Cultural Conversation in Banking

Are your incentives consistent with your strategy and culture?

I was recently interviewed by the Financial Managers Society on this topic, and as a lead-up to my presentation on the subject at the upcoming FMS Forum in Las Vegas in June.

Here are excerpts from the discussion.

FMS: Why is measuring account openings such a misguided endeavor?

JM: If a bank measures product profitability, costs follow activity. Those that don't measure product profitability intuitively tend to believe that the number of accounts drives the work more than balances, even though balances, for the most part, drive revenue in banking.

So if customer A comes in with $10,000, an accounts-driven institution would try to split up that $10,000 between two or three accounts so they can hit their targets. The profit-focused bank, on the other hand, would do what the customer originally intended, and open up that checking account knowing full well that they would get similar or equal spread on the $10,000 in the single checking account, but have less back-office expenses to absorb than if they opened three accounts.

FMS: Which numbers should matter in the quest for better profitability - and why?

JM: Co-terminous spread and direct pre-tax profit - and the trends for both - would create an environment to drive profitability rather than activity. Bankers typically hold lenders accountable for the size of their portfolio and their production. What if they were instead held accountable for the spread (after provision), both in dollar aggregate and the ratio, and the trend for each?

So if Lender A had a $50 million portfolio at a 1.25% co-terminous spread, or $625,000, would that be better than the lender with a $35 million portfolio, with a 2% co-terminous spread? The math says no. But who reaps more reward in today's environment?

FMS: Bigger picture, how can the right incentives lead to a better culture?

JM: We look for the path of least resistance in terms of meeting goals and incentives - it's human nature. If I'm a branch manager whose incentive kicks in if I grow branch deposits by 10%, then I'm looking to do that with the least resistance. So I might call my regional manager daily for CD rate exceptions to get that $200,000 CD, even though with the rate exception, that CD might have a five-basis-point spread.

On the other hand, if I was held accountable for growing my branch's co-terminous deposit spread, would I still chase the CD customer? Or would I maybe seek the operating account at the tire and battery shop down the street, even though that might bring 25% of that CD balance to my branch? Multiply that logic to every profit center within the bank. Now you have a culture!

Bankers: Think about what gets measured.

"What gets measured, gets managed." Why did we need Peter Drucker to point this out? Educators are forever carping about standardized tests because they are spending a lot of time on teaching kids to improve their test scores.

Baseball players are measured on batting average, on base and slugging percentages. So they are spending significant energy to improve them. Why is this a bad thing?

Because in banking, what we measure is not always consistent with where we want our institution to go... i.e. with our strategy. We measure branches by number of accounts opened. And we're surprised that Wells Fargo gets accused of opening accounts without customers' knowledge. We measure lenders by size of portfolio, and we're surprised that we drop rate, points, and covenants to get deals done.

I recently did a podcast for PrecisionLender regarding this subject for lenders entitled: Using Bank Data to Get Better Results. That's right, I did a podcast. I only learned a few months ago what a podcast was.

But if you didn't invest the twenty minutes to listen to the interview, I'll exemplify my comments about another way to measure lender performance. The age-old measure by portfolio has led to what we have today... lenders willing to make any concession to get a deal done. A done deal is the best deal.

But what if your strategy revolves around superior service to a certain commercial customer segment? How would you measure it. Most likely the size of the lenders portfolio plays a part. But should the lender be the best price if he/she provides the best advice? That runs the risk of providing Four Seasons service at Motel 6 prices.

So I suggested using different measurements, such as coterminous spread, coterminous spread less provision, pre-tax portfolio profit, and ROE. See my suggestion exemplified in the table below.

Now this lender's portfolio may be considered small, at $30.3 million in the current period. But it has been growing, while maintaining its spread. When considering the provision expense, which brings credit quality into the picture, spread has grown from 1.95% to 2.01%, all while growing the average balance of the portfolio.

You can see this portfolio took a credit hit in CP-1, as the provision spiked a bit, possibly due to a loan downgrade and the resulting provision increase. 

But overall this lender's trend is good, as represented by the ROE increase from 15.89% to 17.34%. Which brings us to a second report I suggest for lender accountability, the Schmidlap National Bank Lender Ranking Report.

It is clear from this report that Jeff's portfolio is relatively small, ranking him 8th of 12 lenders. This contributes to the bottom half ranking in Net Asset Spread on a dollar basis, Net Asset Spread Less Provision on a dollar basis and ROE.

But the portfolio is growing, ranking him 3rd, and the Net Asset Spread percentage has him 2nd, even when considering the provision. So there are some positives in Jeff's performance. Which is good because I wouldn't want to be let go from my fictitious lending job at a fictitious bank. 

Imagine the behavior that would ensue if you held your lenders similarly accountable? The performance review would go like this: "Jeff you are doing an excellent job maintaining pricing while growing your portfolio with strong credits. Your biggest challenge is continuing to grow the portfolio. For this upcoming period, Schmidlap will do x, x, and x to help you accomplish this while staying in the top quartile for spread. Let's do this!"

I know Jeff pretty well, and being ranked in the bottom half of his peers won't sit well. Let me get back to some fictitious work!

How do you measure lender performance?

~ Jeff