Following a turbulent two years of business disruption, distributing PPP loans, and anemic net interest income, banks and credit unions are looking forward to a calmer 2022.
As banks and credit unions emerge from survival mode and shift focus to profitable growth, a thorough understanding of key financial metrics is required. Finance leaders must present this data in a way that propels confident decisions and gains buy-in across the institution.
BCU and Investors Community Bank (now part of Nicolet National Bank) are on the leading edge of financial institutions that fundamentally understand their profitability drivers and have successfully navigated recent market challenges. Both institutions utilize Axiom™ FTP & Profitability for profitability analysis and reporting, and Investors also uses Axiom™ Incentive Compensation Management to provide transparency to incentives and align them to institutional goals.
During a recent roundtable webinar discussion, executives from both institutions addressed important profitability topics, including:
Key profitability drivers
What profitability dimensions are important
How institutions drive decision-making
Tracking profitability metrics
How the institution pivots, when necessary
What has driven your institution’s profitability in the past year, and has that changed from previous years?
Brett Engel, Treasurer, VP, Finance & Risk, BCU: Provision expense has been lower and a boon to profitability this year. I think we're also in the late innings of the mortgage refi boom, which has significantly increased profitability over the last 12 months. But as we look to 2022, these one-time benefits we've seen in 2021 will be gone, making 2022 more challenging.
Frank Joachim, VP, Assistant Treasurer, Investors Community Bank: A few items are driving profitability. One is better credit quality. We've had some sizable relationships come off nonaccrual and a significant reversal of provision. We’re a bank that traditionally had a heavy reliance on wholesale funding, so focusing on core deposit growth has allowed us to significantly decrease our cost of funds, especially in the rate environment that we’ve been in since early 2020.
We’re also focusing on reducing expenses. We used a zero-based budget for the first time in 2021, which made the lines of businesses more accountable for their expenses.
What dimensions of profitability do you typically report on? And who consumes those reports?
Engel: It's crucially important that we understand product profitability, especially the drivers of profitability for auto loans, personal loans, and credit cards. That data is foundational to the other analyses we do. We provide these reports directly to our product management team, so they understand profitability drivers as they model product and pricing changes.
With $4.9 billion in assets, BCU employs forward-looking profitability to understand expected cash flows as new volume comes on to the books and differences in profitability based on the origination channel. Historical profitability information (modeling previous credit losses and prepayments, for example) is used as a base case scenario to forecast cash flows and predict variable contribution margin. The ability to compare products with dissimilar cash flows and risk profiles (like mortgages versus credit cards) helps with understanding the value of each new loan/account, taking a risk-adjusted return on capital (RAROC) approach.
Joachim: We use a holistic approach, looking at line of business level profitability, and we'll set estimates and targets at that level. But then we get even more detailed and work with the lenders on their officer-level RAROC, which leads to discussions at the customer, product, and instrument level. We look to improve profitability at each of those levels.
Investors, a $1.5 billion institution based in Manitowoc, Wisconsin, uses a 12-month rolling profitability average at the line of business level. This management view shows each area’s level of risk-adjusted profitability and expands to show trends. The bank also uses officer-level profitability; for example, the head of agricultural lending would use this data to drive discussions about profitability and incentive compensation.
Cari Larsen, Vice President, Controller, Investors Community Bank: We can get as granular as we need to for the officers, but we also use Axiom to report up to analysts who are more concerned with earnings per share, return on assets (ROA), return on equity (ROE), and efficiency ratio. We have reports that look at profitability from a macro level as well.
Applicable employees receive a dashboard showing their contribution to common profitability metrics, which provides better visibility across the organization. For example, loan officers understand their performance and can calculate their expected compensation; Human Resources can anticipate payroll based on expected incentive compensation; and the executive team can see how they are tracking to goal.
What types of decisions does your team drive with this information? And how do you get to the point where the front line executes on profitability insights?
Engel: Product pricing or product change proposals go to our asset-liability committee, which has been split into a pricing committee and a risk management committee. In our pricing committee, EVA (economic value added) and RAROC data are, essentially, table stakes for any decision that gets made.
