Getting a Return on Relationship Profitability

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profitability-7-8-19.pngHow profitable are your bank’s commercial relationships?

That may seem like a strange question, given that banks are in the relationship business. But relationship profitability is a complex issue that many banks struggle to master. A bank’s ability to accurately measure the profitability of its relationships may determine whether it’s a market leader or a stagnant institution just trying to survive. In my experience, the market leaders use the right profitability metrics, measure it at the right time and distribute that information to the right people.

Should Your Bank Use ROE or ROA? Yes.
Many banks use return on assets, or ROA, to measure their portfolio’s overall profitability. It’s a great way to compare a bank’s performance relative to others, but it can disguise credit issues hidden within the portfolio. To address that concern, the best-performing banks combine an ROA review with a more precise discussion on return on equity, or ROE. While ROA gives executives a view from above, ROE helps banks understand the value, and risk, associated with each deal.

ROA and ROE both begin with the same numerator: net income. But the denominator for ROA is the average balance; ROE considers the equity, or capital that is employed by the loan.

If your bank applies an average equity position to every booked loan, then this approach may not be for you. But banks that strive to apply a true risk-based approach that allocates more capital for riskier deals and less capital for stronger credits should consider how they could use this approach to help them calculate relationship profitability.

Take a $500,000 interest-only loan that will generate $5,000 of net income. The ROA on this deal will be 1 percent [$5,000 of net income divided by the $500,000 average balance]. The interest-only repayment helps simplify the outstanding balance discussion and replicates the same principles in amortizing deals.

You can assume there is a personal guarantee that can be added. It’s not enough to change the risk rating of the deal, but that additional coverage is always desirable. The addition of the guarantee does not reduce the outstanding balance, so the ROA calculation remains unchanged. The math says there is no value that comes from adding the additional protection.

That changes when a bank uses ROE.

Let’s say a bank initially allocated $50,000 of capital to support this deal, generating a 10 percent ROE [$5,000 of net income divided by the $50,000 capital].

The new guarantee changes the potential loss given default. A $1,000 reduction in the capital required to support this deal, because of the guarantee, increases ROE 20 basis points, to 10.20 percent [$5,000 of net income divided by the $49,000 of capital]. The additional guarantee reduced risk and improved returns on equity.

The ROA calculation is unchanged by a reduction in risk; ROE paints a more accurate picture of the deal’s profitability.

The Case for Strategic Value
Assume your bank won that deal and three years have now passed. When calculating that relationship’s profitability, knowing what you’ve earned to-date has a purpose; however, your competitors care only about what that deal looks like today and if they can win away that customer and all those future payments.

That’s why the best-performing banks consider what’s in front of them to lose, not what has been earned up to this point. This is called the relationship’s “strategic value.” It’s the value your competition understands.

When assessing a relationship’s strategic value, banks may identify vulnerable deals that they preemptively reprice on terms that are more favorable to the customer. That sounds heretical, but if your bank’s not making that offer, rest assured your competitors will.

The Right Information, to the Right People, at the Right Time
Once your bank has decided how it will measure profitability, you then need to consider who should get that information—and when. Banks often have good discussions about pricing tactics during exception request reviews, but by then the terms of the deal are usually set. It can be difficult to go back to ask for more.

The best-positioned banks use technology systems that can provide easily digestible profitability data to their relationship managers in a timely fashion. Relationship managers receive these insights as they negotiate the terms of the deal, not after they’ve asked for an exception.

Arming relationship managers with a clear understanding of both the loan and relationship profitability allows them to better price, and win, a deal that provides genuine value for the bank.

Then you can start answering other questions, like “What’s the secret to your bank’s success?”

What’s More Important—Size or Profitability?

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scale-12-9-15.pngDoes size matter in banking? Many senior bank executives and directors plainly think that it does, based on the results of Bank Director’s 2016 Bank M&A Survey. Sixty-seven percent of the survey respondents said they believe their banks need to grow significantly larger to stay competitive in today’s more highly concentrated marketplace, and about a third of them say their institutions need to get to at least $1 billion in assets.

I struggle with this logic because there is nothing that is necessarily magical about size per se—and particularly a specific number like $1 billion—that makes it more likely that a bank will be able to attain an acceptable level of profitability. The argument you frequently hear is that scale helps you spread your compliance costs—which have gone up precipitously in recent years—over a larger base. It also makes it easier to afford the kind of technological investments that are necessary to stay competitive in a marketplace where consumers and small businesses are using digital and mobile channels in increasing numbers. Both rationales have some basis in fact, but I wonder how many boards of directors have actually put their banks up for sale solely because they couldn’t afford the costs of regulatory compliance and/or technology upgrades. I think not very many.

One of banking’s most persistent problems in recent years has been a low interest rate environment that has compressed net interest margins across the industry and made it difficult to grow both top line revenue and bottom line profits. And herein, I believe, lays the rationale for many of the acquisitions that we have seen in recent years. Perhaps by getting bigger, many CEOs and their boards think they can become more profitable—but that doesn’t just happen ipso facto. Almost always, there’s vital post-acquisition work that needs to be done, such as cutting duplicate administrative costs, rationalizing overlapping branch networks, or deploying one of the merger partners’ expertise in a particular area to the other partners’ untapped market.

Gaining scale can increase a bank’s profits in an absolute sense, but not necessarily its profitability. Profit is the actual amount of earnings that a bank makes for a particular reporting period, while its profitability is what it makes relative to its asset base (return on assets) or market capitalization (return on equity). I believe that profitability is the better yardstick with which to judge the effectiveness of a management team and board of directors because it measures how well they did with what they had to work with. And behind every successful acquisition is, I believe, a strategy for how to increase the combined bank’s profitability rather than its absolute profits.

I really don’t consider doing an acquisition to be a “strategy” per se. An M&A transaction is exactly that—a transaction. This might seem like an overly nuanced point, but “strategy” is what the acquirer intends to do with its prize after the deal closes. How does the acquirer use its new, larger platform to increase its profitability? In fact, I would go so far as to say that if the acquirer’s ROA and (if it is a public company) ROE don’t improve materially within 18 months of the deal’s closing date, than the acquisition has probably failed to live up to its potential even if the bank’s net income is higher. 

Strategy is so important, in fact, that many highly successful banks avoid the M&A game altogether and focus all of their efforts on organic growth, which is rarely achieved and sustained without a well-conceived plan for how to make it happen. I don’t discount the fact that regulatory compliance and technology costs have gone up significantly in recent years, but growth through acquisition needs to be done with a larger purpose behind it than just getting bigger.