Financial institutions have watched their net interest margins (NIMs) shrink for more than 20 years, and the reasons are many: historically low interest rates, a flattening yield curve, and a shift in balance sheet structures. (Figure 1 demonstrates this protracted, troublesome trend.)
Though interest rates are slowly beginning to climb, and margins increasing slightly, analysts do not expect significant NIM improvements any time soon. This margin compression has been the norm for so long that many bankers simply resign themselves to it; fewer still take proactive measures to ensure that they’re optimizing margins. But where banks cannot optimize, they can most definitely analyze.
Probing profit: Making the case for deeper analysis
By better understanding and analyzing contributors to (or drivers of) profitability, institution leaders will adapt more effective methods to manage their margins. In a 2017 study conducted by Kaufman Hall and the Association for Management Information in Financial Services (AMIfs), banking leaders confirmed the need to optimize margins through deeper analysis. More than 100 CFOs and senior finance professionals of banks and credit unions responded to the survey; of these, only 17 percent said they have a clear understanding of the profitability of their products and customers (Figure 1). A full three quarters of respondents also reported gaps in their understanding, but have efforts underway to improve their profitability.
Figure 1. Which Statement Best Describes Your Profitability Reporting and Analytics? Source: Kaufman, Hall & Associates, LLC and Association for Management Information in Financial Services
These statistics are concerning. If an institution fails to understand its profitability drivers—that is, which branches, products and even customer/members are truly profitable—then how can they make informed decisions on where to invest resources? To view the complete picture of these profitability drivers, successful institutions start with the largest component of profitability: the calculation of funds transfer pricing (FTP) and its effect on their overall margin management strategy.
Think inside the margins: Employing proactive margin management
So how can finance leaders harness the components of FTP to benefit their institutions? As with any financial measurement process, the ultimate goal for using FTP as part of proactive margin management is to support better analysis and decision making.
To gain insight into the power of FTP analysis, financial institutions should implement processes that use FTP for:
historical analysis and measurement
strategic planning using forecasted FTP, and
budgeting and forecasting processes, tactically incorporating spread management to ensure alignment with organizational goals and strategies.
The overall enterprise performance management cycle (Figure 2) gives institutions the framework to build both their plan and profitability process. They can then apply this framework on a more granular level to focus on margin management.
As they approach the planning process holistically, finance leaders should focus on each stage of the enterprise management cycle to achieve more insight into what drives margin. Considerations for each of four stages—analyze and measure, strategize, plan, and monitor—are described below.
Stage 1: Analyze and Measure
Some finance professionals question the importance of historical performance analysis because they doubt the value it adds to performance forecasts. Yet using FTP to better grasp the net interest margins and profit contribution of each branch, product, customer/member, officer or channel, allows leaders to better identify areas of underperformance and potential opportunities for pricing improvement.
Stage 2: Strategize
Once potential opportunities for performance improvement are identified through historical analysis, finance teams can evaluate various strategies by analyzing “what if” scenarios. Examples of possible scenarios include:
growth strategies for particular product segments
modifications in pricing strategies to improve spreads, and
strategies to drive existing and/or new customers/members to more profitable channels and/or products
Forecasting FTP as part of the scenario modeling and evaluation processes helps institutions predict specific financial metrics (including net interest margin for each segment) to define and drive a strategy that optimizes financial performance.
Stage 3: Plan
Institutions should create a detailed budgeting and forecasting process to develop, implement and execute a tactical plan to achieve agreed-upon strategies. Typical budgeting and forecasting processes focus on volumes, rates and non-interest income/expense items. By adding forecasted FTP, the budgets (and subsequent forecasts) can also include NIM for each segment. This approach enables leaders to better plan, track, and evaluate whether performance is aligned with goals.
Stage 4: Monitor
When leaders and managers monitor profitability drivers on a monthly cadence and distribute timely information to stakeholders across the institution, they can seize opportunities while they identify potential problems at an early stage. Reporting should consider the audience: summary dashboards for senior management and more detailed reports for front line managers that encourage them to drill into the data for deeper insights on specific profitability drivers.
FTP meets effort: Taking Action
As financial institutions face the continual constraints of tight margins, their leaders should seek every opportunity to increase spreads. Now is the time to leverage FTP to its fullest capabilities. By using funds transfer pricing as a key decision-making tool throughout the EPM cycle, finance leaders can gain a deeper understanding of what drives profitability to optimize margin management. Thus FTP takes on a second meaning, as it helps financial leaders and their institutions reach their Full, True Potential.
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