Importance of Managing Customer Profitability
May 4, 2011
By: Larry Martin
The financial services environment in banking over the past 5 to 6 years has created a false sense of security for most community banks. During the period, most community banks have experienced substantial growth and profits have been good. (Remember, we wrote this article prior to 2008.) Much of this growth was not due to superior operating abilities or strategies of community banks, but was due to customer dissatisfaction with post-merger service of bigger banking companies or irrational pricing and structuring approaches of community banks in loan deals.
Continued success for community banks will require a number of new disciplines and approaches. The focus of this article will be on only one of the required new disciplines: Customer Profitability Systems.
Customer profitability is becoming a requirement for community banks for several reasons:
1. Profitability among households and businesses varies widely from relationship to relationship, requiring informed and segmented decision-making.
-In retail banking, 20% of the households account for 200% of the banking industries retail banking profits, the next 60% of households are a break even for the industry and the final 20% of households are a loss to the tune of a 100% of the industries Retail banking profits.1
-In small business banking, the top 10% of small businesses account for 40% of the banking industry’s profits and 30% of all small business customers are unprofitable to banks.2
2. Profitability isn't always coming from where banks think it may be coming; knowing your bank situation can make a big difference.
-In some cases banks today earn more in aggregate from moderate and even low-balance income customers (households and business) than they do from better-heeled ones. That is because a fair proportion of the latter have already turned over the bulk of their business to other banks and non-banks. These institutions are cherry picking away these “cash cow” customers from community banks with targeted marketing efforts.3
-Not all customer leaving big banks are doing so because they are dissatisfied with the service. The banks often incent customers to leave by raising the pricing on their loans since they represent either higher risk or to improve profitability in order to achieve internal hurdle rates of return, or both.
-Banks often find their least profitable customers are the ones they see the most in the lobby-their most costly delivery system. They are familiar to everyone, ask for favors on pricing and fees-and usually get their requests granted without any formal process to evaluate whether they warrant the "favor" and thereby, further undermine the relationships profitability.
3. The mantra in the industry has been and still is "sell, sell, sell" and "cross-sell, cross-sell, cross-sell" which can worsen a situation instead of improve it if not done properly.
-The focus in cross selling is usually on getting more bank product and services used by the customer. Many customers often do not have enough funds to keep from overdrawing their checking account, let alone maintain one or more deposit accounts. Their finances may be such that they cannot or do not borrow in large enough amounts to offset the losses in the deposit accounts.
-Said another way, not every customer should be sold the same set of services. Even two Senior Citizens are going to have different situations and circumstances that require different approaches-the same is true with business customers, professionals and every other customer and prospect category.
Power of Managing Customer Profitability
Knowing and managing customer profitability has tremendous potential to improve individual bank results. In this example, we are a $100 million bank with a 1.28% after-tax ROA. For purposes of the example, we will assume all of the bank's 5,120 customers are retail household customers.
Using Bank Strategies LLC's and other firms' findings on distribution of profitability and making some assumptions on each segments impact to the balance sheet, the customer base looks as follows:
Using these numbers as the starting point, we will look how the profitability of the bank changes over a five-year period as the bank explicitly manages customer profitability.
Assumptions for Managed Customer Profitability:
1. The bank keeps the entire Top 20% of customers and maintains their profitability level.
2. The bank moves 1/6 of the middle 60% to a 1.00% ROA each year.
3. The bank moves 1/6 of the bottom 20% to break even each year.
4. We do not add any new customers during the five years and the asset size of the existing relationships does not increase.
Managed Customer Profitability
An increase to the bottom-line of 98% or $1.3 million-the effort certainly pays for itself. Industry requirement or not, why wouldn't a community bank want to retain their current top 20% of customers, make informed decisions on pricing, and dramatically improve overall bank results while still being a good corporate citizen?
So the question you are asking yourself is how does a bank move in the direction outlined above? First, you need to have a relationship profitability module as part of your core processing system. This will require significant input and work from the CFO, CEO and other executive officers in the bank to agree on transfer pricing approaches, allocation of support function overhead and so forth.
You then need to identify and group your business, households and other customer into their respective profitability buckets. Then you need to decide on the priorities and strategies you will use to begin to improve profitability over the next several years. Will you start with retaining your most profitable customers and strengthen their relationships to tie them to the bank, or will you focus on those least profitable and begin to identify and work on improving their profitability through capturing other bank services they hold at other banks or through price changes?
The process also requires management to think about the skills and abilities of the people assigned to various customers and the strategic objectives with the customer. Do customer management personnel have the necessary skills or do you need to improve the skills in key areas? In addition, do you have the right product line and pricing or should changes be considered?
In addition, what do your most profitable customers think about the bank and are they willing to refer the bank to family and friends and other business associates?
1 First Manhattan Consulting Group and Bank Administration Institute Study
2 First Manhattan Consulting Group and Bank Administration Institute Study
3 First Manhattan Consulting Group
Improved profitability is achievable, but it requires a comprehensive strategic customer relationship approach that starts based on understanding current profitability of each customer’s relationship. Bank Strategies LLC and our alliance partners can assist you with your efforts in these areas.
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