In a previous The Financial Brand article, I wrote that almost half the nation’s branches may be too small to achieve the desired level of returns. Generally speaking, we recommend that branches with under $40 million in deposits should be targets for action, with a special emphasis on those under $25 million.
Why? Because many of these branches are not growing, or are growing so slowly that they may not reach profitability goals for decades, if ever. That’s a huge concern, especially since consumers and small businesses are using branches with less and less frequency every year. If a branch is not generating a profit now and is not growing at a certain rate, then serious remedial action is required. It’s not like people will ever use that branch more than they are already today.
There aren’t a lot of options for these locations. You can either jumpstart organic growth, or be realistic and take a clear-eyed assessment as to whether managerial resources and corporate capital could be better allocated elsewhere.
Some banking executives recoil at this proposition. “Not my branch!” they decry. “It’s low cost and has good returns, even if it has a low deposit base.” As always, there may be the occasional exception to the rule. Yes, it’s true: there are low cost branches. And there are branches that may be servicing high value customers and are critical to retention.
It’s reasonable to set targets for branch revenues that are twice the all-in costs for each location. If those targets aren’t achieved, it will be difficult for the institution to attain a good overall efficiency ratio.
But it’s worth stepping back a moment to think about the analysis. What methodology should you use to measure the profitability of your branches and set appropriate performance targets?
Assign Each Customer to the Right Branch
It’s common for banking providers to attribute revenues to the branch that originated an account. A more appropriate allocation, however, is one that considers the branch that actually services the account. This requires a different kind of allocation approach, based on how often account holders use each branch during the past several months, as well as where and when the account was opened.
Use a hierarchical approach. For example, if the account opened at the Springfield branch during the past year, Springfield gets the credit. If the account was opened elsewhere more than a year ago but the majority of transactions during the past year were at Springfield, then Springfield gets the credit.
There are various ways to develop these rules, depending on the institution’s systems and processes. While best calculated at the household level, you can use the individual customer as a pragmatic first step. Then re-allocate on at least an annual basis as behaviors change.
Here’s a quick “rule of thumb” to determine whether your allocation methodology is on-track: simply match your customer traffic with assigned customers. Do you have former headquarters branches with lots of assigned customers (and therefore lots of revenue) but limited actual traffic? Do you have newer, suburban branches with lots of expenses but relatively fewer assigned customers? If so, you have to concede that your assignment of “customer value” is out of synch with reality and people’s real world behaviors.
Attribute the Right Revenue
Once customers are assigned to the right branches (or channel), then some portion of the revenue assignment is clear. It’s straightforward to assign deposit account service charges, branch-specific fees (e.g., wire transfer, safety deposit), ATM fees and debit card revenue associated with assigned customer accounts.
Credit card and merchant card fees are a bit trickier conceptually, especially if there is a separate credit card and merchant group that is already counting those fees as part of their business line profitability.
What About Spread Income?
Spread income is best calculated by account based on an FTP (Funds Transfer Price) using the expected life of the account and the interest rates yield curve when the account was opened.
Rough spread income calculations may be used if more sophisticated measures are unavailable or unaffordable. It does require the bank to allocate accounts per branch and then group the accounts into product types. By product type, determine an average duration, and the current yield curve to determine the FTP for each product and its duration. This is a time-consuming process but well worth the effort at least once annually to determine a rough branch profitability.
Don’t Overcomplicate Cost Allocation
Marginal costs and facility costs are easily attributable to a branch. The issue is always how to attribute back office costs to cost centers. This is a zero sum game so nobody will be entirely happy with the outcome. Develop the allocation methodology before calculating the costs. It is easier to sign-off on a methodology than it is to sign-off on numbers that may negatively impact your cost center.
There are many approaches to cost allocations, including the use of simple surveys by back office center to estimate the percentage of time and expenses utilized by each department.
But the real question is: should corporate allocations be driven to the branch level? Good arguments can be made both pro and con, but we favor a simpler approach. Keep the corporate expense allocation at the line of business level, for example, overall retail or business banking. Measure branches on their controllable expenses and require that they achieve enough contribution to overhead to achieve overall corporate profitability. That way, you’ll keep your focus on the ratio of revenue to direct expense and not get hung up on whether the branch allocation of training, marketing — or the Chairman’s salary – is fair.
Key Takeaways and Closing Thoughts
These profit planning tools can give unlock great insight into strategies to improve overall profitability. Combine this analysis with benchmarks, either from overall industry comparisons or comparisons to your best performing branches, to isolate problems and identify opportunities for further improvement — even in your profitable branches.
Look closely at your small branches, even if they appear to be profitable. Older, fully depreciated facilities may be profitable today, but you know that eventually it will require investment and upgrades. When you look at your longer-term planning, be sure to include an assessment of how that facility fits into your overall strategic distribution planning.
Guenther Hartfeil is a senior consultant at Peak Performance Consulting Group based in Austin, Texas, specializing in banking strategy. To connect with Guenther, please send him an email. The author would like to thank David Basri of PointEnterprises for his insight and contribution to this article.