Download Bank Customer Profitability Analysis: Shifting Focus from Deposits to Loans and more Study notes Applied Computing in PDF only on Docsity!
Customer Profitability
Analysis
Part I: Alternative Approaches
Toward Customer Profitability
By Robert E. Knight
I
n recent years banks have become increas - ingly aware of the need to measure the profitability of corporate customer relation - ships. Past emphasis on deposit size as a mea- sure of rank has gradually given way to the realization that large banks are not necessarily the most profitable and that loans, not de - posits, generate most bank earnings. At many larger banks, profitability analysis, essentially a sophisticated version of standard account analysis,' has been introduced to assist in mea - suring individual customer profitability. This article describes the objectives of profitability analysis, discusses some of the general prin - ciples involved in constructing an analysis, and considers the alternative types of profitability measures commonly utilized. A sample profit - ability analysis statement is presented to il - lustrate the interrelationships among vari-
I / A detailed description of account analysis procedures used in correspondent banking can be found in the article, " Account Analysis" in the December 1971 issue of the Monthly Review of the Federal Reserve Bank of Kansas City. Since 1971, the Kansas City Reserve Bank has collected figures annually on the account analysis practices of major correspondents. The 1973 survey results were reported in " How Correspondents Analyze Accounts for Profitability, " Banking, Journal of the American Bankers Association. Vol. 66, N o. 10 (April 1974). The tabula - tions for the 1974 survey will be reported subsequently in this series of articles.
ables. A second article in this series will de - scribe the results of a recent survey of profit - ability analysis techniques at major correspon - dent banks.
ACCOUNT ANALYSIS The application of standard account analy - sis to both corporate and correspondent ac - counts became widespread in the mid-1960's when banks feared they might be caught in a profit squeeze. During that period the costs of providing bank services escalated rapidly as in - flation became more pronounced and as the variety of bank services increased greatly. Corporate treasurers, while asking for larger loans and for highly specialized services, were simultaneously reducing noninterest bearing balances to invest the funds directly in the securities market. As interest rates rose, small - er banks began to sell large amounts of Fed - eral funds, occasionally producing negative collected balances at correspondents. Mean - while, bank liquidity was declining and li- ability management techniques were not prov - ing fully satisfactory in meeting the demands
for loanable funds when Regulation Q interest
rate ceilings were binding. Under these cir - cumstances larger banks initially developed
Monthly Review April 1975 1 1
account analysis techniques to ensure not only that adequate compensating balances would be maintained, but also that the needs of the most profitable customers could be given pri- ority. In performing a standard account analysis, a bank determines the revenue from a cus - tomer's account by multiplying the average collected balance, generally adjusted for re - serve requirements, by an earnings credit or al - lowance. The expenses of servicing the account are computed by multiplying the number of times a given service is utilized by the cost (generally including an allowance for profit) of providing the service. A typical account
analysis schedule is shown in Table 1.
"' :a* 6 fab,i%, :i ( 8 @j* a? $ 8 ' dlR!jT N4TIOVALDAN& kg +&
,Account Analysis for: 4
. ~ o J hofB& I (^) , EARNING+5ALLOaWANCE - 8 g3 $ Average LeYger Balancg =! , $ A:- 4 Less ~ v e r a ~ y ~ n c o l l & e d & u n d ~ 4 * Average Collected Balance s $. ' b s s Legal Reserve pf (1 7He%) " " ~ v & % ~ eB""alance%vail$ble f o ~ l n v e 8 m e n i ' ~ $ jt;e 9 Earnings Allowance ( ?$)
T N V E S T M E N ~ V A L ~ ~ E - 1 : 7 9s r. &
I /
EX&NSES k .$ r 6 ' 6 i&' $
Account Mainteyance g -^ $ 2. 0 0 ~^ +^ $^ *
cre$ts " d p.7$o"&ach9$ " !%' "
Debib i = 7 a e a c h^ '^ $^ * ~ep"bsited&terns%; P' (^) 6 & @ $ !+ + Not Encoded 3aSach $
Encoded :t$ y 4' 4 .2 ~ p h + $ * 3.
