Ken Levey, VP of Financial Institutions for Kaufman Hall, was recently interviewed for the July/August 2019 edition of Forward, a publication of the Financial Managers Society. This excerpt highlights Ken's answers to pivotal questions on the future state of financial institutions and profitability. Download the PDF to read the full article.

Do you consider profitability improvement to be more of an art or a science?

It’s definitely a little of both. The art is to consider the full scope of a customer’s influence on overall institution profitability, but there is solid science behind the ability to make data-driven decisions based on the profitability and risk associated with that customer’s business.

The optimal approach analyzes a variety of profitability drivers – for example, the allocation of net interest income, non-interest income/expense, loan loss provision and capital.

What dimensions or profitability drivers are most institutions tracking? What should they be tracking?

According to our 2019 Profitability Perspectives survey jointly conducted with FMS, over 93% of institutions say it is important to monitor the profitability of organizational / business lines, customers, products and relationships, and nearly three quarters say you should track officer profitability. However, the percentage of institutions that actually track those dimensions is far fewer:

83% track organizational / business line profitability; 54% track product profitability; and fewer than 40% track customer, officer or relationship profitability.

We feel it is important to track profitability across all of these dimensions to get an accurate picture of institution health and to drive appropriate business decisions. Each institution needs to evaluate the importance of each dimension relative to its own business model.

How do customer relationships impact profitability?

A very small percentage of relationships – typically about 1% – generally adds the most value to an institution’s profitability. The loss of any of these relationships can have a significant impact on institution health.

Full relationship management or ‘super-householding’ is typically related to commercial accounts where an individual’s business and personal network are included in his or her scope of influence. These ties can magnify the results of any front-line interaction. Understanding the relationships and where the value comes from is imperative to managing a profitable portfolio.

What profitability benefits can financial institutions achieve through more effective management of their relationships? What are some of the requirements and challenges of doing this?

Correctly defining relationships and accurately analyzing their profitability provides a number of benefits, including identifying trends, opportunities and challenges; limiting the risk of underserving the best customers (and overserving less profitable ones); accurately pricing new business to optimize key profitability metrics; and more effectively managing risk-adjusted contribution over time.

Providing a robust calculation and modeling engine that accurately evaluates profitability and generates acceptable pricing scenarios provides relationship managers with further tools for success. Keys to making this work are defining each calculation needed (examples include funds transfer pricing (FTP), risk-adjusted return on capital (RAROC), provision expense and cost allocations) and agreeing on methodologies for calculation and how to access the source data.

In other words, it starts with making the data transparent. Each institution must establish methodologies, hurdle rates and other thresholds that are easily understood. Making the data transparent also allows institutions to hold relationship managers accountable.

What kinds of decisions might institutions be able to improve through better relationship management?

By accurately defining the full scope of each relationship in the institution (including all related customers and accounts), then quantifying and comparing their profitability, relationship managers can identify and expand their most profitable relationships and provide needed focus on relationships that pose a drain on earnings. These insights can guide several decisions:

  • Individual relationship managers can better manage the relationships within their own portfolio, informing pricing on new business, and appropriately prioritizing their business development and account management efforts.
  • Their managers can identify what top performing relationship managers do differently to coach others, as well as tying incentive compensation to relationship profitability (vs. production volume).
  • Institution leadership can get a more accurate gauge of current performance and better predict future performance based on factors such as relationship profitability of the portfolio as existing loans and deposits mature, and the effect of new business on future profitability.

What steps can an institution take to cultivate the kind of relationships that can lead to better profitability?

Pricing correctly is probably the most critical element. Institutions need to provide the best financial products for their customers at a price point that makes sense to the customer, but do so in a way that is financially prudent for both the institution and its investors. This can be accomplished by pricing new business based on the entire relationship, comparing different scenarios such as changes in interest rates and/or fees that both meet customer needs and meet or exceed established profitability metrics.

Special thanks to Financial Managers Society, Inc. FMSinc.org | 800-ASK-4FMS.