Manage What You Measure: The Perverse Math of Banking

The banking industry is often plagued by misplaced priorities, with resources misdirected in personnel, technology, products, and marketing. Why? Because we don't measure what truly matters.

Consider the common questions that reveal this measurement gap:

• Why are disruptors needed to develop customer-demanded banking products or create demand for new ones? 

• Why do pundits offer platitudes instead of practical advice on what a bank branch should be? 

• Why is "white glove service" focused solely on customers with large balances? 

The Misleading Metric: Balance vs. Value

When we look at two hypothetical customers, Jane Doe and Joe Buck, the flaws in current value perception become clear.

The Perverse Math: In current banking math, Joe Buck is valued more and assigned the most capable bankers because of his greater balances. However, while it would take five Janes to match one Joe’s pre-tax profit, Jane is a stronger candidate for "relationship banking" and requires significantly less capital. The underlying issue is that bank revenues are often calculated as simple spread x average balance. As banks grow, this leads them to prioritize larger, more transactional, and commoditized loans. The continuous pursuit of "Joe's" leads to concentration issues, funding issues, and greater commoditization of our bank.

From "Worry" to "Action": The Power of Measurement

The lack of measurement turns potential improvements into unproductive "worry". A classic example is a bank worried about the attrition of its Passbook Savings accounts, which still had significant balances at one of our clients. If they had measured product profitability, they would have a basis for action:

• An assigned product manager, seeing the trend of declining balances, numbers of accounts, and profitability, would make necessary modifications.

• The discipline of continuous profit improvement enables the financial institution to evolve a product from being demanded by few to something more in-demand.

  
  

The same principle applies to managing branch systems:

• By measuring the profit performance and trends of each branch, managers can be empowered to try new strategies to improve struggling locations and maintain strong performers.

• Continuous feedback loops, judged by improved profitability, allow successful strategies to be implemented across other branches.

• The result is an evolved branch system, with resources re-deployed from unprofitable branches into more promising markets.

The takeaway is simple: If we don’t measure it, we can’t manage it. Continuous profit improvement is the key to evolving products, targeting and providing white-glove service to the most valuable customers and segments, and optimizing resource allocation.

By not doing it, we don't evolve, leading to draconian efforts to modernize our products and branches so we can focus on serving our most valuable clients. By not doing it, we are less relevant today as we were yesterday.

And I want my readers to be around for a long, long time.

~ Jeff

 

The Valuable Bank Customer

Over the past two weeks I taught at two separate banking schools. What value do I get from teaching at banking schools? Learning. So often I am trapped with bank executives that carry career-long paradigms with them. Some are beneficial, such as knowing when you should say no to a loan, even one that meets your Debt Service Coverage Ratio (DSCR) hurdle. Some paradigms, however, become outdated because of our changing industry. 

Such is the case for our funding strategy paradigms.

But bankers that are newer to the industry carry no such paradigms. And I was interested to hear how their bank is navigating the challenging deposit environment when they compete with names such as Capital One and Sofi Bank, both of which have much higher-yielding assets than the local community bank and therefore can pay more for deposits.   

I wrote about this extensively in my book, Squared Away-How Can Bankers Succeed as Economic First Responders. Specifically in Chapter 10, The Hot Rate Stalemate. In that chapter, I distinguished between Store of Value versus Accumulation Accounts. One was price sensitive (Accumulation), the other not so much. They key is to have a blend that will deliver a superior cost of deposits. 

This is where the back and forth with students was valuable. The bankers who specifically dealt with deposit customers, either retail or business, discussed the challenges of offering so much less than the Capital One's of the world. Here is an example of what I wrote on the board:

Question #1: What is the value of a relationship? 

Does a customer value the relationship manager and the bank, the branch location, the customer experience, the work you do in the customer's community, and the fact that you lend the vast majority of deposit dollars into the customer's neighbor's home or the local business? 

I think they would, if it is well-positioned, visible, and meaningful to your customer and his/her community. The community bank could do a far better job at positioning the value of your bank beyond price.  Your customers make premium pricing decisions almost daily. Why not for you? 

I don't think, however, that the difference a customer will pay to bank with you versus a competitor is significant. The example above shows a 50 basis points rate difference between Capital One and you, or $500 annually for an account with an average balance of $100,000.  That puts the value of your relationship at 50 bps, which is good except that the average direct operating expenses to average deposits in the hundreds of branches that my firm measures is 99 bps, an expense a branchless bank does not have. Somewhat offsetting this disparity is the average of 35 bps of fee income to average deposits in branches.

