FIVE CRITICAL ASPECTS OF PROFITABILITY ANALYSIS A GUIDE FOR FINANCIAL INSTITUTIONS

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Evelyn Cole
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1 FIVE CRITICAL ASPECTS OF PROFITABILITY ANALYSIS A GUIDE FOR FINANCIAL INSTITUTIONS

ntro ction y nstit tions o l eas re Profitability As it ost b sinesses profitability is one of t e

Benefits of a robust profitability framework: elps n erstan t e tr e rivers of cost an

pro cts an c sto ers are profitable an ic ero e val e entifies t e tr e cost of provi in s pport

2 ntro ction y nstit tions o l eas re Profitability As it ost b sinesses profitability is one of t e ost critical perfor ance etrics for s ort ter an lon ter financial ealt of financial instit tions Benefits of a robust profitability framework: elps n erstan t e tr e rivers of cost an profitability in t e instit tion eveals ic parts of o r instit tion enerate c sto er val e o s ic pro cts an c sto ers are profitable an ic ero e val e entifies t e tr e cost of provi in s pport services Assists in analy in o s are services are bein cons e 2 Five Critical Aspects of Profitability Analysis

ey Co ponents of Profitability Fra e or Funds Transfer Pricing t e process of c ar in f n

balance s eet Service Transfer Pricing t e process of allocatin centrali e costs to profit

e penses to t e vario s i ensions of profitability Capital Allocation t e process of

ation allo s an instit tion to better n erstan its overall profitability by nitin t e o tp

3 ey Co ponents of Profitability Fra e or Funds Transfer Pricing t e process of c ar in f n sers an cre itin f n provi ers by allocatin t e net interest ar in to eac acco nt on t e balance s eet Service Transfer Pricing t e process of allocatin centrali e costs to profit centers base on cons ption or se allocates an instit tion s non acco nt specific inco e an e penses to t e vario s i ensions of profitability Capital Allocation t e process of allocatin capital to allo eas re ent on a ris ret rn basis assi ns capital base on t e ris profile of an instr ent or portfolio alon it t e c sto er an acco nt type for a ret rn on capital calc lation Multi-dimensional Reporting t e ability to e ibly slice an ice infor ation allo s an instit tion to better n erstan its overall profitability by nitin t e o tp ts of t e above processes in a sin le lti i ensional repository 3 Five Critical Aspects of Profitability Analysis

4 Critical Aspects of Profitability Analysis e follo in five aspects of profitability analysis are critical to creatin an s stainin a profitability eas re ent pro ra t at can be se to rive ecisions an i prove financial perfor ance F n s ransfer Pricin Determine i ensionality C oose t e i t Approac on nterest nco e an pense Allocations Assi n ent of t e oan oss Provision an is base Capital 4 Five Critical Aspects of Profitability Analysis

Profitability eas re ent ar in eas re ent Pro ct Pricin ecentrali e ecision a in F P allo s or ani ations to ans er estions incl in ic loan pro cts

5 1 Funds Transfer Pricing F n s ransfer Pricin F n s ransfer Pricin F P is t e process of c ar in f n sers an cre itin f n provi ers by allocatin t e net interest ar in to eac acco nt on t e balance s eet Goal of FTP - Acc rately an rationally eas re t e cost or cre it of f n s in s pport of Profitability eas re ent ar in eas re ent Pro ct Pricin ecentrali e ecision a in F P allo s or ani ations to ans er estions incl in ic loan pro cts are profitable ic branc es are losin oney o eposits contrib te to profits ic c sto ers are profitable 5 Five Critical Aspects of Profitability Analysis

to i prove profitability Consi er loo in

an eac one in ivi ally Consider these key

6 2 Determine Dimensionality eter ine i ensionality eter ine t e i ensionality yo nee by t in in abo t o yo ant to loo at profitability ata so yo can ta e action to i prove profitability Consi er loo in at a cross section of i ensions rat er t an eac one in ivi ally Consider these key dimensions for analysis: r ani ation ranc es ines of siness e ions ar ets Pro cts Pro ct ines n les C sto ers o se ol s e ents iers eciles C annels eb A ric an ortar cers 6 Five Critical Aspects of Profitability Analysis

7 2 Determine Dimensionality r ani ational profitability val ate contrib tion of nits incl in all costs bot irect an in irect eveal nits t at brin t e ost profit to t e or ani ation eter ine t e cons ers of s are services ana e reso rces ore e ectively ile aintainin or i provin services 7 Five Critical Aspects of Profitability Analysis

