Wednesday, May 02, 2012

Is branch profitability out the window?

About 10 years ago my firm analyzed the hundreds of branches in our profitability database to determine exactly what is "critical mass". We sorted by pre-tax profit contribution as a percent of branch deposits, and further sorted by "direct" profits and "fully-absorbed" profits.

The results were not surprising to me. In order to be profitable on a direct cost basis, a branch needed to be $9.5 million in deposits, on average. Fully absorbed cost bases... $18.7 million. In order to deliver a pre-tax profit of 1.5% of average deposits, the branch needed to be $23.6 million.

A note about the data: Branch spreads are calculated using funds transfer pricing (FTP) on a co-terminous basis. This means that interest rate risk is removed from the equation. Deposits receive a funds credit for a similar or identical duration market instrument, such as a Federal Home Loan Bank borrowing. Branch loans similarly receive a funds charge. Fully absorbed costs include allocations from support functions such as Deposit Operations and IT, and overhead functions such as Finance and Executive.

In preparation for a banking school where I am scheduled to teach this month, I recreated the analysis, knowing that the average branch deposit size went up. The results were alarming (see table).


Today, based on the revenues generated and expenses incurred, a branch must have $31.3 million in deposits to break even. To absorb the army of support personnel, systems, and facilities serving it, the branch must be $61.5 million. To generate a 1% pre-tax profit, it must grow to a whopping $121.8 million. That's New York City big, folks.

How can this be? One reason is the extended interest rate environment, where checking accounts can't go lower than 0% interest. The market based credit, or re-investment rate, has been very low for quite some time. Perhaps you hear your CFO lamenting that he/she has no place to put more deposits. This has caused the spread on deposit products to be a historic low of 1.23%.

Another reason is declining deposit fees. When bankers began implementing automated overdraft protection, the bounce in total deposit fees as a percent of deposits was palpable, typically 50 - 60 bps. Today, due to regulation and customer behavior changes, deposit fees as a percent of deposits range between 30 - 40 bps, a noticeable decline.

Lastly, bankers have not adjusted the branch model fast enough to compensate for declining revenues. We typically have six or seven staffers, mostly tellers, in spite of transaction totals being low and trending lower. We maintain the high real estate costs from the branching boom of the late 90's through the mid 2000's. So branch expenses remain around $600 - $700 thousand per year in operating expenses. Indirect expenses to run a branch (Deposit Ops, IT, overhead, etc.) add another $500 - $600 thousand to the expense pool. This is quite a millstone to overcome when the average branch is generating 2.02% in total revenue as a percent of deposits.

In order to bring back branch profits, three things need to occur, in my opinion: 1) drive more revenues through branches in the form of small business and consumer loans, and right size our deposit mix to maximize spread, 2) re-tool the branch model, using fewer full-time equivalent people with multiple skill sets including business development, customer service, and transaction processing... and have less space, and 3) hope for the spread miracle that will come when the Fed has had enough with zero percent at the short end of the yield curve.

Yes, I said hope. How do you think FIs can increase the profits in their branches?

~ Jeff

2 comments:

  1. Or maybe instead of trying to resuscitate a corpse, Community Banks could focus on delivering value to their customers? What is so magic about a branch anyway? It's just a place with your Bank's sign on the front... What is it about this dying service and (hmmm...) sales channel that bankers simply cannot forsake?

    Imagine how much more productive and efficient a Bank could be if it simply redirected the investment of just one branch - a minimum of $1 million in annual expenses - to product development & real consumer marketing? WOW!!!

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  2. Serge,

    Perhaps the model may transform into a hybrid bank rather than a pure Internet play, such as EverBank in Florida, or Bank of the Witchitas in Oklahoma. Even Charles Schwab balances its online presence with bricks and mortar.

    What do you do with all of the customers that respond to surveys that a physical presence is very important in deciding where to bank?

    ~ Jeff

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