2018 Profitability Perspectives

FINANCIAL INSTITUTIONS
2018 Profitability Perspectives Analytical Trends in Financial Institutions


About This Report
This report provides the results of a research study that was jointly conducted in early 2018 by Kaufman Hall and the Financial Managers Society (FMS). Based on a survey completed by 179 senior finance professionals in banks and credit unions, the report focuses on the priorities and practices in profitability analysis in financial institutions nationwide. This publication is the second such report; the first report, published in early 2017, had approximately 100 respondents.
Community banks were represented by approximately 37 percent of survey respondents. Commercial banks and credit unions also had strong representation, accounting for about 30 percent and 23 percent of survey participation, respectively.
With some questions, professionals from institutions with assets
of less than $1 billion—who comprised about 41 percent of survey participants—responded significantly differently than professionals from larger banks. Relevant comments about the breadth of difference and why this may be the case are included in the report, as appropriate.
Additional information on survey participants appears at the end of the report.
Institution Types
% 7
% 3
Other
Savings Banks Credit Unions
37
30
Commercial Banks
% 23
%
Community Banks
%
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© Copyright 2018 by Kaufman, Hall & Associates, LLC


Profitability Analysis in Today’s Economic Climate
Many business sectors are experiencing a challenging operating environment—and the financial services industry is no exception.
In today’s global economic climate and regulatory environment, assessment of the “drivers” of profitability is a mission-critical priority. Two key findings set the stage with this report:
of their structure, talent, technology, and operations—particularly financial planning processes and tools—likely will require modification.
Armed with such modification, executives will be better able to forecast and manage profitability performance in response to changing financial conditions.
•
•
About 91 percent of all respondents believe their institutions should be doing more to leverage profitability analysis to inform strategic decisions. This percentage was an even higher 95 percent among respondents from banks with more than $1 billion in assets compared with 90 percent among respondents for banks with less than $1 billion in assets.
More than three-quarters of respondents (79 percent) have limited confidence in their institutions’ ability to forecast and manage profitability performance in the changing banking environment, based on current financial planning processes and tools. Of these, most respondents (74 percent) feel only somewhat prepared, and a small proportion (5 percent) feel not at all prepared.
% 91
79%
The role of finance executives in today’s environment is to operate in the current business while simultaneously preparing for evolving conditions.
Limited confidence in the ability to respond to business changes—as indicated by all but 21 percent of respondents—points to an area of needed improvement in financial institutions. Some core elements
of all respondents feel their institutions should be doing more to leverage profitability analysis to inform strategic decisions
have limited confidence in their institutions’ ability to forecast and manage profitability performance based on current financial planning processes and tools
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Understanding and Using Profitability Analysis
Profitability is at the heart of any financial institution’s long- and short-term strategy, so credit unions and banks of all types and sizes should thoroughly understand what contributes to their bottom line.
Only 11 percent of respondents say their institutions have a clear understanding of the profitability of their customers, products, organizational units, and channels. Without such understanding, which is the case for 89 percent of respondents, it is difficult to make informed decisions around where to invest resources to pursue opportunities.
Nearly two-thirds of all respondents (66 percent) say they have gaps in their understanding of profitability, but are working to improve their profitability analytics; another 19 percent say they have not ventured very far with profitability analytics, but intend to do so.
While 63 percent of respondents report that they are spending more time on profitability analysis this year than last year, much work remains to be done. This is particularly true with leveraging analytical results to inform the decision-making process in institutions. Pressures to use data to understand the link between financial results and business strategy are common among financial executives today. Most respondents (91 percent) believe their institutions should be doing more in this area.
66%
11%
have a clear understanding of profitability drivers
say they have gaps in their understanding of profitability
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Measuring Profitability Across Dimensions
With compressed margins and increasing competition, it is more critical than ever for financial executives to identify the factors that drive profitability for their institutions.
When ranking traditional dimensions in order of importance, finance professionals in our first survey widely recognized individual customers as the foundational dimension for profitability measurement.