Question #2: Is the customer price sensitive in his or her specific account? 

The answer to this question is rarely known but should be discovered during the account opening process (know your customer should be more than a compliance exercise). If not known during the account opening process, perhaps technology could answer this question based on how it is used, or some good old gumshoe investigation by the relationship manager. 

In the above example, Capital One hypothetically thinks the customer is price sensitive in every account. We intuitively know this to be untrue. I have no idea what I'm earning in my checking account or the account that I use to accumulate money for taxes and my next vacation. But if the Money Market Account was my family emergency fund, I would likely want a competitive rate. Community banks should know what's what in terms of what an account is for and what the customer's price sensitivity is.

The above customer collects 2.47% in interest from their community bank. Assume this customer pays 35 bps of fees, and the net cost to the bank is 2.12%. The transfer price on this deposit relationship, assuming a four-year duration is 3.85%, driving net revenue of 1.73% (3.85%-2.12%). This would be a much more profitable relationship than just getting the $100,000 Money Market Account at a 10 bps spread (3.85%-3.75%) because that is what Capital One is paying. 

This math should drive funding strategies into the future. We can no longer rely on Rip Van Winkle customers accepting 250 bps less than branchless banks because the customer is not paying attention to what you are paying them in their price-sensitive accounts. It erodes trust, is easier to uncover, and easy to switch to a competitor. There is a reason why FDIC-insured banks lost $900 billion in deposits during the last Fed tightening and money market mutual funds gained $900 billion.

Our cost of funds should be managed by mix of funds. 

Few of my banking students knew this math. Shouldn't all of them know it? For my students, they know it now.

 

~ Jeff

Bankers: Ask What Customers Want. Then Do That.

Steve Jobs showed customers what he thought they would want, and convinced them that they wanted it. An unlikely scenario for bank products, wouldn’t you agree?

So what do your customers want?

This presumes you know who your target customers are. Bankers used to try and be everything banking to everyone in the towns where they had branches. This approach left the legacy of the General Bank. Where the answer to the question on what your bank is known for was “nothing in particular”. Or the most common bromide, “superior service”. We’re still either stuck on this legacy or are shedding it at tortoise pace.

Identifying your target customers does not mean you will not serve others. But who do you want your front line people focused on? What processes do you want to streamline first in your support functions to provide superior service? What technologies do you want implemented right away?

The answer to the above should be based on your strategy. And your strategy should be based on target customers. And target customers should provide sufficient quantity, growth, and margins to serve and meet your desired profitability. 

Next question… what do these customers want? 

Take SoFi as an example. Their desired customers are millennials with college degrees that typically result in higher paying jobs. Pretty specific. They started their company refinancing student loans, because their target audience was graduating college, and many of them with high impact degrees such as lawyers or accountants had mountains of student loans.

As their target audience ages, they are moving on to other financial needs, such as car loans and mortgages. In fact, SoFi applied for an industrial loan bank charter to offer banking services to their target customers. They later withdrew because their CEO left. But still, here is a company focused on their target customers and were building the lineup of products they demanded.

How about you? If your audience is small businesses, do you offer the lineup of products they want? Bankers frequently impose limits on their product set based on what they want to put on their balance sheet. Must this be so?

I marvel at the ROE of the New York City loan broker. Many if not most loans (other than the very large ones) in NYC are handled by loan brokers. They match borrowers and lenders. For a fee. Like 1.25% of the loan balance. So a $3 million loan deal, chump change in NYC, yields a $37,500 fee for a guy/gal that has a storefront in Astoria, Queens. 

Back to the small business. What if they want early stage funding and that type of lending doesn’t fit your bank’s risk appetite? Why can’t you broker it and match them with a partner that does? There are partnerships you can forge with non-competitors to meet this customer demand. It’s not like you haven’t done this before. How about SBA lending, or merchant services? You likely partner with someone to provide these services.

Why not identify all of the financial products and services your target customer segment demands. And figure out how to offer it.

Or, you could send them somewhere else.

How do you meet the financial needs of your target customers?

~ Jeff


Note: This is my last post of 2017. I want to let all of my readers know that I appreciate your readership and comments. Thank you! And have a safe New Year celebration and a blessed 2018!

Three Ideas for Banks to Reverse the "Silvering" of Their Customer Base

Are your customers older than your markets? A common theme among students that expressed concern about it during our Executive Development Program (EDP) sessions in Seattle, Montana, and Salt Lake City.

