The Profitability Analytics Culture

Two cultures guided the financial services industry up to the early 21st century. The first was the Banking Hours culture and it defined financial services from the 1930s to the early 1980s. Competition drove the management decisions, leading everyone to follow the market leaders.

Beginning in the 1980s, the Sales Culture grew out of a need to expand wallet share. Financial institutions based management decisions on the external environment focused on selling anything and everything to whoever came through the doors. Success was based upon balance sheet growth and volumes.

As consolidation in the financial services sector has increased over the past 20 years, surviving banks and credit unions have had to adopt more effective strategies to achieve sustainable growth, which has led to the Profitability Analytic Culture of today.

Although many banks and credit unions are still firmly entrenched in the Sales Culture, the Profitability Analytic Culture is gaining significant momentum and support from leadership. This culture is defined by institutions maximizing profitable growth by selling and up-selling profitable products to profitable target markets in profitable ways. Management is making decisions based upon profitability analytics, and is focused on the income statement rather than the balance sheet to ensure sustainability.

Profitability analytics proves out that most customers/members, products, markets, branches and frontline personnel are unprofitable and are constantly putting the financial institution at risk by conducting business as usual. Exposure to Profit Risk, which is defined by the concentration of income sources versus the distribution and diversification of profitability streams, is driven by unchecked growth of unprofitable components of the balance sheet and the lack of an actionable strategy to protect the profitable relationships and markets from competitors. When Profit Risk is minimized, income volatility is mitigated, income and capital are maintained and the institution remains viable and poised for profitable growth.

Managing Profit Risk requires that institutions begin to learn about the dynamics of their income statement, understanding the general ledger in a detailed approach and calculating profitability at each level of the institution; including every customer/member account and relationship, product, market, branch and sales officer. This deep analysis will clearly reveal that no two similar accounts with identical balances or customer/member relationships with identical product mixes are truly alike. Understanding the differences in account profitability based upon multiple factors is key to developing an effective strategy to mitigate your Profit Risk and improve your institution’s overall profitability.

How to Get Started:

1. Comprehensive allocation of non-interest expenses to each account that created the expense. A key objective of this exercise is to differentiate between the direct and indirect expenses and analyze them differently. This includes teller visits, ATM transactions, marketing programs, provision for loan loss and statement and postage expense.
2. Comprehensive allocation of non-interest income to each account that generated the fee. These fees are generally easily tied to a product or service and include interchange fees, NSF/courtesy pay fees, loan servicing fees and origination fees.
3. Setting up the proper Funds transfer pricing model to reflect the institution’s operations and environment. Funds transfer pricing is a systematic method for creating economic value for every loan and deposit – matching a yield to each deposit and a cost of funds to each loan to create a spread.

Bringing It All Together in a Single System Will Clarify That:

• Costs must reflect changes in capacity, usage and expenses and expense structures
• Revenues must reflect changes in pricing, fee practices, and ways in which clients manage their accounts
• Funds transfer pricing must reflect changes in the economic environment and yield curves
• Calculating precise profitability is about sensitivity and change

To maximize the value of the investment in analytics, an institution should create a profit risk discipline. This could be the creation of a new executive position or the assignment of analysis, reporting and mitigation responsibilities to an existing officer.

The institution should develop profit risk strategies and tactical plans addressing; pricing, product management and development, delivery channels, target marketing, incentive plans, service levels, marketing and sales programs and cost reduction and efficiency programs. Most importantly, the institution should define success throughout the organization based upon increased profitability, earnings and capital growth.

Financial institutions that adopt the Profitability Analytic Culture will be the most informed, profitable and most likely to survive this evolutionary stage in banking.