Improving Earnings: It’s Everybody’s Business

In many banks, only the directors, senior managers, and shareholders are actually focused on earnings. Almost everyone else in the organization is intent on simply doing his or her job. The idea of the bank as a profitable commercial entity may be far from their minds. Earnings improvement, however, should be everyone’s immediate business.

The prerequisite to sustained profitability is an organization in which everyone is focused on earnings improvement. That means, of course, communicating. It means getting people involved at all levels of the organization and helping them to understand that they are part of something bigger. It means clearly and continuously articulating the bank’s objectives and goals and telling them that it is importantu00e2u20ac”indeed urgentu00e2u20ac”for them to see that larger picture.

A Simple Formula

A lack of focus and urgency, rather than a lack of knowledge or options, is the most common obstacle I see to increasing bank earnings. In many banks, inertia sets in because people believe that either bank earnings are a function of the economy and business environment over which they have no control, or that earnings improvement is a measurement, not a basis for management action.

The interesting thing about earnings improvement as a management discipline is that, first, it tends to involve the obvious things that are in front of people all the time. Second, it’s not all that complicated. Opportunities for earnings improvement, though abundant, fall into just three categories:

1. increase net-interest income;

3. decrease noninterest expense.

Our firm recently published a booklet suggesting seven possibilities for earnings improvement in each of the above three categories. While some of the suggestions involve offering new products or adopting new strategies, most of them simply involve looking at existing activities in new ways.

Always the Basics

For each earnings improvement option you choose to undertake, certain basic management steps are necessary to make it work. Briefly, they are as follows: After prioritizing opportunities, action plans for each initiative are developed in order of priority. The action plans, among other things, set earnings targets, define accountabilities, specify deadlines and performance measurements, and tie results to employee incentives.
During the implementation phase, people at all levels of the organization should understand

• the purpose of the earnings improvement initiative (ultimately, to make money);
• their personal role in its advancement (to directly contribute to that ultimate purpose); and
• what they can expect to gain from it (to be part of a high-performing institution and share in the fruits of its success).

Finally, senior management should monitor the bank’s earnings improvement initiatives and, if necessary, make adjustments. A critical element, here again, is communications. As senior management and the board track results, they should treat everyone in the organization as stakeholders, which means reporting the findings back to them, holding them accountable, and rewarding them for success.

Take Your Pick

The following are some brief observations about the three ways to move the earnings needle hard to the right.
Net-Interest Incomeu00e2u20ac”Regardless of what you hear about how banks are making money today, interest spreads still represent the lion’s share of bank earnings. The Federal Deposit Insurance Corp., in releasing its bank earnings report for third quarter 2002, noted that almost three out of every four banks reported improved year-to-date earnings, primarily because of higher net-interest income.

In most banks, interest spreads are still the major drivers of earnings. This is true certainly of small community banks, but it is also true of the largest regional and nationwide banks. In a report that focused on the earnings of the 25 largest banks in the United States, the FDIC stated, “The continuing climate of low short-term interest rates and a steep yield curve has been the key to net-interest income stability and the maintenance of high margins.”

How do you improve loan yield? Pricing models that balance risk and profitability are one way. Another effective approach is to offer incentives to loan officers to price loans at or above a target yield, based on established criteria. It is truly amazing how suddenly and dramatically loan pricing turns favorable when such incentives are used.

An obvious way to grow loan volume is to expand the bank’s geographic reach. However, the expense of a full-service branch can slice into any profits attributable to the new loan business. Loan production offices located in storefronts, office buildings, or other existing facilities allow a bank to test the waters before committing to building a new branch.

Banks are also favorably affecting interest spreads by paying more attention to core deposits. Marketing to “centers of influence,” customer activation programs, and premarketing campaigns to build business before a branch opens are some of the ways that banks are using marketing principles to grow core deposits. Experience shows that deposits bought with marketing dollars will stay longer than those bought with high rates, which tend to attract price-sensitive (read “not loyal”) customers.

Finally, bankers are becoming savvier about alternative sources for funding loans, such as Federal Home Loan Bank borrowings and Internet posting services. Obtaining funds from these and other alternative sources is, in many cases, less expensive than what the bank would have to pay in the consumer deposit market.

Increase Noninterest Incomeu00e2u20ac”Community banks are slowly but surely migrating toward more fee-income-producing activities. For example, some banks are revitalizing dormant trust departments or establishing start-up trust operations to serve the trust and/or wealth management market. Others are taking advantage of authorities granted by the Gramm-Leach-Bliley Act to enter new fee-based businesses, such as title insurance. These activities are generally having a positive impact on bank earnings.

A foray into a new business line, though, is a risky proposition, and it may take several years to show a profit. In contrast, overdraft services are a unique and immediately available source of significant noninterest income. We believe a financial institution adopting such a program can increase its NSF income between 50% and 150% within four to six months of implementation. Simultaneously, a dramatic lift occurs in customer satisfaction with how the institution handles overdrafts.

It also pays to keep account service charges adjusted to the market. An ongoing service charge monitoring program will keep these fees current with the market (which usually means higher). Commercial loan fees are another important revenue opportunity that can be maximized through loan officer incentives.

Decrease Noninterest Expenseu00e2u20ac”Expense control is, in some ways, the most important element of earnings improvement because no matter how much you increase revenues, uncontrolled costs will put a drag on profitability. In addition, banks with low operating expenses are able to maintain profitability with thinner interest margins.
When searching out ways to reduce expenses, senior management should look at both immediate and long-term cost controls. Some immediate controls can be found simply by asking employees to identify waste and duplication or a more efficient way of doing something.

Longer-term expense controls are more difficult to implement and may entail costs in the short term. But long-term controls also have the advantage of permanence, and the savings can be eye-opening. For instance, a professionally facilitated data processing vendor review takes the guesswork out of technology contract pricing. Many banks have achieved significant long-term savings by knowing what other vendors customarily charge for comparable systems and services.

Similarly, staffing models allow managers to more precisely schedule staff to accommodate predefined target service levels. Human resources is an important area to look at because salary and benefits represent most banks’ highest noninterest expense. Finally, process improvement studies can unlock a host of opportunities for saving time and costs.

A Banner Year

Commercial banks earned $23.4 billion during third quarter 2002, a figure that was only slightly lower than the earnings figures for the previous two record-setting quarters. Overall, the industry earned $68.5 billion during the first three quarters of 2002, compared to the $74.7 billion that banks earned in all of 2001.

Earnings improvement is influenced by more efficiently managing the three major drivers of profitability: net-interest income, noninterest income, and noninterest expense. The good news is that virtually every bank can find opportunities to achieve and sustain increased profitability. |BD|