As financial institutions face margin pressure due to continued low interest rates, a decline in traditional fee income like overdraft fees, and new classes of competition (e.g., neobanks like Chime and payment applications like Venmo and Apple Pay), they must learn how to assess their current profitability and consider opportunities to diversify their revenue streams with non-interest income sources.
The Changing Financial Landscape
Prior to the coronavirus pandemic, the banking industry was evolving in several ways. Once the pandemic hit in early 2020, the transformation accelerated. Syntellis research in late 2020 revealed that over half of respondents expected their institution’s profitability to decline or remain flat in 2021.
Digital transformation: The COVID-19 pandemic shifted consumer expectations around purchasing methods and digital experiences, from food and grocery delivery to remote work. Now, consumers want the same kind of personalized, convenient experience from their financial institutions. However, most institutions (75%) aren’t equipped with the necessary capabilities — data, analytics, and artificial intelligence — to deliver those experiences.
Interest rates: In 2020, financial institutions saw a dramatic plunge in interest rates, which impacted loan yields and added significant margin pressure. Overall, U.S. bank profits fell 36.5% in 2020 compared to 2019. It’s predicted that revenue may not recover for two to four years, testing banks’ operational resilience.
Tightening regulations: Fee income was already in decline, but that dip accelerated over the past year amid increasing regulatory scrutiny around overdraft and other penalty fees. U.S. retail banking revenue could see an impact of 6%-7% over the next three to five years.
Finding the Silver Lining: Opportunities for Financial Institutions
Though these shifts introduce significant challenges, not all of the changes are grim. The past year has also created positive shifts:
Influx in deposit balances: As customers saved relief and stimulus funds, as well as surplus due to reduced discretionary spending, financial institutions are flush with high cash levels. Institutions can loan against those deposits at a lower cost than borrowed funds.
Drop in provision for credit losses: Pandemic-level loan loss provisions were often generous. As people return to work, there is a reduced risk of default, so banks have been able to recapture large amounts of loan loss reserves.
Active home buying market: 2021 purchase originations are on pace to increase 16% to a record $1.67 trillion. Increased origination fees can drive yields.
Accelerating card use and contactless payment adoption: The push for digital transformation has revealed changing consumer behavior, particularly when it comes to the use of cards and contactless payment options.
According to Mercator research, due to the COVID-19 pandemic, 41% of surveyed users report that they will more often use charge cards, and 40% report they will more often use reloadable prepaid cards. Users say that they will use some methods of payment — notably cash and checks — less often. Increased card use presents the potential opportunity for fee generation as an additional source of non-interest income.
In addition, consumers increasingly view contactless payment methods as cleaner, faster, and more convenient. While the transaction time for a chip-enabled card can be as much as 30 to 45 seconds, a contactless transaction can reduce that to as little as 10 to 15 seconds. Given this trend, 56% of the cards used in the U.S. are expected to be contactless by 2022.
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. And with the move to digitization, wire income, ACH fee income, and ATM and debit card interchange fee income are all expected to continue to rise. 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, but drill into the specific, granular details for any particular item. In addition, tools with comprehensive reporting functionality can enable you to create a wide variety of reports, analyses, and data visualizations to gain insight into potential drivers of profitability.
For example, dynamic types of visualizations can be used to support your profitability analysis. With this type of visual, you can 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 now and explore the impact of potential changes, applying learnings to your goals and budgets going forward.
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. Modeling pricing scenarios in real time — 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 — can help you best balance client needs with institution goals.
The past year introduced many challenges for the banking industry. Still, with the right approach — for example, reducing loan loss provisions, ramping up mortgage lending, and progressing toward digitization with card and cashless transactions — financial institutions can turn those scenarios into opportunities.