As time zones around the world rang in the new year, you could almost hear a collective sigh of relief. 2021 is a year of hope – that as more and more of us are vaccinated against COVID-19, we can begin to achieve some sense of normalcy in our business and personal lives.
There is, however, a lot of ground to recover. Financial institutions continue to face challenging economic conditions and are targeting technology and process improvements that drive agility and readiness for the road ahead, according to Syntellis’ 2021 Financial Institutions Finance and Technology Trends report.
For our two-part series discussing the report’s findings, Part 1 explored the key issues that financial institutions faced in 2020. Looking ahead to 2021, to ensure sustainability and profitable growth, finance teams must have the tools and processes to accurately measure the products, branches, accounts, officers, customers/members, and relationships that drive profitability.
The report revealed that 85% of financial institution leaders feel they should do more to leverage financial and operational data to inform strategic decisions, and offered three key strategies that banks, credit unions, and farm credit associations should consider in their quest for profitable growth:
- Incenting profitable growth through compensation plans
- Employing a tool to price new business based on relationship profitability
- Using an instrument-level matched-term funds transfer pricing approach to profitability analysis
Incent Profitable Growth
As learned in the past decade, not all growth is good; efforts to grow the balance sheet need to be performed in a controlled and profitable manner that drives success for the institution. Therefore, it's best to tie compensation plan goals to profitability, rather than just volumes. Yet, only 45% of institutions use profitability as a factor in calculating employee incentive compensation.
One approach to incenting profitable growth is to set risk-adjusted margin as the critical performance driver, or a combination of margin and portfolio growth. This departure from calculating incentives purely based on loan volumes or the number of new accounts originated ensures that growth aligns with and advances the institution's strategic goals.
To then tie incentives to profitability, you can incent loan officers on each loan's net margin contribution, which considers the cost-of-funds and perhaps capital requirements. This approach requires each loan to be transfer-priced and given an economic capital allocation. The result is better alignment of behavior with desired outcomes for the institution, ultimately driving profitable growth.
Price New Business Based on Relationship Profitability
Effective portfolio management starts at the relationship level. Knowing the value of all relationships is key to successfully guiding actions that support profitability. Yet, 59% of financial institutions lack a pricing tool that allows immediate evaluation of how a new account impacts an existing relationship's profitability. To price based on relationship profitability, you must be able to define the relationship. Sixty-seven percent of institutions, however, report not having automated means to create, maintain, and analyze the profitability of complex business relationships, including business and household ties.
With the right data and an understanding of each relationship's value, relationship managers can prioritize portfolio management activities designed to expand and support satisfaction for top-performing relationships and increase the value of bottom-performing relationships, ultimately leading to profitable growth.
Knowing the value of all relationships will allow you to implement relationship pricing and expand relationships with your "best customers" by pricing loans and deposits appropriately and providing a commensurate service level. To balance value and risk, you'll need to take several things into account: product and service costs, risk, the value of the whole relationship, and whether the new business still allows you to meet your institution's hurdle rate (such as RAROC).
To further accelerate profitability, incentivize each relationship manager to optimize their portfolio based on relationship profitability. The result is a strategic portfolio management plan that drives profitable growth.
Use Matched-Term Funds Transfer Pricing
The general ledger enables institutions to measure net interest margin (NIM) on an aggregate basis for the entire institution. In contrast, funds transfer pricing (FTP) helps financial institutions understand NIM at a more granular level for every segment, such as products, customers/members, officers, branches, and departments. However, research revealed that just over half (51%) of financial institutions use FTP, and only 28% use the preferred instrument level matched-term approach.
Matched-term FTP, the most widely used approach and the one used by Syntellis' Axiom™ FTP & Profitability solution, lets you transfer prices at the individual instrument/record level based on its characteristics, such as origination date, term, options, and expected cash flows. This approach has several advantages, including consistency (in most cases, both sides of the balance sheet are valued against a single market yield curve), accuracy, insulation from interest rate risk changes, and improved margin management, allowing you to disaggregate margin into its proper components.
Analyzing profitability across all dimensions of an organization — especially relative to complex business relationships — and using tools such as matched-term FTP enables finance leaders to better understand profitability drivers and potential risks. They then can leverage those insights in budgeting and planning, including pricing and employee compensation decisions, to drive profitable growth in 2021 and beyond.