Wednesday, July 5, 2017

Corporate Banking – How to turn around unprofitable clients

Compliance, minimum capital requirements and their reporting, technology,… Basically all hot topics in banking today cost money and don’t generate revenue. How can banks then remain profitable?

Bain & Company has looked at this question and, on May 16, 2017, published a short paper on the topic: The main message is to shift management attention from cost cutting and operational efficiency in back offices to managing corporate client profitability.

The bank’s corporate client portfolio

Bain writes that a typical corporate client portfolio looks like this:

  • 20 % generate economic profits (In addition, 5 % of this 20 % or 1 % of the total portfolio actually generate most value).
  • 50 % generate moderate value or just break even.
  • 30 % fall below the threshold for economic profit (In addition, 3% of this 30 % or 1 % of the total portfolio actually have the most negative impact).

The numbers seem pretty devastating to me. After all, should banks’ employees be motivated and fully client focused if 30 % of the latter destroys value and 50 % hardly generates any profit?

So what to do? There are basically two ways to tackle the problem:

  • You focus on the profitable customers and get rid of the rest.
  • You keep the rest and focus your attention on increasing their profitability.

Bain chooses the second alternative. That makes sense: Can you imagine a bank firing a substantial portion of its customers while maintaining a good brand in the general public and the economic / political sphere? Besides, increasing clients’ profitability seems to require more consulting services as well…

How to manage corporate client profitability?

There are three basic steps:

  • Step 1: Which clients are (not) profitable?
  • Step 2: How to serve unprofitable clients in a different way?
  • Step 3: Move ultimately unprofitable clients off the book

The main problem of the first step is cost allocation data. If a bank’s IT system cannot track costs and clients properly, you cannot determine customer profitability either.

Bain suggests Return on RWA (RoRWA) as the main profitability indicator. Typically between 2-3 %, RoRWA is expected to increase with future higher interest rates. The message of this indicator is pretty simple: “Let’s get way from pure revenue growth towards profitable revenue!”

Turning to step 2, Bain says that the main cause for low profitability is a high RWA (typically through lending – Denominator up) without getting ancillary high margin business such as transaction banking, risk management, and advisory services in return (Numerator flat).

To avoid step 3, the bank needs to show low profit customers that it tracks client profitability individually and that the client needs to provide ancillary, more profitable, business to the bank.

Ideally, the above analysis is carried out over the entire life cycle of a client relationship, i.e.:

  • Onboarding: You should only spend money on new clients if they have the potential of being profitable.
  • Deal pricing: Deal pricing decisions must link the deal profitability as such to promised ancillary business. In other words, exceptionally low pricing can only be granted if compensated through other, more profitable business.
  • Profitability management over the entire business cycle of a client. This means, if the client earns a lot, the bank should earn a lot and vice versa.

There is one thing I find bizarre in all this discussion: Shouldn’t the prices for an unprofitable banking business simply rise to make it profitable again instead of cross-subsidizing it? Once again, markets don’t seem to work here…