Profitability and Growth are the two drivers of shareholder value. Banks are excellent at tracking and incenting growth. Quite the opposite is true on tracking and incenting profitability.
Boards of Directors, senior executives, and shareholders correctly obsess about profitability. But ROA, ROE, and related profitability metrics, while very prominent in annual reports and quarterly statements, tend to disappear from performance reports as we move down the organization. Rarely does one see true profitability, let alone ROA or ROE, reported at the branch, RM, or even Business Unit levels.
It is baffling that profitability metrics get lost somewhere between the Quarterly Analyst call and the day-to-day interactions of the front line with their customers and prospects. The primary reason is that, unlike other industries, in banking the notion of “Cost of Goods Sold” is not intuitive. Once we move below the bank level, we no longer have a balanced balance sheet of loans compared to deposits and other sources of funding.
How can a commercial lender know the true cost of funds of the loan she just originated? How can she know the capital that that loan is “consuming” and the cost of that capital? What about operating costs?
Likewise how can a branch manager know the value of the deposits his branch has gathered relative to the alternative cost the bank would have to incur to raise those funds in the market? In accounting terms, deposits generate (interest) expense, not revenue. However, in economic terms they are often the biggest driver of profitability.
While many bank Treasury and Finance departments have been using Funds Transfer Pricing (FTP) curves and Capital Charge formulas for decades, these constructs rarely find themselves into unit or banker reports. If they do, they are misunderstood or simply not understood and ignored.
For banks that are the exception to this rule, the benefits are tremendous. These banks can answer the following questions, not just in an obscure central analytics area, but at the front line level:
What is the profitability of customer X? Is the customer accretive to shareholder value?
What is the profitability of each customer household? Each RM’s book of business?
What is the profitability of Geographic Region Y, or of Product Z (including deposit products that in accounting terms misleadingly appear as expenses), or of Customer Segment Q?
What is the profitability of each Business Unit?
A management team that has access to this information, and makes it (appropriately) available to the entire organization, can give very sharp direction to its various Business Units as well as each of its bankers and front line units.
At a minimum, this type of information enables the bank to:
Identify which relationships are very profitable and need to be defended
Understand why certain relationships are not profitable and how to fix them
Hone in on cross-sell and upsell opportunities
In addition, account level profitability measurement can enable the systematic transformation of:
Front line incentives
Risk measurement at customer level
Why is it difficult to implement?
If this is so obvious how come not every bank measure profitability down to the account level? Common reasons include:
“Great is the enemy of the good”. Some banks embark on titanic projects to dissect and allocate expenses. Underlying issues to define a customer and a customer household lead to endless philosophical debates that stall progress.
Difficulty in communicating the concept of FTP and difficulty managing the constantly moving (i.e., dynamic, not static) nature of the yardstick to measure profitability.
Capital Charges are challenged as artificial since regulatory minimum capital requirements at the balance sheet level require banks to anyway carry enough capital to support a healthy loan book.
Established interests are threatened; groups inside the bank feel attacked. Generally speaking, FTP curves, especially when coupled with Capital Charges to reflect the risk profile of accounts, tend to make loans appear less profitable and deposits more profitable. Typically, bankers who originate loan portfolios tend to be more senior than bankers who gather deposits. The transition from the perception of what is most profitable (i.e., loans) to the reality (i.e., deposits) can cause cultural issues that, if the C-suite does not manage, can very quickly kill such efforts.
How should this be done?
The two most important principles are:
Accept that the introduction of FTP-based profitability reporting will be a versioned release with Version 1.0 having many weaknesses. These can be fixed in subsequent releases. Capital Charges can also wait as they tend to be more complex and more controversial. But if you wait to be able to release Version 5.0 before you launch, chances are something will happen in the meantime that will derail the entire effort. There is significant value, both economic and cultural, to be extracted from even the early versions; delay in releasing Version 1.0 will only delay the realization of this value.
Manage the organization. The concept of FTP in particular is not intuitive and will be questioned and attacked. Certain bankers or entire units will feel threatened. It is important that these fears be managed by senior management. It is not easy for any transformation to work unless it receives senior support. In addition, there are approaches to simplify FTP in ways that would not be appropriate for your Treasury but will improve acceptance by the front line. One example is to lock the FTP for a period and absorb its natural volatility (there are creative ways to do this depending on the application).
From a tactical perspective the steps are more straightforward:
Agree on the FTP methodology for Version 1.0. This should include an agreement on the governance of the FTP, i.e., which area or which committee will be responsible for the definition and/or calculation of the bank’s profitability yardstick.
Agree on the hierarchy of customers. In other words which accounts belong to which customers (generally easier to do) and which customer belong to which consumer or SME household (generally harder to do). Establish at which level(s) profitability will be calculated.
Agree on capital allocation and Capital Charges at the account level. Be consistent with the Risk area. Be prepared to not introduce this concept in Version 1.0.
Agree on cost allocation methodology. This will most likely be very crude in the first release. For Version 1.0 don’t try to calculate how many times a particular customer called the call center and how much the cost per minute is, nor whether the customer has or has not signed up for e-statements.
Agree on plans to upgrade to Version 2.0 and beyond.
Who in the organization should own FTP?
Without question, the lead role should rest with your Treasury Area. You can have an FTP steering committee that could include the heads of major business units, but it is Treasury that has to be the “honest broker”. Treasury has the least incentive to manipulate FTP especially if directed to near-zero profit from differences between FTP curves for FTP credit and FTP charges adjusted for the costs of managing duration mismatches. While FTP versions used further down the organization, closer to the front line, might need to be simplified, your Treasury Area must have the know-how and infrastructure to properly administer an FTP environment.
Is all this worth it?
Yes it is!
Imagine a world where you know the profitability (or lack thereof) of each account, household, branch, RM, etc. Imagine the tactics you can design to protect the profit-star customers (who you may not even be able to correctly identify today). Imagine having the ability to manage each front line unit and give them clear and objective guidance to reach maximum profitability.