8 2 Determine Dimensionality Pro ct profitability val ate contrib tion of pro cts incl in all costs bot irect an in irect eveal pro cts t at brin t e ost profit to t e or ani ation Analy e tren s in pro ct profitability relate to vol es sales an i Analy e fi e vs variable cost i MTD Product Rankings as of 11/30/11 (Ranked by Net Contribution Margin) 8 Five Critical Aspects of Profitability Analysis

analysis Top 10 Contribution 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000

9 2 Determine Dimensionality C sto er profitability Analy e rivers be in c sto er profitability an top an botto contrib tors val ate cost benefit of pro otions e ent c sto er portfolio for eeper analysis Top 10 Contribution 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 Customers Officers Top 10 Remainder 9 Five Critical Aspects of Profitability Analysis

10 3 Choose the Right Approach op o n approac r ani ations typically ta e eit er a top o n or botto s p approac to profitability analysis A top o n approac is typically a eneral le er centric approac ile a botto s p approac typically involves an instr ent level foc s elo is a top o n approac Loan Systems Deposit Systems Fee Based Systems Transactional Data General Ledger Organizational Profitability Customer Profitability Allocate Costs to Profit Centers Different Methodologies between systems Product Profitability Provide Unit Costs Multiple Reconciliations Allocate Costs to Products 10 Five Critical Aspects of Profitability Analysis

11 3 Choose the Right Approach otto s p approac Loan Systems Deposit Systems Fee Based Systems Transactional Data Transactional Data Customer Profitability General Ledger Serves as a Point of Reconciliation and a Reality Check to Profitabilty Results Product Org Channel Officer Rollup to Other Dimensions Consistent Methodologies Single Reconciliation 11 Five Critical Aspects of Profitability Analysis

4 Non-Interest Income and Expense Allocations on interest inco e an e pense allocations en allocatin non interest inco e an e penses on t e P state ent it is i portant to consi er t e follo in

12 4 Non-Interest Income and Expense Allocations on interest inco e an e pense allocations en allocatin non interest inco e an e penses on t e P state ent it is i portant to consi er t e follo in factors ata availability an i ensionality st ave s pportin ata at t e level yo ant to analy e et o olo ies f ll absorption vs activity base costin approac es Acco ntin for corporate over ea 12 Five Critical Aspects of Profitability Analysis

4 Non-Interest Income and Expense Allocations F ll absorption approac to

profit center ac cost center ses appropriate rivers an allocation percenta es

reveal e cess capacity oes not i entify reso rce tili ation properly penali es

13 4 Non-Interest Income and Expense Allocations F ll absorption approac to allocations is approac ses rivers to allocate all bac o ce costs o t to eac profit center ac cost center ses appropriate rivers an allocation percenta es Pros: Allocates all costs a rees to res lts easy to e plain ana e Cons: oes not reveal e cess capacity oes not i entify reso rce tili ation properly penali es profit centers for bac o ce ine ciencies 13 Five Critical Aspects of Profitability Analysis

4 Non-Interest Income and Expense Allocations Activity base costin approac to allocations is approac eter ines t e cost per transaction or activity ic can t en be applie to transaction vol e

areas it non repetitive f nctions ar etin - Pros asy to i ple ent an e plain oo involve ent fro t e or ani ation - Cons ata collection res rvey fails to i entify e cess capacity less acc rate

ployee resistance Time-Driven at ers ti e re ire to perfor i erent activities an ltiplies vol es to eter ine t e total ti e perfor e an percenta e of e ort oo for areas it repetitive tas s

14 4 Non-Interest Income and Expense Allocations Activity base costin approac to allocations is approac eter ines t e cost per transaction or activity ic can t en be applie to transaction vol e to eter ine total costs for allocation A fe co on activity base costin et o s are Percentage Driven at er in percenta e ter s t e a o nt of a f nctions ti e evote to an activity itable for areas it non repetitive f nctions ar etin - Pros asy to i ple ent an e plain oo involve ent fro t e or ani ation - Cons ata collection res rvey fails to i entify e cess capacity less acc rate Time Capture Driven capt re ti e fro applications p nc car s etc oo for prof services - Pros reat for e icate ti e to specific pro cts an c sto ers - Cons Fails to i entify e cess capacity e ployee resistance Time-Driven at ers ti e re ire to perfor i erent activities an ltiplies vol es to eter ine t e total ti e perfor e an percenta e of e ort oo for areas it repetitive tas s eposit processin - Pros i entifies e cess capacity - Cons ata availability ata vol e can be c berso e to ana e Hybrid co bination of above approac es 14 Five Critical Aspects of Profitability Analysis

5 Assignment of the Loan Loss Provision and Risk Based Capital Factors to consi er in loan loss provision assi n ent ata availability Pro ct type Cre it is is ratin Cre it core Assi n ent et o all at