This year, in addition to the four traditional drivers, the survey added a new profitability dimension, namely the full relationship a customer brings to the institution. Relationship, as used here, involves the
network of connections between customers that may magnify the results of any interaction and impact customer satisfaction and profitability (see the figure on the next page).
When asked about the most important profitability dimensions to monitor, with a “1” rating being most important, Relationships had the highest ranking this year, followed closely by Product, Customer, and Business Lines.
What are the most important profitability dimensions to monitor in your institution?
# 123
Relationships #
Product #
# 45
Customer Channel
Business Lines #
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Measuring the Complete Relationship
The figure below illustrates the relationship concept. ABC Healthcare
is a multi-physician practice with ties to seven other customers and 20 accounts that span commercial and retail business as one relationship.
• ABC Healthcare has a business checking account, a commercial equipment loan, and a line of credit.
• Three of the five partners in the practice also are customers of the institution.
• Jane Smith is also the chairperson for a local hospital’s board.
- The hospital has a business checking account, a commercial real
estate loan on its building, and a line of credit.
- Two of these partners each have a checking account and a savings account.
- The third partner is Jane Smith.
ABC Healthcare
Jane Smith
Business Checking
Equipment Loan
Daughter
Daughter
Mr Smith
Hospital
Checking
Checking
Checking
Business Checking
Line of Credit
Credit Card
Credit Card
Savings
Commerical Real Estate Loan
Student Loan
Student Loan
Credit Card
Line of Credit
Mortgage
Partner 1
Partner 2
» Jane and her husband have two daughters, both in college.
» Jane Smith and her husband have checking and savings accounts, a credit card, and a mortgage.
Checking
Checking
Savings
Savings
» Each of Jane’s daughters has a checking account, a student loan, and a credit card.
One relationship, 8 customers, 20 accounts
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Measuring the Complete Relationship (continued) Knowing the value of a complete relationship offers many important
benefits that impact profitability (see Sidebar).
When asked why their institutions are not analyzing the profitability of relationships, more than two-thirds of respondents cited:
• Challenges in sourcing the data required to perform the analysis (67 percent)
• Lack of tools to effectively and efficiently calculate and analyze results (66 percent)
In addition to these two reasons, 39 percent of respondents from banks with assets of under $1 billion cited another factor:
• Limited organizational knowledge about how to perform the analysis Twenty-six percent of respondents from larger banks also cited this
factor. These data highlight the need for educational initiatives in this area for financial institutions of all sizes.
Benefits of Knowing the Value of All Customers in a Relationship Grouping
• Price loans and deposits appropriately
• Market products and services appropriately
• Share perspective of customer’s value
• Identify sub-par customers, who represent improvement
• opportunities
• Retain “best customers”
• Accurately target cross- and up-sell opportunities
Service best customers appropriately
67% 66%
Cited challenges in sourcing the data required to perform the analysis
Cited lack of tools to effectively and efficiently calculate and analyze results
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Measuring the Complete Relationship (continued)
Many banks and credit unions currently struggle to appropriately define relationship interconnections. This might be due to a lack of connectivity between various data warehouses within the institution, or a lack of visibility to the right data. Additionally, IT systems may have been assembled through dozens of decisions, reflecting different leadership teams and acquisitions and mergers through the decades.
Additionally, relationship managers working with a customer
may not have the benefit of the full picture of the relationship, related accounts, and the impact of their decisions on the overall relationship. A robust profitability tool can identify and quantify all profitability metrics at the individual customer level and aggregate these at the relationship level to help inform specific customer interactions.
•
• About 58 percent of respondents noted that they are not able to
Nearly 59 percent of respondents said their institutions lacked an automated means to create and maintain complex business relationships.
59%
58
%
view the profitability components of all the accounts influenced by one customer—i.e., the relationship value of that customer.
• A higher 69 percent of respondents at institutions with assets of less than $1 billion cited both these concerns.