Returned lieems , - I 25aeach $ 31 !' -'
Stop P a y q ~ n t s+ ,$2.00each $ - '" W i e Tranifers + i 7C$1 :&! %$ id
Coupon Etyelopes i s 2
cu,iency*~rans&ionif 9 $38 $ - Coin Shipped , 16 *
Acbunt Reconciliation% 9 @p #& *@ $ ' 5 , a : .:
Lockbox Services $
FloM O v e d r a h 2 4: @$ $:;, 2 *
*- C
- d 9 $3 p "2 u !j $ a @ $ $ z
.TOT A L EX PE NSE S; $.? A -:NET & O F ~ ~ ~ ( O RLOSS) 9% $& $$ $ *'O W 5
While the account analysis represents an important step in determining the profitabil - ity of a customer relationship, it is not a mea - sure of total profitability. For example, the analysis tends to focus on activity charges for which compensating balances are maintained -account maintenance, items deposited, ledger entries, wire transfers, etc.-but rarely makes allowance for other types of services such as loans, investment counseling, Federal funds transactions, trust services, or data pro- cessing. Its value, therefore, is primarily in analyzing the accounts of nonborrowers with heavy activity charges, such as respondent banks. For other customers. the omission of loan relationships has at times allowed the double or even triple use of compensating balances. Since cross - checking is frequently not automatic, a compensating balance required for a loan might at times be used to compen - sate for activity charges and also serve as a justification for a future call on credit.* The primary objectives of account analysis are to measure the adequacy of compensating balances and to obtain an indication of the profits generated by an account relationship. The meaning of the profit figure obtained, however, is generally uncertain and can rarely be related directly to the profits of the bank.
Since the price of a service often includes a
markup, a high volume customer is likely to be more profitable than a low volume relationship, even though the computed profits are identical. Moreover, some banks build in an additional profit margin by granting an earnings allow-
2 1 Increasingly, banks have sought to correct the double use of balances by deducting both the compensating balance for a loan and required reserves from the collected balances shown in an account analysis. While this approach represents a step in the right direction, it does not allow for an analysis of the prof - itability of the loan. Possible tradeoffs between interest rates on loans and compensating balances are not shown. Moreover, the costs of making loans, variations in risk, necessary return on capital, etc.. cannot readily be handled in this framework. By comparison, profitability analysis seeks to determine the total relative profitability of a customer relationship.
12 Federal Reserve Bank of Kansas City
CURRENT PERIOD LAST 12 MONTHS SOURCES AND USES OF FUNDS
- Avemge Loan-Balance:
- Avemge Collected Balance: a. Investable Balance (17.5% reserve):
- Average Time Balance: a. Investable Balance (3% reserve):
c. Data Processing: d. Total (80 + 8b + 8c):
- Total Income (6 + 7 + 8): EXPENSES " " '
- Activity ~osts'gomAccount Analysis:
- Interest ~ c c d a$n Time Deposits:
12. Charge fbr B&C Funds Used:
a. AllocatedCapital (20% of 50): b. Pool Funds (=Oh of 5b): c. Total (120 + 12b):
- Loan Handling Expenses:
- Cost of Fee Services:
items in process of collection and an allowance for reserve requirements from gross ledger balances. Some banks also make deductions for the compensating balances required to cover the activity charges in the account analy - sis. Regardless, the deposit figure remaining after the various deductions have been sub -
tracted is then netted against average loans outstanding to obtain the average net bank funds used by the customer (line 5). The customer, in other words, is assumed to bor - row his own funds first. For many banks the previous step com - pletes the analysis of bank funds advanced to
Federal Reserve Bank of Kansas City
a customer. If the bank, however, wishes to relate the profit on the relationship to the return on bank capital, as is the case in the example, the net funds loaned to the customer must be subdivided into at least two categories. The first is the proportion of funds supplied from the bank's capital account. Allocated capital (line 5a) is frequently a flat percent - age of gross loans. Some banks, though, assign capital in proportion to the estimated risk on loans, while others assume capital is also required to support the customer's deposits. Since profits will ultimately be related to the assigned capital, variations in its allocation can have a significant impact on the estimated profitability of a relationship. All other things being equal, a higher capital allocation tends to reduce the profit rate. In any event, if the return on capital is to be a measure of actual profitability, the capital assigned to a customer relationship should be selected in such a way that for the bank as a whole the total assigned capital is equal to the bank's actual capital. The remaining category of bank funds sup - plied (line 5b) is a residual and represents funds obtained from sources other than the capital accounts. If the bank chooses to differentiate further among alternative sources of funds, such as purchased funds and deposit funds, this entry could be subdivided. The use of multiple pools of funds, however, is relatively uncommon.
