Making Relationships Pay

By Ken Levey

It’s no secret that the current rate environment makes it difficult for banks and other financial institutions to drive profitability. At the beginning of December, just 68 basis points separated the three-month interest rate (1.60 percent) and 30-year rate (2.28 percent). For comparison, in pre-Great Recession days of 2005, the net interest margin was far more profitable due to wider spreads.

This situation is made even more dire by the possibility that the yield curve could flatten or even invert for a long period of time. Throw in the uncertainty and nervousness among consumers and businesses that often accompanies a presidential election year, especially if the economy slows, and it appears unlikely there will be much (if any) improvement in 2020.

What all this means is banks can no longer rely on the spread between the interest paid on deposits and the interest collected from loans to deliver profitability and growth. They must find alternative strategies.

To weather the difficult rate environment, many institutions are already performing “below the margin” assessments of how to lower operating costs, increase fees and reduce tax exposure and non-interest expenses. But saving your way to profitability is not a long-term strategy; you can only cut expenses for so long.

Banks need to understand how to manage their portfolios. One of the most effective approaches institutions can follow—understanding and taking advantage of the value of the institution’s relationships with its clients—relies on data they already possess. Institutions just need to be able to extract it. As with many things, however, it’s not quite that easy.

According to a recent Kaufman Hall report, more than 90 percent of financial executives surveyed said monitoring key profitability drivers, such as customers and relationships, is important. Despite that belief, such parameters are not currently monitored in more than 60 percent of the institutions surveyed.

This is an unfortunate deficiency, because industry studies show that the greatest value to overall profitability is derived from the top 1 percent of an institution’s client base. Placing greater focus on selling additional products to these clients and taking advantage of their influence on others to further expand opportunities will help mitigate the effects of an overall difficult rate environment.

Fortunately, gaining a full understanding of the scope and value of each relationship (including the risks the institution faces if the client becomes unhappy) is now much easier with the introduction of technology that automates this process. This technology can support effective portfolio management, quickly parsing through all the institution’s data to rank each relationship, from most profitable to least. Armed with this information, executives can develop products and strategies appropriate to their profitability levels to gain a greater share of wallet.

For example, analysis may show that you have several relationships with a high deposit volume but low profitability. Upon investigation, you find that a client in one such relationship is on the board of a medical clinic, but the clinic has only a business checking account with your bank. There may be a cross-sell opportunity for higher-profitability instruments, perhaps an operating line of credit or a new commercial real estate loan. Understanding the profitability of the current relationship and layering on potential new business can, if priced correctly, improve performance. Having these capabilities is imperative for banks.

This process offers a value beyond the shorter-term benefit of the money made from a new loan. It also increases the “stickiness” of that client. The more products and services the client has with the institution—especially those accompanied by features such as direct deposit that work to create closer ties between the institution and the client—the more likely those clients are to remain for the long term.

Banks that understand the relationships and profitability of each client also can use that information to determine pricing for a variety of products. In other words, it may be worth giving a high-value client with a great deal of influence among other clients a loan at 3.25 percent rather than 3.75 percent to maintain satisfaction, particularly if it will lead to other higher-value opportunities. You may also be able to ensure the total relationship remains profitable by offsetting a rate concession with the requirement that a certain level of deposits be added. This strategy helps avoid the need to compete on price alone and empowers relationship managers to ensure profitability hurdle rates are met while offering multiple options to the client—a win-win.

Of course, this approach doesn’t mean lower-value clients should be ignored. It just means the opportunities are different. For these clients, exploring cross-sell opportunities with high-value products or replacing maturing accounts with more attractive terms may be more appropriate.

To really derive the full benefits of relationship management, however, the institution must look beyond the core relationships and present considerations by building a robust calculation and modeling engine that also considers both historic and future profitability. This model should start with using fund transfer pricing to gain the most accurate view of exactly who and what is driving that profitability.

FTP (and overall profitability) should be performed first at the account level. Once the value of each individual account is understood, it can be aggregated to accurately measure profitability across not only specific accounts, but also for individual customers, products, relationships or even loan officers. By rolling up the account information in different ways, the institution will gain greater insights into who and what is driving profitability today and where the best opportunities lie.

This doesn’t mean financial institutions should throw caution to the wind around loans. As we learned in 2008, it is still important that institutions not sacrifice credit quality to increase loan volumes. Here again, analytics that provide deeper insights into relationships and trends will help draw the line between risk and reward to avoid losses that will impact profitability—which today is more critical than ever.

The tools for this type of in-depth relationship analysis exist, although 68 percent of respondents to the survey I cited above said their institutions lack an automated means to analyze the profitability of complex relationships. Investing in these tools and accompanying processes will not only deliver the capabilities described above; it also lets management tie incentive compensation to relationship profitability, aligning individual and institution goals.

In the current hyper-competitive market, traditional methods of increasing income (such as raising fees for early withdrawals and late payments) could lead to long-term damage to the institution’s reputation with repercussions long after NIM improves.

The better approach is to gain an in-depth understanding of every account and relationship and nurture them as appropriate to increase revenue while delivering a higher level of client service.