In some institutions, knowledge of each relationship may reside solely “in the heads” of individual managers with direct customer- facing responsibility. This may be particularly true in smaller banks and credit unions. Such institutions could be at significant risk of losing this information due to staff turnover and incomplete transfer of relationship knowledge during a transition.
said their institutions lacked an automated means to create and maintain complex business relationships
said they are not able to view the profitability components of all the accounts influenced by one customer
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Improving the Accuracy of Profitability Analysis through FTP
Funds transfer pricing (FTP) offers particularly important insight into profitability. Using a system that is designed to calculate accurate FTP rates at the instrument/account level helps financial professionals measure margin contribution across any dimension, such as customers/members, products, organizational units, and channels.
Net interest margin typically is the largest component of overall institutional profitability, so it is critical to get this calculation right for each account. Net interest margin at the account level
includes interest income (loans) or interest expense (deposits)
and the corresponding FTP charge for loans or credit for deposits. Understanding how the various components of net interest margin contribute to overall profitability leads to more informed decision making regarding product pricing and other key decisions.
Answers to the question “Are you using funds transfer pricing?” differed significantly based on the size of the respondent’s institution:
•
•
A significant 72 percent of respondents from institutions with more than $1 billion in net assets use FTP, with the majority of these being users of an instrument-level matched-term approach (64 percent)
and the remainder, a pooled approach (8 percent).
Only 41 percent of respondents from institutions with less than $1 billion in net assets use FTP, with only 19 percent of this sum using the best-practice approach of instrument-level matched- term transfer pricing.
Yes, instrument approach
No interest 13%
13%
64%
19%
19%
37%
No, but plan to
Yes, pooled approach 8%
22%
Other
2% 3%
Larger institutions have benefitted from using FTP, as could a greater proportion of smaller institutions.
>$1B in Net Assets <$1B in Net Assets
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Making High-Quality Pricing Decisions
Pricing decisions are a central piece of the profitability picture. This year’s survey probed further about where and how pricing decisions are made in financial institutions. Key findings include:
• Nearly half (48 percent) of respondents indicate that corporate provides pricing guidelines/thresholds, while approximately 25 percent indicate that corporate central product management defines strict pricing.
• Pricing is done at a local market level in 15 percent of institutions and regions/lines of business provide pricing guidelines/thresholds in 11 percent of institutions.
• Should be considered scores of between 83 and 87 percent went to elements including “income and expenses generated,” “costs plus spread of product,” and “value of the entire relationship.”
• But are they actually considered? Those same elements scored a lower 63 to 68 percent.
• “Volume” maintains a consistent score of 56 percent in both situations.
1%
What should be considered in making pricing decisions? And are these elements actually considered in making pricing decisions?
48%
11%
15%
25%
Regions/lines of business provide pricing guidelines/thresholds
Pricing is done at a local market level
Corporate central product management defines strict pricing
Corporate provides pricing guidelines/thresholds
Other
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Making High-Quality Pricing Decisions (continued) To enhance their pricing decisions, loan officers and other
customer-facing personnel should use information on the current and forecasted value of the current relationship, and then layer
in new loans and deposits. Not taking into account the value of a relationship when pricing new business creates risk that could result in either driving the customer away or unnecessarily diminishing the institution’s revenue through insufficient pricing.
Use of high-quality pricing tools that integrate relationship data has been limited to date industry wide:
• Nearly 57 percent of respondents say their institutions do not
have a pricing tool that allows immediate evaluation of how the profitability of an existing relationship is impacted by a new account.
A pricing tool that includes the forecasted profitability from current relationships enables users to develop new and creative ways to capture and retain high-value relationships. Proactive executive teams will wish to consider putting such a tool in place.
57
do not have a pricing tool for immediate evaluation of the impact of a new account on a relationship’s profitability
%
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Elevating Profitability
Accurate and timely profitability analyses enable institutions to identify the value of customer relationships, which, in turn, inform policies and processes that enhance the customer experience.
Bank and credit union leadership teams can make profitability analyses matter more in their institutions through two efforts: creating an effective steering committee to guide profitability analytics and tying profitability to incentive compensation.
