If you are a bank targeting margin, cost of funds or even risk-adjusted margin you may be using an incomplete equation to drive profitability. This might help explain why your large bank competitor is making loans at margins that you can’t touch. Ironically, some of the loan deals and relationships that banks pass on due to margin might be the more profitable ones. If this has happened at your bank, consider these metrics to have a more well-rounded approach to profitability. Also, by the end of the article, we will propose some strategies that will help you identify some opportunities that, if properly exploited, will improve your own bank’s success.
To tie your bank’s long-run profitability into your customer profitability, it helps to understand your customer acquisition cost, customer value breakeven, churn rate and customer lifetime value.
Almost every bank wants the growing commercial customer. If you include the incremental cost of your infrastructure (management, branches, logo, policies, capital, etc.) add the direct cost of calling on that customer (sales trips, lunches, etc.) and then combine that with the direct transaction costs (underwriting, loan approval, account opening, etc.), you get “customer acquisition costs.” For most banks, commercial acquisition costs range from $9k to $35k with an average of around $16k.
Let’s say you make a 5-year, $400k term loan and after taking into account risk, capital (directly associated with the loan) and incremental cost and your pure operating profit is a little over $5k. In this example, it would take your bank a little over three years for “customer breakeven” on your initial acquisition cost.
Now, should that customer decide to repay the loan early and go to a competing bank, that is called a “customer defection” and can be captured in what is known as “churn.” The opposite of churn is “retention, ” and so banks usually measure one or the other. However, if the customer doesn’t leave, then each year that customer will contribute approximately $5k in profit from just that one product. If you add up all the years that customer stays with the bank, that will be your “lifetime value.”
Putting This Knowledge To Good Use
The first major point of understanding is the lifetime value. How long does your average customer stick around? There are some good statistics on this, and a bank customer’s lifetime is largely driven by items like age, income growth, type of customer, products used and experience. On average, the average customer sticks around just shy of seven years.
Thus, with this basic understanding in place, bankers can now look at strategies to that go beyond single product pricing. First, it pays to track, monitor and manage acquisition costs as this single factor helps move the point of breakeven faster. Becoming more efficient at the sales processes, more effective marketing and reducing loan processing costs are all simple examples of what banks can do to increase profitability by lowering acquisition costs.
Cross-selling products is another easy one, which also serves to extend the expected lifetime value. This is why products like bill pay, payroll services, and other cash management products are so valuable. While they all generate fees on their own, what these products do is extend the life of the customer, reduce churn and help retention. In the same vein, attributes like yield maintenance on loans, 1-year deposit penalties, and loyalty programs also increase lifetime value.
If you keep going with this logic, bankers start to realize that you would rather bank a $3mm loan at Prime less 1% loan to a quality credit with an eight-year expected life than book a $400k credit at Prime plus 0.50% and a five-year expected life. Because of size, life and cross-sell opportunity (to include deposit balances), the former is almost twice as profitable despite having a worse margin.
This also explains why at CenterState we are focused on the customer experience. Yes, happy customers are good, but they also have lower churn. Lower churn increases the lifetime value thereby increasing profitability.
Upsell and Cross-sell
There is also a question of upsell and cross-sell. Getting a business customer to move from a basic account to a premium account is an example of “upsell.” This also shifts the line. When a customer that initially took out a loan also does payroll with your bank, that’s called “cross-sell.” As you can see from the dotted line in the graphic below, accomplishing upsell and/or cross-sell success improves lifetime value. In fact, the sooner they occur in the relationship, the more lifetime value geometrically increased due to the magic of growth and compounded.
This math is fortunately also behavioral. Customers are more likely to take that next product within six months after the successful completion of their first product. This is why all banks need a dedicated “best next product” cross-sell initiative to be invoked after the closing of a transaction. Thus, if you close a loan, not only is it the most economically advantageous for the bank to cross-sell international services, but also more likely.
Submitted by Chris Nichols on October 04, 2017