Customers leave their banks for the 4-D's: Death, Divorce, Displacement, or Dissatisfaction. Three of the four are life events outside of our control. And with switch rates that have persistantly hovered around 10% of total customers, how do we get 'em in, and keep 'em in?

Here are three ideas.

What other ideas do you have?

~ Jeff

Should Banks Jettison Unprofitable Customers?

No.

I will tell you why in a moment, but first why I thought of this question.

Alan Weiss of Summit Consulting penned a book called The Consulting Bible (see my bookshelf if interested in the book). In it, Weiss suggests you jettison the lower end of your client list when you win new clients. His reasons:

• The client is no longer profitable.
• You are bored with the work.
• The client is troublesome.
• The work is unpleasant.

Financial institutions rarely go through such an exercise. In fact, I am currently preparing for a meeting with a client to discuss what to do about unprofitable branches. It has always been challenging to advise clients to reduce rather than to add. But to add value to customer interactions in banking, we have to dedicate time to making our customers situation better, in some way. Continuing to rely on having a nearby branch or a mobile app to add value will solidify our position as a commodity, in my opinion.

Instead, what we can offer customers is hassle free banking, improved financial condition, and peace of mind. To do that, we need talented employees with time. Time cannot be expanded. Giving 110% of your time only makes sense on a t-shirt.

But unlike consulting, financial institutions make most of their revenue on the spread. If an unprofitable customer keeps $10,000 in deposit balances with you and you can re-deploy that money at a 3% spread, then you generate $300 in revenue on very little marginal cost. Letting that customer go to a competitor will not reduce employee or occupancy expense. In fact, you would experience very little cost reduction (FDIC insurance and possibly a small data processing savings). 

But what you can do is push customer service to the appropriate level based on the value of the customer to you. Keep your most talented employees reserved for your most profitable and strategically important customers. Because those customers have the greatest potential to appreciate the value your FI brings to their situation. Growing high value customers while properly serving commodity customers is critical to improving your FI's relevance and breaking the commodity cycle.

Any stories out there about identifying and serving high value customers appropriately?

~ Jeff

Customer Profitabilty in Banking: Do you do it?

According to an ABA survey (see table), I doubt it.

I am speaking at the upcoming ABA Marketing Conference next week. Well, maybe not as much speaking as appearing. Mary Beth Sullivan and I are appearing as guests of Susquehanna Bank's Susan Bergen, in an Oprah like talk show format. I suggested Saturday Night Live's Point-Counterpoint format, but it was rejected. To appease my objection to appearing on Oprah, they orchestrated my entrance to a Pitbull song. I did not know who Pitbull was.

Our discussion will revolve around an ABA survey done this summer regarding actions banks have taken, or intend to take, to improve profitability. One question that didn't make the cut in the interest of time, was the one represented in this post's table: Does everyone in management know profitable versus unprofitable customers the bank serves today?

If you were in the corporate headquarters of McDonald's, you would be alarmed at the results. If you are in banking... not so much alarmed as happy that so many others remain as in the dark as you. I think lack of knowledge of profitable customers comes from three things:

1. Getting such a number requires investment in resources your FI currently does not have:

2. The regulators don't require the information; and

3. Even if you had the information, what would you do about it anyway?

All are related. FIs earn money on the spread. In order to create spread, FIs focus on creating a basket of the highest yielding assets within risk parameters, while funding them with a basket of the lowest costing funding. Why do you need some fancy profitability information to tell you that?

Problem: Various assets and liabilities take differing amount of operating expenses to accumulate. Also, based on risk, different assets and liabilities require different equity allocations. If your attitude is that the "incremental" cost of chasing this business or that is minimal, you may very well be mis-allocating your precious resources to low profit customers.

For example, we have a client that served the bar/restaurant business in a college town. These establishments brought decent balances to the bank. The problem: we found employees that spent half their day sorting through the bag-fulls of cash delivered every day. Could the bank allocate that operating expense to a campaign to acquire and serve higher profit customers? Without determining the profitability of those customers, we would never know about the opportunity lost.

I think it's time to change the paradigm from acquiring the highest yielding assets and the lowest costing liabilities based solely on interest earned or cost of funds. We should instead focus on acquiring and serving baskets of the highest profit customers. Doing so will efficiently allocate resources, improve our profitability, and enhance our FIs value.

~ Jeff