New research from Novantas estimates that 75% of a bank’s market value comes from retail-and-commercial-deposit franchises, representing more than $1.3 trillion in the U.S.
But cyclical and secular challenges are putting significant stress on these businesses, raising the stakes for executives who must manage profitability challenges over the next 18 months, while also advancing the bank’s shift toward a digital future.
First-quarter earnings were solid and second-quarter results will provide more insight about the competitive and economic landscape in coming weeks. Many experts say that the rest of the year may get tougher. But Novantas believes that banks can target noninterest expense and interest expense to achieve quick, material profit improvement without sacrificing digital advancements.
DRIVERS OF PROFIT SQUEEZE
The industry is grappling with a number of challenges that are certain to crimp margins and profitability through the rest of this year — and beyond.
First, a slowdown in economic growth is challenging banks’ ability to significantly expand their loan portfolios. As a result, loan pricing and yields are under pressure.
Second, the slowdown in Fed rate increases is reducing deposit margins. Based on prior rate cycles, the industry could see margins tighten by another 10 to 15 basis points (bp). And that doesn’t even take into account a potential reduction in rates.
Third, longer-term secular challenges to deposit raising are only intensifying. Competition for checking offers and rate-based deposits is steadily eroding bank profitability. Banks send out nearly a billion checking offers a year and cost per acquired customer is now in the $300-$750 range. As a result, the marginal cost of funds (MCoF) across consumer, small business and commercial accounts is typically 300-450 bp. Economics 101 tells us that “economic rent,” or the amount earned that is above the required rate of return, will be competed away.
EYE ON EXPENSES
Tactical management of vendor expenses and human-resources costs (such as vacancies) are among the logical candidates for expense reduction. But Novantas believes that the industry should also do more to quickly reduce branch costs.
Building on the Novantas concept of “perceived convenience” and based on an analysis of mobile phone geolocation data, we estimate that some banks have a “convenience surplus” of as much as 25%. That means the difference between a consumer seeing five branches a day or three branches a day has a minimal impact on sales — and many banks are still at the five-branch mark.
Banks can continue to reduce this surplus, even if it means closing large profitable branches. After all, the $100 million-plus branch will likely be a prime target in the next wave of shutdowns. This will take more like 12-24 months to occur, but should be addressed as soon as possible.
OPTIMIZING INTEREST EXPENSE
Interest expense represents an even more significant area for cost reductions. The banking industry’s annual interest expense is roughly $120 billion. That represents about a quarter of non-interest expense, but it can be adjusted more quickly.
Novantas sees three potential strategies here, all of which take a page from the credit-card industry’s transformation to improve customer management by using analytics to minimize MCoF.
Retail lines of business should accelerate the transition away from broad-brush pricing and toward customer-level pricing and offers. Novantas has found that MCoF can drop as much as 100-200 bp using targeted customer-level campaigns instead of mass-market campaigns. This can be reduced by an additional 50 bp with the use of customer-level MCoF scoring, a deposit strategy similar to credit scores on the asset side. <--a href="/industry_insights/">(See Using Analytics to Identify Valuable Customer Deposits)
Also, Novantas believes that banks should introduce consumer-style precision pricing and analytics to business lines that rely on relationship managers, such as small businesses, wealth management and commercial. Relationship managers will be better equipped to negotiate price when they have access to these tools.
In particular, such data can be used to more efficiently apply exception pricing. Commercial businesses are already seeing balance erosion and the use of broad-brush exception pricing to retain balances can be as much as 100 bp more expensive than targeted pricing. Relationship managers need analytical support to understand the elasticity of a customer relationship.
As an example, one Novantas client uses a simple exception-pricing approach: give the best rates to the customers with the deepest relationships, such as lending and treasury management. Novantas believes, however, that the better approach is often the opposite: a true customer relationship means not conceding every last basis point.
CORPORATE FUNDING OPTIMIZATION
Lastly, banks typically operate with a siloed approach to interest expense, setting growth goals by line of business and then letting each business optimize. This approach costs most banks as much as 50 bp on marginal growth. A better practice is to optimize the deposit-growth goals and strategies based on MCoF across businesses.
As an example, many banks assume that retail is the best place to go for growth since average portfolio yields are typically much lower than commercial. But it turns out that the reverse is often true when measured on a MCoF basis.
Novantas estimates that the combination of all these interest expense strategies can reduce MCoF by 50-100 bp. For a typical regional bank that grows deposits by $4 billion a year, this translates into some $30 million a year in savings, which can free the bank up to make other investments that will help pump up future profitability.
Regional banks have recovered some of their recent growth shortfalls compared with national banks, but the strategy has mostly relied on price. As a result, the structural challenges for these institutions remain in place this year as they must also confront investments needed for a digital future. The only way that banks can live to fight another day is to implement these near-term profit levers, while also developing a longer-term plan that achieves differentiation.
Banks that figure this out will succeed as being acquirers in the industry’s consolidation. Those that don’t will find themselves as one of the thousand of banks that will be swallowed up over the next five years.
By Rick Spitler | CEO | firstname.lastname@example.org and Robin Sidel | Director | email@example.com
Taking a sledgehammer to your cost structure isn’t the way to boost profitability. Neither is draining funds from certain lines of business just because it may be difficult to quantify their value. But chances are that your bank can benefit by using your budget in a smarter way.
The challenges facing the industry are complicated. Here are two more areas that may be ripe for cost reduction by using precision analytics.
MARKETING: This isn’t the right time to slash marketing budgets, pull back on campaigns or reduce advertising. In fact, if you are pursuing a thin-market or direct-bank strategy, this is exactly the time when you need to make potential customers aware of the bank’s presence and products. Consider tailoring advertising to a local presence. And do you really know which customers should receive your direct mail or your email campaigns? Chances are you can target the right people in the right places by analyzing your direct-to-consumer communications and measuring how customers respond to your efforts.
WORKFORCE EFFICIENCY: Banks are still being challenged to manage a workforce that is facing a digital future. Sure, branches still need to be staffed, but how many of your bankers are sitting around with nothing to do? Spend more time analyzing when your customers walk in, what they are doing, and who they are. Tools like appointment-setting software can help make your branch efficient and ensure that customers are seeing a banker who has the appropriate skills.
EVP, San Francisco