Author: Jon Kozlowski, firstname.lastname@example.org
The existence of an “80/20 rule” is an accepted notion in most industries; banking is no exception. Conceptually it is easy to grasp that some customers may be more profitable than others, mainly due to their higher volume. And this is indeed true. What is not well-understood is just how true this is.
At community financial institutions, the “80/20 Rule” is actually a “200/20 Rule.” ProfitStars provides customer and product profitability solutions to hundreds of financial institutions. What we’ve learned from talking to these institutions is that typically more than 200 percent of their total net income is generated by the top 20 percent of the customer base. At the opposite end of the spectrum, over 60 percent of community bank customers lose money for their institutions.
Less of a surprise is the composition of customers at the high and low ends of the profitability range. The most profitable customers tend to be those with the largest loan balances, thereby generating the greatest interest income.
In a blog I published here on July 31, 2013, I discussed the notion of “one size fits all” pricing as one of the biggest contributors to underperformance in loan portfolios. Due to inelastic costs, the size of the loan being booked is one of the most significant factors in that loan’s profitability. Holding other variables constant, smaller loan sizes require progressively higher rates to maintain a constant return to the portfolio. Exhibit 1 illustrates the required loan rate to achieve a constant return on allocated capital for loans of different sizes:
Exhibit 1: Rate Necessary to Achieve a Constant Return on Allocated Capital
Unfortunately loan size is also one of the most overlooked factors in the pricing decision. For many (if not most) community financial institutions, the mark-ups on small versus large loans are disproportionate. What we’ve found out talking to our customers is that many don’t consider loan size as a factor in pricing. To the extent that there is a differential in the pricing of small versus large loans, the mark-ups are largely “accidental” and driven by other factors such as lower credit quality among the population of smaller commercial borrowers. The profound impact that economies of scale has on loan profitability, and the lack of dispersion in pricing of larger versus smaller credits exhibited by most community banks, leads to an inevitable conclusion: Most institutions are over-pricing their most profitable customers and under-pricing their least profitable.
Great opportunities for performance enhancement lie in pricing credit opportunities at the instrument level, using an analytically robust pricing model that consistently applies all factors that drive profitability. Doing so will allow the refinement of strategy based on which “bucket” (large/mid-tier/small) the opportunity falls into. (Tier ranges are representative for a <$1 billion institution.)
Large (over $750,000) credits: Customers in this category are most likely to occupy the top 20 percent in the profitability distribution. The fact that these credits are priced similarly to much smaller credits puts these accounts at risk to overtures from more aggressive competitors for their business. It also often leads to the conclusion that the institution can bid more aggressively for new business in this bucket while still securing an attractive rate of return.
Mid-Tier ($150,000-$750,000) credits: These opportunities are frequently the “sweet spot” for high-performing community banks, as they are large enough to produce strong returns while attracting less unwanted attention from competitors. While the institution can bid these opportunities aggressively and still generate solid returns, customers in this bucket tend to be less transactional in their approach to credit and are more likely to value the total relationship with their bank rather than rates/fees exclusively.
Small (under $150,000) credits: These credits dominate the lower range of the profitability distribution, especially those in the under-$50K tier. The challenge here is to parse this population of individual credits into those that are related to larger, profitable relationships and those that are not. A robust relationship profitability model can readily accomplish this. Relationship pricing at sub-optimal or even negative returns can be justified if the dilution of the overlying relationship can be demonstrated to be immaterial. For those where it is not, significant mark-ups are in order, or the opportunity should be passed on.
The restoration of economic growth, albeit modest, has taken some of the pressure off of bank earnings, but many headwinds remain. The significant build-up of liquidity that the industry saw during the financial crisis for the most part remains, leading to aggressive and at times irrational bids on the limited lending opportunities available. An instrument-level approach to manage pricing will allow for a more optimal portfolio composition and a more rational approach to new business opportunities.
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