A Data Driven Approach to Profitable Growth

At Baker Hill, we spend a great deal of time helping our clients bring finance, marketing and sales together to create profitable growth. Our focus is not on building a balance sheet at the expense of income, but instead building a balance sheet while growing net income. This is an important distinction that sets highly effective banks apart from their peers.

Cross-selling everyone something is a great way to grow your assets while reducing your profitability. It’s also expensive to execute. A financially compelling approach is to segment your customers and target specific offers that they have the propensity and capacity to purchase. This approach has the benefit of reducing retention risk, reducing profit concentration risk, and growing profitable relationships.

What becomes clear when you implement bottom-up profitability analytics is that the majority of products, customers, markets, branches, and officers are just not profitable. Most banks generate all of their profit from the top 20% of their customers; 80% of your customer relationships are not profitable. Doesn’t it make sense to pay attention to how you’re growing your institution? In this article we will lay out how to profitably grow.

The following Decile Report indicates that the top 20% of Relationships generate 379% of the banks profit.

Chart P1

Rules of Thumb for Profitability Analysis

The best way to understand profitability is to do a bottom-up analysis. For profitability analytics, you want to avoid industry averages. You also want to avoid using average profitability. You don’t want to make top-down assumptions or non-interest expense allocations based on revenue percentages. The best approach is a microanalysis based on your organization and your general ledger. This means you have a complete balance sheet and income statement allocation and the allocations are at the account level based on account specific characteristics. For example, if an account makes a teller visit, the account gets a teller visit expense allocation. If an account generates interchange, the account receives an interchange allocation.

You build an income statement for each account by fully allocating all the non-interest income and non-interest expense. Interest margin allocates through funds transfer pricing. Expense allocation is a zero-sum game. If you remove an expense from one account, it must be allocated to another, so all expenses are accounted for and tie to the general ledger.

Here are two account level income statements for the same type of accounts. Note the profit differences and how they are derived.

Both accounts have the same small balance. The first account, labeled chart P2 has non-interest ATM Fees and Interchange- ATM, which drives the accounts profitability.

Chart P2

The second account, with a similar balance, is not profitable. The source of the non-interest expense is teller visits. The account has no Interchange income to offset the teller visits.

Chart P3

These detailed allocations at the account level allow us to create a product with embedded characteristics which drive the behavior requirements of a profitable account like Visa Debit, direct deposit and ACH.

With detailed allocations at the account level, we can quickly create the same detailed income statements for every relationship, each product, each market segment, each branch and every officer.

Best Places to Focus

A focus on profitable growth requires that you measure profitability at five levels. They include relationship, product, market segment, branch and officer. Now that we have bottom-up profitability for each level, let’s see how we apply them to grow our balance while also growing our net income.

At the relationship level it’s important to understand what’s driving profitability and what relationships may be at risk. Start with a simple segmentation of your customers by profitability and put them into 5 segments; A through E.

Chart P4

The A segment is the most profitable 10%. This first segment may very well be the source of 100% of your profit. Note in the chart P4, Segment A is 145% of the banks profit. In many instances we see the top 10% Cross Sell Service Ratio being very close to the bottom 10% ratio. This is an indication that just selling more products to your existing customers is not the right thing to do. This is building your balance sheet at the expense of your income statement.

In chart P4, we set Segment C to breakeven and force 10% of relationships into that segment. We also force 10% into segment E and segment A. This leaves segment B and segment D to be defined by the relationships in neighboring segments. In chart P2 we see that Segment B is 20% and Segment D is 50%.  Segment B contains 57% of your profit and 20% of your relationships. An ideal strategic initiative to increase profitability and reduce concentration risk is to build segment B to reflect 30% of your relationships. Based on chart P4, you have 25,970 D relationships and 5,194 C relationships to target with cross sell campaigns designed to move them into that segment.

Quickly Identify Retention and Concentration Risk

We further deconstruct the top 10% and create deciles to understand the source of the profit within this segment. See chart P5 for an example. Notice that 80% of total profit reside in the top 1% of customers.  This is where your retention focus should lie and where your concentration risk is revealed.

Chart P5

With your 5 segments in place you can identify relationships that you want to nurture, retain and cross sell additional services to.

Product Optimization and Customer Behavior

Product level profitability allows you to identify products and their characteristics that generate the greatest returns for your bank.

Chart P6

This is where what if analysis combined with profitability allows you to optimize products and pricing. This is also an area to think about customer behavior like use of the electronic services, debit, interchange fees and teller visits.

Product development should consider the behaviors we are trying to create with our customers through creative, thoughtful incentives. Use product level profitability to reprice products based on hurdles. Set minimum pricing at breakeven and package products to maximize profitability on a combination basis.

Use your profitability analysis to identify market segments that contain profitable growth opportunities. As an example, you could review all your customers with $10,000 or more in deposits. These high deposit households can be further segmented into single service, transactors, and credit users.

Review the profitability for each segment. Ask yourself, what accounts do these relationships have in common? What transaction types are common? What combinations of products drive profitability?  Which products are single service? Which create retention risk?

A customer’s previous behavior tells you their propensity and their capacity for deepening their relationship with you. High deposit households have money elsewhere and are a great target for cross sell deposits. Those that do use credit have a strong capacity to borrow and are ideal cross sell targets for additional credit products, especially home equity. This type of segmentation should be used to create marketing campaigns that are highly targeted and call lists for branch and officer use. Since existing customers have already proven their propensity to work with you, it should be the focus for profitable growth.

Branch Profitability – a Different Approach

Review branch profitability based on the relationships assigned to that branch. This is not a traditional stand-alone branch income statement but a focus on the accounts held by the relationships assigned to each branch. This is an aggregation of the accounts owned by the customers assigned to the branch.

This approach allows you to assess any size branch based on how they are building their business. This view allows you to see whether the branch is adding profitable accounts. Based on the number of relationships, does the branch stand a chance at adding positively to the income statement? What needs to change to make the location profitable? In chart P7 we can see similar size branches with materially different profit contributions.

Assess the contribution of each branch to the income statement as show in chart P7. Align branch manager compensation with income generation and balance sheet growth. Develop a plan for each unprofitable branch with a focus on improving non-interest expense and non-interest income. The profitable branches can provide the path to getting there through a review of product mix and demographics.

Chart P7

Shift your staffing to high profitability branches. Provide branches with regular calling list and scripts based on profitability potential. This aligns your resources with the source of your current profit, your growth while reducing retentions risk and concentration risk.

Officer Productivity and Incentives

Officer incentive plans should include a focus on profitability. Each officer should understand what drives profitability, which customers are the most profitable and where they should focus.

Chart P8

An account-based income statement is easy to read and understand. Aggregating these under each relationship makes it clear how relationship profitability is generated. You should provide officers with regular calling lists and scripts based on profitability potential.

Driving profitable growth is much easier if you understand how you are driving net income.  A bottom up profitability analysis allows you to identify the source of your profit at the account level. From there, you can aggregate accounts and get to profitability at the product, relationship, market, branch and officer. Using this data, you can make decisions that can reduce retention risk, reduce concentration risk, and increase net income while building your asset base.

Author Bio

As the Manager of Implementations for our profitability model and over 15 years’ experience, Jeff Dwornicki leads the discussion for funds transfer pricing and expense allocations to reflect the institution’s own reality. He understands that every institution has different outlooks and environments, so flexibility in taking different methods to fit each client is one of his strong suits.

Jeff manages all Implementations of new financial institutions for the profitability model for Baker Hill. His background with general ledgers and understanding allocations within the model allow him to guide new clients to build the best model for their needs.