Income The second section of the profitability state - ment lists the major sources of income derived by the bank from the customer relationship. Most of the entries shown are self - explanatory. Gross interest income (line 6 ) includes the interest accruing on loans during the analysis period. Interest earnings on deposits .(line 7) are imputed on the loanable funds supplied by the customer. This entry is required to give the customer income credit for compensating balances maintained. Service charges (line
8a) represent any fees paid to the bank to cover deposit activity costs or any charges associated with obtaining loans, such as points. Since these charges are most likely to arise when compensating balances are inadequate, pro - vision must be made for their inclusion. Under the loan commitment entry (line 8b), a fig- ure would be entered only if the customer had paid an outright fee for a commitment or a line of credit. If a compensating balance had been maintained instead, these funds would be reflected in the sources and uses section of the table and earnings accordingly imputed. In addition, net bank funds used by the customer would be reduced, resulting in a lower charge for bank funds loaned in the expense section of the analysis. If the analysis and the charges were internally consistent, either approach would have the same effect on estimated prof - its. The inclusion of income from data process - ing services (line 8c) is somewhat contro - versial. Some banks feel income should be in - cluded only to the extent it is related to regular bank services or loans. Under this view, spe-
cialized services, such as EDP or trust depart -
ments, are treated independently of normal bank operations. These functions serve as separate profit centers but any income and ex- penses are not included in a profitability analy - sis related to loans. Others, however, feel that an accurate picture of the profitability of a customer relationship can be obtained only if all income and expenses from services are in - cluded. Banks in this latter group often believe that customers are not likely to differentiate among different profit centers in considering the compensation for a bundle of bank services. On balance, neither approach is wholly satis - factory and practices vary among banks. Never- theless, if a bank includes the funds received for a specialized service in the income portion of the profitability statement, the charge for providing that service should also be listed under expenses.
Monthly Review 0 April 1975
under expenses. Possible examples might be charges for account reconciliation, lockboxes, payroll preparation, and night depository ser- vices. Finally, the inclusion of data processing expenses (line 15) is required, as discussed earlier, to ensure consistency in the treatment of income and expenses.
Net Income and Profitability
The last lines of the profitability statement are used to derive different indicators of the profitability of the customer relationship. Total profits or net income is shown in line 17. In line 18, the allocated capital index is com - puted by dividing profit by allocated capital. If greater than zero, this index indicates that the bank is actually realizing a higher profit rate on customer relationships than the goal previously established by the bank. A nega- tive figure would suggest that profits were not sufficient to meet the target, while a zero figure would imply the goal had just been met. The return on capital is by necessity an important criterion in judging the profitability of a customer relationship, but it is not the sole concern. For example, it provides no indi- cation of the size of the relationship. The index could be high, but profits low. The amount of capital allocated to a relationship is also some - what arbitrary, possibly leading to distortions in the index number. These types of considera - tions have caused many banks to compute more than one profitability ratio. One possi- bility is to determine profits as a percentage of net bank funds borrowed by the customer (line 19). While the specific methods of computing customer profitability differ greatly among banks, the general objectives are often quite similar. Not only does the analysis provide a guide to whether a customer is adequately con - tributing to the profits of an institution, but it also formalizes the tradeoff between the terms on loans. For example, if the interest rate on a loan were to increase, income, net profits, and the profitability indexes would all
rise accordingly. Similarly, if larger compen - sating balances were to be maintained, profita - bility would also rise as the imputed interest on deposits increased and as the charge for net bank funds borrowed declined. Some profita - bility statements even contain a series of en - tries at the conclusion of the analysis specify- ing what interest rates on loans would be nec- essary to meet bank profit objectives given dif- fering compensating balance requirements. Regardless, the applicability of profitability analysis tends to be limited largely to custom - ers which borrow. If the customer in the exam - ple were a nonborrower, the profitability in - dexes would be meaningless, although capital could perhaps be allocated on some basis other than gross loans. Some caution must be exercised in analyz - ing the sample profitability statement. While the sample illustrates the general principles in - volved in computing customer profitability, the specific entries and the precise approach cannot be taken as representative of the analy - sis methods at all banks. There are wide differ - ences among banks, not only in the ap - proaches used to measure customer profita - bility, but also in the items included in the analysis. Many banks exclude some deposits or some loans in measuring the sources and uses of funds. The range of services for which income and expenses are listed can also vary greatly. Differences in the structure of an analysis can have a significant impact on estimated profits. Most banks, for example, determine only the total of investable funds represented
by deposits, implicitly allowing those balances
to serve as compensation for either loans or ac - tivity services, but some also make an explicit deduction from collected funds for the com - pensating balances required for activity ser - vices. The effect of this latter approach is to increase net funds borrowed, thus lowering the estimated profitability of a given customer at those banks using a net funds borrowed ratio.
Monthly Review April 1975
Some banks allocate capital to borrowings while others assign an explicit expense charge for risk and loss. Similarly, some banks charge customers the cost of money on the gross amount borrowed and give an interest credit on gross investable funds. By comparison, others charge only for net funds borrowed. For these two methods to yield identical results, the interest rates used for funds borrowed and supplied must be iden- tical, yet such is not always the case. Some banks compute the profitability of loan and investment services separately to avoid having to allocate all profits to loans and some use slightly different formulas for calculating the profitability of different types of custom - ers. Additional examples could be cited, but these demonstrate a few of the differences that exist among banks in the techniques of com - puting customer profitability.
