Banks and other financial institutions continue to face significant turbulence in the third year of the COVID-19 pandemic as they attempt to adapt to a rapidly evolving environment. A confluence of forces is driving ongoing margin challenges and financial uncertainty across the industry, including new classes of competition such as neobanks like Varo and Chime, and payment applications like Venmo and Apple Pay.
Yet, finance professionals at U.S. banks, credit unions, and other financial services companies are overwhelmingly optimistic about their institutions’ future performance. Syntellis research in late 2021 revealed that 92% of finance professionals expected their institutions to meet or exceed their annual profitability goals. The positive outlook is an improvement over late 2020 when just 46% of respondents expected to meet or exceed profitability goals.
At the same time, the trials of the pandemic have tempered leaders’ expectations and reinforced the need for agility and versatility. To succeed moving forward, they must learn how to assess their institutions’ current profitability and consider opportunities to diversify revenue streams with non-interest income sources.
Seven Key Trends
Seven trends affecting the industry today, both positively and negatively, include:
- Digital transformation: The COVID-19 pandemic accelerated the industry’s digital transformation as consumers developed new expectations around purchasing methods and digital experiences, from food and grocery delivery to remote work. Consumers today want and expect the same kind of personalized, convenient experience from their financial institutions. However, while 83% of institutions have clearly articulated digital transformation strategies, six in 10 have yet to report significant progress in executing those strategies. Many institutions lack essential capabilities, such as data, analytics, and artificial intelligence.
- Interest rates: In 2020, financial institutions saw a dramatic plunge in interest rates, which impacted loan yields and added significant margin pressures. Overall, U.S. bank profits fell 36.5% year-over-year in 2020, only to jump nearly 90% in 2021 due to economic growth and banks reducing their credit loss reserves. In 2022, major U.S. banks raised their lending rates after the Federal Reserve increased its benchmark interest rate and announced plans for additional increases throughout the year in efforts to control inflation.
- Tightening regulatory oversight: Fee income was already in decline before 2020, but that dip accelerated during the pandemic amid increased regulatory scrutiny around overdraft and other penalty fees. Such fees historically constitute a significant share of revenues for financial institutions. For example, overdraft fees alone generate more than $15 billion in annual revenues for banks and credit unions.
- Influx in deposit balances: Financial institutions nationwide became flush with high cash levels in the early years of the pandemic as economic uncertainties drove many customers to save relief and stimulus funds and reduce discretionary spending. Institutions can loan against those deposits at a lower cost than borrowed funds. A rebound in consumer spending in recent months signals a possible slowing in deposit growth, despite inflation pressures.
- Drop in provision for credit losses: Early pandemic loan loss provisions often were generous. As people return to work, default risks decrease and banks can recapture large amounts of loan loss reserves. Once again, finance professionals are optimistic. For example, just 30% of respondents to the Syntellis survey expect increased mortgage defaults in 2022 expect to see increased mortgage defaults in 2022, and two-thirds of those expect only a 1%-2% increase in default rates.
- A hot housing market: Higher interest rates are expected to temper intense housing demand driven by rapidly rising home values and low interest rates in recent years. Even so, the Mortgage Bankers Association projects the 2022 housing market will surpass 2020 and 2021 performance, with mortgage originations estimated to reach $3.93 trillion. That includes $2.32 trillion in refinances and $1.61 trillion in purchases.
- Accelerating use of cards and contactless payments: The push for digital transformation has revealed changing consumer behavior, particularly when it comes to the use of cards and contactless payment options. Increased card use presents the potential opportunity for fee generation as an additional source of non-interest income. Nearly 80% of consumers report using contactless payments, which they view as cleaner, faster, and more convenient. A contactless transaction can reduce transaction time to 10-15 seconds compared to 30-45 seconds for chip-enabled cards. To gain a competitive advantage, financial institutions should consider how to drive card and contactless transactions and minimize cash logistics.
Analyzing Bank Profitability, Revenue Mix, and Non-Interest Income Opportunities
Based on the current environment, financial institutions have several opportunities to develop strategies to survive and thrive into the future:
- Accelerate the shift to contactless and digital payment with flexible personalization options
- Enable merchants with digital capabilities to create omnichannel experiences
- Modernize payment infrastructure to enable faster, secure cross-border payments
- Encourage simpler, more accessible payment options for the underbanked and unbanked
In the current environment, fee-based income can be a helpful offset against weaker net interest income. Wire income, ACH fee income, and ATM and debit card interchange fee income are all expected to continue to rise with greater digitization. Additional opportunities could come from increases in fee income in other loan-related areas, as well as from wealth management functions.
Profitability analysis can help you assess your current revenue mix and evaluate the changes that will drive the most value.
The Role of Profitability Analysis Tools
Financial institutions need modern technology to support accurate and timely analysis for determining the revenue streams that will add the most value.
Advanced profitability analysis tools allow you to view separate components — such as net interest income, provision, non-interest income, and expenses — from a summary level and then drill into specific, granular details for any particular item. In addition, tools with comprehensive reporting functionality empower you to create a wide variety of reports, analyses, and data visualizations to gain insight into potential profitability drivers.
For example, dynamic visualizations can be used to support your profitability analysis. Such visuals allow you to isolate a particular area of focus — like non-interest income — to see the role it plays as one component in calculating the return on assets (ROA).
With Axiom™ FTP and Profitability, you can efficiently and accurately assess what’s driving value, explore the impact of potential changes, and apply those findings to your future goals and budgets.
Relationship-based pricing for new business is another example of leveraging best-of-breed technology. Axiom™ Relationship Profitability and Pricing System (RPPS) helps you further understand profitability based on complex business relationships, optimizing portfolios, and accurately pricing new business.
Pricing tools capture the most up-to-date assumptions while leveraging Axiom Funds Transfer Pricing to project forward-looking profitability. You can model pricing scenarios in real time, including applying different combinations of loan terms, fees, and deposit requirements, and considering changing factors such as customer risk profiles, loan provision requirements, and capital allocation. These models can help you determine how best to balance client needs with institutional goals.
The banking industry has faced numerous challenges in recent years. With the right tools, finance leaders can tackle future challenges head-on, identify new opportunities, and build a foundation for long-term success.