15 5 Assignment of the Loan Loss Provision and Risk Based Capital Factors to consi er in loan loss provision assi n ent ata availability Pro ct type Cre it is is ratin Cre it core Assi n ent et o all at ori ination apply over a certain perio set perio loan ter i in i erences RISK RATING CODE PRODUCT CATEGORY Commercial Loans 0.50% 0.75% 1.00% 1.00% 3.00% 5.00% 15.00% Agricultural Loans 0.50% 0.75% 1.00% 1.00% 3.00% 5.00% 15.00% Municipal Loans 0.50% 0.75% 1.00% 1.00% 3.00% 5.00% 15.00% Assigned Calculated Loan Balance Product Type Rating LLP% LLP Consumer Secured 0.25% 0.50% 0.75% 1.00% 3.00% 7.50% 15.00% Loan A $ 100,000 Commercial % $ 1,000 2nd Mortgages 0.50% 0.75% 1.00% 3.00% 5.00% 7.50% 15.00% Loan B $ 100,000 Mortgage % $ 250 Home Equity Loans 0.25% 0.50% 0.75% 1.00% 3.00% 7.50% 15.00% Personal Loans 0.50% 0.75% 1.00% 3.00% 5.00% 7.50% 15.00% Consumer 0.25% 0.50% 0.75% 1.00% 3.00% 7.50% 15.00% Auto Loans 0.25% 0.50% 0.75% 1.00% 3.00% 7.50% 15.00% Overdrafts 0.50% 0.75% 1.00% 3.00% 5.00% 7.50% 15.00% Mortgage Loans 0.25% 0.50% 0.75% 1.00% 3.00% 7.50% 15.00% Participations 0.25% 0.50% 0.75% 1.00% 3.00% 7.50% 15.00% Credit Score Bands Five Critical Aspects of Profitability Analysis

16 5 Assignment of the Loan Loss Provision and Risk Based Capital There are three common options for assigning risk-based capital - regulatory, peer-based, and multifactor matrix. Capital Assi n ent e latory is ei te Assets approac ses re latory i ance relatin to asset cate ories an capital percenta es + Pros - Cons asy to i ple ent stifiable ea ily Available ates nly consi ers Cre it is oes not acco nt for iabilities or t er Assets oes not acc rately eas re t e instit tion s ris till nee to allocate o n fro total ban level! eco en ation nly se as an intro ction to t e overall concept 16 Five Critical Aspects of Profitability Analysis

17 5 Assignment of the Loan Loss Provision and Risk Based Capital Capital Assi n ent Peer base Consi ers eac line of b siness a stan alone entity ses peer infor ation for t ose s to eter ine ar et capital ratios + Pros - Cons partial analysis ase on e ternal ob ective ar et ata stifiable! eco en ation i c lt to fin peer ata or ali in capital ratios can be i c lt oes not acco nt for iversification Peers ay be i erent an non co parable nly assi ns to not ot er i ensions ay be sef l in certain cases 17 Five Critical Aspects of Profitability Analysis

18 5 Assignment of the Loan Loss Provision and Risk Based Capital Capital Assi n ent lti factor atri Assi ns ei tin s to ris cate ories cre it operational an factors in t e ris s in erent in in ivi al pro ct ro ps co ercial loans cons er loans cons er As + Pros - Cons Acco nts for t e vario s ris s it in t e institution Consi ers liabilities an ot er assets Collaborative stifiable ei tin s are s b ective Can be i c lt to et consens s on ratin s ess strai tfor ar to e plain! eco en ation ost acc rate et o ot er t an a e icate application 18 Five Critical Aspects of Profitability Analysis

eco pose to s o etails an calc lations cate yo r or ani ation abo t profitability an F P efine

19 5 Assignment of the Loan Loss Provision and Risk Based Capital o e best practices to consi er Fin yo r level at s its yo r oals et b y in fro cons ers of analysis yo plan to pro ce Al ays be able to eco pose to s o etails an calc lations cate yo r or ani ation abo t profitability an F P efine refine refine contin e to i prove an en ance yo r approac 19 Five Critical Aspects of Profitability Analysis

20 A io oft are s nifie Perfor ance ana e ent ol tions Delivering a Financial Planning and Decision Support Platform for Financial Institutions strategy management Ali n b siness realities an financial plans it t is inte rate perfor ance ana e ent platfor esi ne for financial instit tions A io oft are elivers sop isticate plannin reportin an ecision s pport f nctions in a sin le sol tion incentive compensation management loan portfolio analysis budgeting & forecasting funds transfer pricing & profitability management reporting & analytics reenb r ite Portlan p one fa a io ep co

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