Every banker is comfortable using averages to describe financial performance. We all use mean, median or mode to help explain and understand financial performance and historical achievement. Unfortunately, analyzing performance based on averages impairs success for many banks. For example, on average a bank’s achievements are reflected in the income statement and the balance sheet, but that average is composed of many products, relationships, branches and bank officers whose respective performance is widely dispersed above and below the average. Understanding which products, customers and lenders are profitable and which are not is an important aspect of banking that can boost performance with minimal investment. Even if your bank does not subscribe to an enterprise-wide relationship profitability platform, there are a few key determinants of bank success which we would like to describe that can help banks get more granular than simply measuring averages.
Segmenting Bank Performance
All bankers agree that bank customers are not equally profitable, but many bankers are surprised by how profitability is so widely scattered. The average bank’s total profits are generated by just a few accounts. By ranking customer profitability, management can better understand how to allocate scares resources, plan for growth, compensate employees, target prospects and increase profitability.
The 80/20 rule, which states that 80% of profits for an organization are generated by just 20% of the accounts, does not hold in banking.
We found that the top 10% of customers at a bank generate 120% of profits. The other 90% of the customers subtract 20% of the bank’s entire profits. BakerHill states that in smaller financial institutions, the top 10% of accounts generate between 200% and 400% of that institution’s profit. That means that the remaining 90% of customers generate large negative returns.
Even if a bank does not have the tools to stratify customers, products, branches, and employees on profitability, by using general principles bankers can still identify which customers are not profitable and create a strategy to increase profitability or shed the relationship. Not every bank can purchase the software nor devote the resources to quantify profitability on a granular level to each account or product. There are some simple principles to follow to identify which accounts are more or less profitable, and how to prospect for new business that enhances profitability.
How to Segment and Rank Customers
To segment customer profitability, the first step is to accept that your community bank is not there to sell more products to more customers. Profitable banks do not simply wait for customers to walk in the door and drive growth by selling and cross-selling to everyone. Banks take the following three steps: first, define who has the potential to become a profitable relationship; second, identify who the bank wants to do business with; and third, market to those prospects to see if they are willing customers.
First, how do we identify profitable customers or prospects?
Profitable or wealthy: It is almost impossible for banks to earn excess profits by delivering banking products to indigent people or businesses. Some bankers point to certain auto loans, credit cards, checking accounts or overdraft structures that make a profit and can be a fit for the less-than-wealthy customers. However, the vast majority of return at banks is generated by customers who are profitable, have substantial wealth or are on the path to achieving those goals.
Size matters: Whether a loan, money market account or treasury management services, more volume from the same customer translates to more profit for the bank. As an example, CRE loans under $500k are substantially less profitable for a bank than the average CRE loan. If a customer needs a $250k CRE loan, and there is little evidence that credit needs may increase in the near future, and there are not substantial cross-sell opportunities, then the customer will probably fall in the 90% bucket of unprofitable customers.
Credit quality: There are entities that can make outsized profits dealing with challenging and over-levered credits. However, most banks deliver higher profitability dealing with better credits. We respect all of the discussion around risk/reward tradeoffs. However, there is always a bank willing to underprice risk – banking is most profitable when risk is minimized, and not when yield is maximized.
Relationship banking: Profitable customers are cross-sold and upsold, and spend at least the majority of their wallet with the bank. Please see our blog from last week HERE.
Lifetime value: Banking is a low margin but a long-term revenue stream business. Profitable customers must have the intention of staying with the bank for at least 5 to 7 years, and the bank must have the products to offer the customer for that period. Banks that offer products that reprice and can be shopped every year or two find it more difficult to generate profits.
Barriers to exit: To solidify lifetime value, to form relationships and to add cross-sell opportunities there must be monetary, contractual or friction costs to switching. This is where treasury management and long-term credit facilities are the glue that binds the relationship and makes switching a less desirable outcome for the customer.
Second, a community bank cannot be all things to all people and bankers must identify who they want to bank. Consider that 90% of the customers at a community bank are unprofitable primarily because they were a bad fit for the bank at inception. So after identifying what may be profitable customers, how can banks identify who they want to bank? This is where banks must understand their competitive advantages, product offering and reach. While IBM and Amazon may be profitable for your bank, there are other banks that can better serve these companies’ needs, and your bank cannot reach China, India, and Brazil where these companies require banking services. However, for the vast majority of community banks, there is no shortage of profitable entities where the bank’s competitive advantage, product offering, and reach are well aligned.
Third, customers will now decide if they want to bank with you - this is a passive step. After identifying potentially profitable customers that the bank wants to do business with, marketing to these prospects will uncover those that want to do business with your bank. But banks that avert the first two steps and simply do business with whoever walks through the door will only load up on unprofitable customers and only accidentally find profitable ones.
Every relationship profitability is unique, and banks should try to measure or at least stack clients from unprofitable to most profitable utilizing some basic criteria such as loans outstanding, fee generation and deposit balances. Banks that wait for business to come to them are asking for trouble because profitability is planned and does not occur by happenstance. Luckily for community banks, some simple principles can be applied to identify which accounts are profitable and which may need to be upsold, cross-sold or de-emphasized. Community banks can substantially reverse the 90% of accounts that make up negative 20% of profitability by simply marketing their services to potentially profitable prospects that the bank actually wants as customers.
Submitted by Chris Nichols on March 13, 2019