Many bankers use this equation:
Shareholder Value = Net Interest Margin
However, the equation really looks like this:
Shareholder Value = Discounted net cash flow of customer relationship x probability of recognizing net cash flow
This equation applies to every current and potential relationship at the bank. The first part of the relationship is the complete value stream discounted back and includes loans, deposits, fees, costs and life of the relationship. The second part is your risk component and not only takes into account credit and operational risk, but also the optionality of the relationship cash flow – most importantly how long the customer’s relationship will last at your bank. Banks want the largest, longest and most stable net cash flow stream possible when it comes to generating relationship profitability.
Now ask yourself honestly: Do you really think this way when you are underwriting a relationship? Most loan officers get a credit that they will accept and then try to get the best price. This approach tends to be one dimensional. As pointed out above, both return and risk are multi-dimensional and a bank’s return is partially derived from the interplay between each component. Further, when managing a credit portfolio you can also add to the equation leverage and how each credit might offset the other.
In banker’s defense, this is how the industry was taught: find acceptable credit, get the best price and then put it on your books. Probabilities, leverage, structure, optionality, referral value and customer terminal value are distant consideration if considerations at all.
The problem with the traditional way of thinking is that making a decision on a loan without respect to structure or overall customer value is asking the wrong question. The issue is not which credit will pay off, but which customer or portfolio of customers will offer the best risk-adjusted return. Banks need to think about managing customers for profitability before managing loans, deposits and products.
Working backwards in terms of importance, the objectives look something like this: 1) Put the right products in place; 2) Manage individual loans, deposits and services; 3) Manage aggregate assets, liabilities and capital; and 4) Manage customer relationships. The end result should be a very profitable bank. Profitable customers using profitable products managed in a profitable way equals a superior performing bank.
The concept of taking a relationship’s account may sound elementary, and many bankers may think they are following this principle, but few actually do. Under the mindset of relationship management, everything but the relationship’s return and the probability of that return fades from view.
There is no such thing as “bad” or a “good” when describing a customer or credit in a bank – only mispriced risk. A low quality credit customer can generate the most fees for the bank, while a highly profitable customer can be ruined by selling them a high yield CD. A commercial loan at Prime minus 1% may be unacceptable for many banks, until you realize that the customer has a terminal value of almost three times your average customer.
It is not enough for bank management to have a strategy of booking acceptable loans and deposits. To be successful in this banking environment, banks must have a strategy and set of tactics to create a series of customer net cash flow streams that will remain at the bank for ten years or more. This takes the confidence and Zen-like temperament to look at relationships and understand how your products, service and pricing can help or hurt a customer’s value.
Consider for a moment the energy that goes into getting the right collateral value. However, the top performing banks over the last ten years are the ones making unsecured consumer loans without a gram of asset protection. Think of the resources used to generate loans and achieve a high net interest margin in your bank. However, even if you are successful, that only results in a superior performing bank 27% of the time. Devote those same resources to generating fees from your relationship and, if done the right way, you now have a 91% probability of becoming a top performing bank.
In the coming weeks, we will be exploring the key components and equations of building a more profitable bank in a competitive banking environment. Producing a top performing bank is doing a lot of little things right, but there are some things that count more than others. Stay tuned and get the rest of your organization signed up as we have some exciting findings and topics planned for 2014 that can make your bank even a higher performing organization than you have now.
Submitted by Chris Nichols on January 13, 2014