expense reductions. A better approach is to understand that net income is not only the net of revenue and expense. It is also the net of: profitable products and unprofitable products; profitable branches and unprofitable branches; and most importantly, profitable customers and unprofitable customers.
Utilizing this information can help you proactively redesign and re-price unprofitable products, consolidate and redesign unprofitable branches and restructure and re-price offerings to unprofitable customers. The key to accomplishing that is to possess credible profitability information for lines of business, market segments, products and customers.
Developing such information cost effectively is the first step. Ultimately, getting middle, senior and executive management to embrace the results and use them in planning and executing on a consistent basis is how leading banks differentiate themselves from their competitors.
Many of the business managers we speak with are dissatisfied with their organizational and product profitability calculations because they are based on arbitrary expense allocations. With customer profitability, their dissatisfaction rises exponentially. Profit center managers, product managers and customer relationship managers lack clarity into the expense amounts allocated to their P&Ls and cannot validate the allocations. In addition, they cannot articulate the problem or understand the amounts they should have been charged. As a result, they usually blame back office managers for overspending and bicker with finance managers over the allocation rates and rules. None of this improves net income in the company.
There are two important components to measuring profitability in a bank and both should be evident in the profitability results. The first is measuring how much resource was positioned to service customers and to process their transactions. The second is measuring how much of that resource was actually consumed by customers. Most operating expenses are incurred in positioning employees in the bank to service customers and process the transactions they create. When banks allocate 100% of their expenses to revenue, they are allocating 100% of their resources, whether or not customers consume them. This creates a false picture of operating results and leads to poor decision making.
We recommend separating unused resource from the cost of generating revenue. This creates a clear picture of profitability by correctly aligning revenue with the cost of generating that revenue. It also enables a robust resource management reporting process that is the heart and soul of managing targeted expense control initiatives. In addition, it is less expensive and easier to implement than the traditional expense allocation models.
Consider the current banking model of providing multiple channel offerings to customers. Each day, customers are deciding whether to write checks, visit the branch, contact the call center, mail in a payment or use their debit card. How effectively are resources positioned in these channels? There are only three possibilities. First, you have positioned exactly the correct amount of resource every hour of every day – an ideal scenario, but impossible to achieve. Second, you have too little resources allocated, which leads to customer dissatisfaction and potential lost revenue. Lastly, you have deployed too much resource to ensure there is enough to meet customer demands and maintain customer service and satisfaction. Every bank plans to have too much resource; they just hope it’s not way too much.
To better understand the problem bankers are having understanding the information generated by their allocation-based profitability systems, consider this example. Imagine that you put up your capital (so you really have a net income focus) and buy a Porsche dealership. A lot of people look at your cars but only one person buys one, for $100,000. You get to the end of the month and it was the only car sold. Now you turn on the typical bank profitability system and it reports that you sold a Porsche that costs $700,000 for $100,000. Now, what do you do? Do you try to figure out how to sell Porsches for $800,000? Or do you get out of the business because the product is unprofitable?
Obviously the car didn’t cost $700,000. And yet the profitability system allocated 100% of the actual expenses of the dealership to the product. The total dealership incurred a loss with $700,000 in expense and only $100,000 in revenue. But management needs the insight to know that the Porsche only cost $80,000 and that represents a great margin on the product (product profitability). Management also needs to know that the customer that purchased the car is also very profitable (customer profitability) and is the kind of customer you want to profile and target market.
Local Market Profitability
The concept of managing local markets is critical to a successful branch management strategy. How does local market profitability differ from customer profitability and how does local market profitability change over time?
A local market is defined as a specific demographic area that is serviced by a branch or cluster of branches. Best-practice banks want to view local market results from a number of perspectives, such as location profitability and the profitability of the customers in that location. They need this information in aggregate to be able to compare markets and to target attractive markets to penetrate. They also want to know individual customer profitability to identify customers for target marketing. Lastly, they want to know how the location is being utilized by walk-in customers. This is different from local market profitability because the walk-in customers may actually be customers of record of other branches or local markets.
The difference between local market profitability and customer profitability is that customers can move from one local market to another impacting the local market profitability but without impacting their individual customer profitability with the bank. With the right data, you can analyze the impact on local market profitability as customers move in and out of markets. Further, looking at the movement of customers over time is very important as it impacts the very nature of local market demographics. Neighborhoods change; a very profitable location could become unprofitable over time. Tracking local market profitability over time allows banks to identify trends, anticipate changes, and make decisions before a local market becomes unprofitable.
Measuring and managing local markets involves the two most important measures of a branch or location: profitability and productivity. How profitable is it to have a presence in a specific location and what’s the productivity of the employees who staff the location to service the walk-in business.
Local market profitability is the revenue of the customers of record of the local market less the cost of generating that revenue. Unfortunately, not many banks are computing the cost of generating the revenue. Most banks misstate branch profitability by comparing the revenue of the customers of record of the branch with the direct expenses of the branch and some allocated expenses. The direct expenses of the branch are incurred in positioning resources in the branch to service the walk in customers from any branch. This mismatch of revenue and expense distorts results and adversely impacts decision-making.
It’s now possible to use profitability measurement functionality known as inter-branch accounting to reconcile branch of record and branch of process and resolve the mismatched reporting. This creates one report with local market profitability by product and a second report with resource utilization that shows how effectively resources are positioned to service the walk-in customers.
In order to truly understand customer profitability, customer behavior must be apparent in the financials. At leading banks, the charges to the P&L are usage-based and reflect the channels the customer utilized and the resources they consumed. The P&Ls reflect the impact of customer behavior on net income. Behavior is evidenced by the size of the balances in customer accounts, the number of transactions they create, the channels they use and the fees they pay. In combination, this is the story line behind understanding and analyzing customer profitability.
We worked with one leading bank that had been creating retail customer P&Ls for a number of years using enhanced calculations. They had retained all of that history in their data warehouse. Someone in their marketing department came up with a brilliant idea. The retail bank had adopted an objective of retaining their profitable customers. (You can’t have this objective if you can’t identify which customers are profitable.) Since these P&Ls contain customer behavior information, the marketing manager suggested that they use their predictive modeling software and look at the last three years of history and search out the profitable customers that had left the bank. They decided to look at the last 90 days of their behavior and apply what the software learns to the existing customer base and identify the profitable customers that are planning on leaving the bank. The software came back with a list of names of customers likely to close out their relationships.
The marketing department then assembled lists by branch and sent them out to the branch managers. One of the branches called to say they received the list around noon and found that one of the names on the list had closed out their relationship at 10 a.m. that morning. This obviously enhanced the credibility of the effort and word spread throughout the branches. Their calling efforts succeeded in retaining many of the customers on the list.
There are numerous examples of key decisions arising out of enhanced profitability information. The key is having the right information that creates the transparency, credibility, and actionable insight so that business managers can move beyond bickering over rates and rules to truly understanding the impact of their decisions and to create a consistent approach to sustaining profitability and growth.
Holly Hughes, BAI CMO, will share BAI’s latest banking channel research and host a conversation with Colleen Wilson, Vice President, Product at MANTL, on what the trends mean for financial services leaders....
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