While bankers have generally become more sophisticated in their understanding and execution of profitability analysis, all too often, they are limiting their potential for success by failing to utilize tools such as funds transfer pricing (FTP) to their full capabilities. Many bankers are already familiar with FTP, often leveraging it to measure the net interest margin at various institutional levels. And the opportunity that FTP provides goes so much deeper when used as a primary component of a more comprehensive analytical framework. However, in some cases, this may require a bit of a cultural shift in how the bank prioritizes its profitability initiatives.
Establishing a comprehensive profitability framework requires a commitment in time and resources, but the value derived from gaining a true understanding of what drives costs and profitability throughout the institution, and which parts of the institution are generating the most customer value, are worth the investment.
How else can a banker truly know which products and services (and even which customers) are most profitable, which ones actually erode value and the institution’s true cost of providing supporting services?
The first step is for bankers to have a better understanding of FTP and how it helps institutions better understand the effectiveness of pricing. When used in an analytical framework, FTP can even offer insight into things like pricing behavior. As net interest income typically represents between 50% and 80% of the institution’s bottom line, the analysis of those pricing decisions is imperative to understanding overall profitability. By analyzing pricing against such metrics as credit (internal or external), or by comparing pricing between officers, products or organizational sectors, management can gain insight into how those decisions have affected performance.
Once this analysis is complete, bankers can analyze profitability by various dimensions, including:
Organizational. Evaluating the contribution of units (including direct and indirect costs) to reveal which areas actually generate the most profit and identify the actual consumers of shared services in order to better manage resources to maintain or improve these services.
Product. Evaluating the contribution of products (including direct and indirect costs) to reveal which products bring in the most profit and to analyze both profitability trends (volumes, sales, mix) and costs (fixed vs. variable).
Customer. Ranking top and bottom contributors and segmenting the customer portfolio for deeper analysis and evaluation of the costs and benefits of specific customer promotions.
Channel. Determining how to best allocate revenue among the institution’s various delivery channels.
Officer. Look beyond just loan volume and break down the loan portfolio by employee to determine which officers actually contribute the most to the institution’s bottom line.
For an institution to develop a solid profitability analysis framework, support from senior level management is a necessity. The insight gained through FTP-enabled profitability analysis can lead to changes in how staff members are compensated. As a result, it is advisable for the institution to establish an FTP/profitability steering committee comprised of members from all lines of business to clearly establish best practices and present a unified philosophy to the rest of the institution.
Even those institutions that are fully committed to putting a framework in place through the use of FTP still face some common challenges, including misunderstanding of the data, inconsistent FTP methodologies or failure to include affected groups in methodology development meetings. Perhaps the worst mistake is failing to establish a clear process on the front end which, in turn, leaves staff unclear about exactly what is being analyzed, which can lead to distrust in the overall process. If properly managed, however, the benefits to the entire institution far outweigh the risks of not employing FTP to its full potential.
Bankers that stretch their understanding to go beyond their traditional use of FTP can gain a much greater understanding of the specific “how,” “why” and “what” issues involved in order to directly benefit their institution’s bottom line.
Explore how to accurately analyze the profitability of your institution
Originally published in BAI Banking Strategies, February 24, 2016