Today’s tight margin environment makes it difficult for financial institutions to maintain profits. Those that don’t understand the sources of that profitability will continue to struggle the most.
Measuring the profitability of relationships is often deemed too difficult due to a lack of data and tools that accurately create and analyze these complex relationships. By compiling and leveraging this data, relationship profitability information moves from the back office to the front lines, where it can be used to make decisions that improve customer service and the value of key clients.
Consider this: Can you easily rank your client relationships from most-to-least profitable? And does a client’s position on that list influence your interactions with them? The answer to both questions should be “yes,” if you want to ensure your institution and your clients receive maximum value from the relationships.
1% of Clients Drive Institutional Profitability
Industry studies show that an institution’s top 1% of clients contribute the most value to overall profitability, which makes maintaining each of these relationships critical to institutional health. To get an accurate picture, an institution must understand the totality of the relationship.
Full relationship management should consider an individual’s scope of influence, which includes his or her business and personal networks. Understanding these ties can influence client loyalty and institutional profitability.
In a 2019 survey, 69% of CFOs and senior leaders in North American financial institutions indicated they cannot view the total value of any one relationship. Without knowing how to empirically value relationships, an institution cannot make meaningful changes to boost profitability.
Understanding the value of each relationship offers important benefits that impact profitability, including the ability to:
- Retain and expand relationships with your best clients, pricing loans and deposits appropriately and providing excellent service
- Identify sub-par clients, who represent improvement opportunities
- Market products and services appropriately to maximize success of cross- and up-sell efforts
Use Historical, Future Approaches to Measuring Profitability
Sixty-eight percent of survey respondents say their institutions lack an automated means to analyze the profitability of complex relationships. Respondents cite lack of data (45%) and lack of analytics tools (55%) as top impediments to relationship profitability analysis.
Once your institution can effectively build and manage relationships, it’s critical to use a robust calculation and modeling engine that measures both historical and forward profitability.
A consistent approach between historical and projected profitability is vital in how you analyze profitability across the organization, products, branches, and relationships. Agree on methodologies for calculating and accessing the source data across dimensions, and define each calculation needed — i.e. the net margin calculation, including the Funds Transfer Pricing (FTP) charges and credits; allocation of non-interest income and non-interest expense; provision for loan loss; and calculation of net profitability — to arrive at the Risk Adjusted Return on Capital (RAROC).
Institution leaders can accurately predict future performance based on factors such as runoff of the current portfolio and the effect of new business. Additionally, performance by individual relationship managers can be used to guide incentive compensation, inform coaching opportunities, and identify best practices used by top performers.
By understanding how each relationship in a portfolio performs, relationship managers can prioritize their business development and account management efforts, focusing extra time on the top and bottom deciles.
Adding Value to the Relationship
Once you understand your client’s sphere of influence and empirical profitability, each deal you make should add value rather than dilute it.
The ability to understand how proposed new business impacts profitability hurdle rates (such as RAROC) and the ability to compare pricing scenarios before making a deal empower relationship managers to achieve a win-win for the organization and for the client.
For the institution, value is created through:
- Enhanced earnings
- Retained or improved relationships (especially those in the top 1%)
- Profitable growth
- An effective and efficient process for loan officer and other relationship managers
For the client, you create value by:
- Delivering an increased level of service appropriate to its magnitude of business
- Providing multiple options to best structure deals to meet individual needs
- Promoting a strong relationship with the institution, focused on long-term value
A Winning Strategy for 2020
Financial institutions continue to face tight margins, challenges in growing loan and deposit levels, heavy competition, and continued pressure on earnings. Understanding the value of each relationship and the impact on profitability can help financial institution leaders create more profitable growth.
Ken Levey, Vice President Financial Institutions Software, Kaufman Hall/Axiom Software