INDEXES OF CUSTOMER PROFlTABlLlTY Just as a bank has numerous options in designing a profitability analysis, a wide variety of profitability measures could be com - puted. Nevertheless, at most banks, profitabili - ty is generally judged on the basis of a handful of standard indicators. These include the ratio of gross profits to net funds used, net profits to net funds used, net profits to gross amount borrowed, and net profits to allocated ~ a p i t a l. ~ While only one of these commonly used in- dexes makes any explicit reference to bank capital, the alternative ratios can often be re - lated in a fairly direct way to earnings on capital. As a result, the desired return on capital can set minimum acceptable values to the noncapital ratios. Gross ProfitsINet Funds Used One of the profitability measures least like- ly to be subject to sizable distortion, and there-
4/ A detailed discussion of alternative types of profitability mea- sures is presented by Kenneth E. Reich and Dennis C. Neff in Customer Profitability Analysis: A Tool for Improving Bank Profiu, a booklet published by the Bank Administration Institute and the Robert Morris Associates (1972).
fore one of the most credible, is the ratio of gross profits to net funds loaned. Gross profits are equal to total profits when the cost of money is not included in expenses. Under this approach, customers are assumed to bor - row their own funds first and funds supplied by a customer are implicitly granted an earn - ings allowance equal to the average rate on the customer's loans. In mathematical terms the standard formula is:
Gross Profits Y - E Net Funds used=='
where Y equals gross income derived from the
customer relationship; E equals all costs of
servicing the relationship other than the cost
of funds; L equals average loans attributable
to the relationship; and D equals average loan -
able or investable funds provided by the cus- t ~ m e r. ~ The behavior of this ratio under varying circumstances can be readily seen. By elimi- nating the cost of funds from the analysis, a bank can avoid a situation in which the profit- ability index for customers with fixed rate loans and compensating balances varies in- versely as money market interest rates rise and fall. The index, though, would be sensitive to changes in loan terms. Since the interest paid on loans is reflected in Y and the compensat -
ing balances maintained are included in D, the
index would rise if either of these variables increased. If net funds borrowed declines, the ratio - other things equal-will approach in - finity. This tendency implies that large borrow- ers unable to keep sizable compensating bal- ances may have a comparatively low profitabil - ity ratio and that smaller borrowers are likely to rank higher. If the customer is a net borrow - er, the value of the index can be compared di - rectly to the bank's cost of funds or money market rates. As long as the ratio exceeds the bank's cost of funds, the relationship would
5 / In terms of Table 2, this measure corresponds to line 21.
Federal Reserve Bank of Kansas City
capital. Since the example at the beginning of this article used the capital allocation ap - proach, little need be added about the general description of the m e t h ~ d. ~Mathematically, the formula is:
Net Profits - --, y-E-c
Allocated Capital K
where K represents capital allocated to a cus- tomer relationship. If capital is allocated to both earning assets and deposits, this index is perhaps the most versatile of those widely used. The profitability of all customers, wheth - er or not they are borrowers, could be analyzed.1° Other Measures of Profitability In addition to the four basic ratios, many banks have adopted additional indexes of customer profitability. These include such ra - tios as net or gross profits/total revenue, net profits/total expenses, total incornelnet funds borrowed, gross profits/total loans, actual in- corneltarget income, and total revenue/total expenses. Some banks simply compute net or gross profits but do not relate the figure to any specific indicator of the size of a customer relationship. Although each indicator has unique properties and should be selected to
9'/ In terms o f Table 2, this measure corresponds to line 18. 101 The pioneering work in the capital allocation method of mea- suring customer profitability was performed by Philadelphia Na - tional Bank. A detailed description of the analysis methods used at Philadelphia National is contained in a publication the bank has prepared entitled " Profitability Analysis of Commercial Cus- tomers. "
reflect management objectives, the choice of a particular indicator is not likely to be a crucial matter. Under normal circumstances, most indicators produce roughly the same ranking of customers. CONCLMBlNG REMARK In the future, bank profitability is likely to depend increasingly on the differential be- tween loan rates and the cost of funds. Since profitability analysis tends to focus on this spread, it represents an important innovation for commercial banks. By combining numer- ous aspects of a customer relationship into a single analysis, it allows for a more ac - curate measure of customer profitability and overcomes some of the limitations of an ac - count analysis. While the mathematics of customer profitability analysis are relatively simple, the emphasis on one or two index numbers tends to mask the numerous choices which must be made in constructing a prof- itability formula. On the first level, there is the question of what to include in a measure of a customer relationship, and on the secon - dary level, the issue of how to measure those items that are included. A balance between theoretical precision and practicality is al - ways necessary. As a result, each portion of a profitability analysis has some controversial features. The second article in this series will describe the individual elements commonly used by banks to measure a customer relation - ship and will discuss some of the conflicts which can arise.
Federal Reserve Bank of Kansas City