We built an income statement and balance sheet report for each branch to understand branch profitability. We’ve shifted to operate more like a retailer in terms of branch measurement, with a same-store sales view. And the way we get at that is by looking at the productivity of each branch.
To help understand branch productivity, I just multiply the amount of loans that a particular branch originates by the EVA of those loans. And I can look at that relative to the amount of direct expense required to keep that branch in operation.
Most of our branches are in-office locations, and a lot have been impacted by COVID and less foot traffic. We use this forward-looking productivity approach to model changes to volume and staffing to ensure that we’re allocating resources in the areas that are poised to drive the most productivity.
Joachim: We also use this information to help us determine which products are most beneficial to the bank's bottom line and focus on driving business with those products. We’re then moving toward basing incentive compensation on our profitability metrics.
Larsen: We’ve been educating the frontline, whether it’s the personal bankers or the lenders, and using and trusting the model. We've moved from a point of doing whatever you can to retain a customer to looking at and trusting the data and acknowledging that if the rate expectation isn’t good for the bank, it’s okay to let those customers go.
What profitability metrics do you track and report on? And do you measure success? Is your strategy working?
Joachim: The two metrics that we’re keyed in on are RAROC and shareholder value-added (SVA). Initially, we were primarily focused just on RAROC but quickly realized that because we have such a large portfolio of loans that are sold and serviced, we needed to focus on SVA, as well. Otherwise, every loan looked most profitable if it was sold off balance sheet and did not require the bank to carry additional capital. SVA helps us decide when to keep assets on the balance sheet or when to sell them off and collect on service fees.
We're seeing improvement almost entirely across the board. Month-to-month there could be variables that are holding a line back, but overall, when you look at our 13-month trend reports, you see improvement at pretty much every level.
Larsen: We also focus on our non-interest income, primarily because of our large sold in-service portfolio. Of course, net interest income and net income, but then because we are so focused on driving down our cost of funds, we look at transactional deposits. We want to focus on bringing those customers in at a relationship level and minimizing the customers who are just parking money in the CD and shopping rates.
Engel: RAROC, for sure, is a focus, as well as EVA, which is synonymous with what Investors calls SVA. EVA is the dollar-denominated view and RAROC is the percentage return view.
We do a lot of sensitivity and stress testing of losses to understand the resilience of the different products. What if losses are 2x or 3x the base case? Is that portfolio or are those loans still profitable? Are they still above hurdle? Are they still economic break-even?
Are you prepared to pivot if current strategies aren’t working?
Joachim: There's value in consistency because you don't want to constantly make changes to assumptions. When you do that, it kills your baseline, and you can lose credibility and buy-in.
That said, we’re constantly monitoring. If we feel adjustments are needed, we can make those on a month-to-month basis, ensuring that it's communicated and agreed upon. And we encourage everyone at our bank to question everything because, ultimately, that's only going to improve what we're trying to accomplish.
Engel: The key to driving profitability at BCU ultimately is going to be driving more revenue growth. If I can take the foundational product profitability values or measurements that I have, I can apply those to the problem I'm trying to solve.
We can take our existing foundation and apply that to a new framework to stay nimble, instead of trying to recreate frameworks or reports to try and solve each question individually. We try to work from a solid foundation and branch off from there.
Intentional Profitability Pays Dividends
Focusing on institutional profitability should be a daily endeavor, using consistent metrics to measure profitability across all dimensions. RAROC is a best practice, risk-adjusted profitability approach, starting at the instrument level, then aggregating data to the product or branch level to ensure accuracy across product offerings.
Other important profitability tactics include assessing both historical and anticipated profitability, and incenting officers on profitability — not volume — while making the criteria and reporting visible across the institution to create consistency and transparency to support company goals.
As the past two years amply demonstrate, pivoting when conditions change or a current strategy isn’t working is much easier within a strong profitability framework that supports quick and consistent analyses.
Axiom FTP & Profitability improves profitability and product mix, incentivizes growth, and streamlines reporting. Learn about our software return on investment (ROI), then request a personalized analysis for your institution.