Create a Profitability Steering Committee
For profitability analysis to be truly successful, executive leaders must commit to the process. An effective approach to gain buy-in involves creating a cross-functional profitability steering committee to review metrics, determine methodologies, and institute changes.
Unfortunately, 74 percent of survey respondents said their institutions lack such oversight. This percentage is an even higher 90 percent for institutions with less than $1B in net assets.
One model bank established an effective steering committee that included management executives and professionals across disciplines—from credit and finance to marketing and retail. Finance worked with the steering committee to establish goals, timeline, and milestones. This encouraged ownership of the process, fostered communication, and provided a better understanding of the committee’s value in elevating profitability analysis.
Does your institution have a profitability steering committee?
No 74%
?
Yes26%
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Elevating Profitability (continued) Tie Profitability to Incentive Compensation
A profitability-based incentive plan will align employees with the institution’s overall strategy.
time, effort, and cost of setting up and maintaining a stand-alone incentive compensation management system to support ICPs.
To help ensure success, best practices include:
Sixty-seven percent of respondents say their institutions do
not include profitability as a metric in calculating the incentive compensation of employees, although 41 percent of these • respondents would like inclusion of this metric.
metrics may not be the best approach.
Instead, use of profitability metrics for incentive compensation programs (ICPs) better aligns employee behavior with institutional goals. Additionally, it provides employees with a reward system that can help them maintain a high level of career satisfaction.
Data and reporting frameworks already available as part of high-quality enterprise performance management systems can be leveraged for development and management of profitability-based programs. This saves the significant
Clear communication of the incentive plan’s drivers, assumptions, and calculations
Timely measurement and reporting of plan results
Establishing a direct tie between desired behaviors and compensation
No 67%
Yes 33%
No, but would like to
41%
No current plans
26%
Traditionally, incentive compensation has been tied to loan and • deposit volumes and metrics associated with volume growth. The • banking crisis of the past decade made clear that not all
growth is good growth, so compensation tied to volume
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Managing the Institution’s Margins
How do the priorities and practices in your institution compare to these findings? Are you satisfied with your institution’s approach to profitability measurement and analysis?
With tight margins and continued pressure on earnings, many banks and credit unions are looking to better understand what’s driving their profitability and where they have opportunities for its enhancement.
Front-line managers can unlock access to greater profitability by analyzing and understanding profitability drivers across dimensions that include not only business lines, products, customers, channels, and officers, but also the complete network of relationships each customer has with the institution.
By better understanding and analyzing all profitability drivers, finance executives will have more effective methods to manage their institutions’ margins. These methods will give executives greater confidence in their ability to manage the financial impact of evolving business circumstances into the future.
Kaufman Hall and FMS each provide a wealth of educational resources on the topics of profitability analysis/management and funds transfer pricing. Please let us know how we can be of assistance. Contact information appears on the last page.
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Survey Participants
Job Roles: Approximately 180 CFOs, CEOs, Controllers and other senior finance professionals responded to the survey. More than
76 percent of survey participants hold a Vice President title or higher, with approximately 30 percent of respondents serving on the board or at the C-Suite level.
Asset Size: Approximately 72 percent of respondents were from institutions with less than $5 billion in assets.
VP and Above
C-Suite and Board
Analyst 12%
46% 30%
<$1 Billion $1-$5 Billion $5-$10 Billion $10-$30 Billion $30-$60 Billion $60-$100 Billion >$100 Billion
41%
Manager Other
10%
10%
10% 3%
1%
4%
31%
1%
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2018 Profitability Perspectives
© Copyright 2018 by Kaufman, Hall & Associates, LLC


Survey Participants (continued)
Geographic Location: Institutions participating in the study were spread across the United States and Canada, with the largest representation in the Midwest and Northeast regions of the U.S.
Northwest 7%
West 6%
Southwest 9%
Northeast 23%
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Midwest 41%
Canada and outside the U.S. 2%
Southeast 8% South 4%