One could argue that for most banks their Retail franchise is the most valuable part of the company. That has never been more obvious than during the recent banking “crisis” when banks without a strong retail franchise and a dependence on highly concentrated deposit portfolios came under severe pressure and, in a few cases, failed. Conversely, those with strong retail franchises have emerged from the worst of the crisis well positioned to not only survive but, importantly, capture market share and increase overall shareholder return.
Yet, because of the way many banks approach business unit accounting, Retail is often considered the least profitable line of business; especially during the last few years when deposits were plentiful, alternative funding sources cheap, and interest rates essentially zero. Consequently, the internal accounting value of deposits has declined precipitously from an already low level, reducing the valuation of the retail business even further. However, no area of banking is changing faster, or needs to change faster, than retail. Customer delivery channel behavior is evolving quickly, new entrants are using their access to the payment system to attract your customers, regulatory requirements are imposing new burdens on your people and systems, and legacy costs are difficult to eliminate. To keep pace, significant investment is required in multiple areas – facilities, systems, and people. So, how do you obtain the needed funding when resources are scarce and other business units can, and do, make more compelling financial arguments for a bigger piece of the pie?
Enlightened CEOs instinctively understand this dilemma and a few banks have made the decision to invest heavily in transformational initiatives regardless of the business unit P&L: a few, but not many, and certainly not all. To get more widespread support for these transformational activities, it is necessary to transform the discussion. This requires new approaches to business unit valuation, alignment between clear strategic principles and investment requests, and an effective test and learn environment that builds confidence in investment business cases and increases the probability of successful implementation.
Most banks, and certainly the larger ones, use some sort of business line profitability accounting. And, many of these include some variant of FTP (Funds Transfer Pricing) to determine a funds credit on deposits and a funds charge on loans. While actual models differ slightly, they all use some combination of rate and duration to determine the appropriate level of credit or charge on each type of deposit or loan based on comparable instruments in the Treasury or wholesale markets. Most retail banking businesses are net funds providers with relatively low loan to deposit ratios. As a result, the bulk of the interest income reflected on the business unit’s P&L is the margin between the deposit cost of funds and the FTP credit. Over the last few years, this margin has been in the 2% range, or lower. With the drastic decline in fee income, this margin has proven insufficient to cover both the direct and indirect (i.e. allocated) costs associated with running a successful multi-channel retail network. As a result, most retail “P&Ls” are just an “L”. Most CEOs do not believe that their retail businesses are creating little, no, or even negative value for the enterprise. Do they wish they would be doing better? Absolutely. Do they think they are “value destroyers”? Absolutely not.
In discussions with finance and treasury folks I often hear, “You may hate FTP now, but you’ll love it when interest rates climb.” Maybe, but probably not. It just doesn’t seem right to use a valuation methodology based on short-term vagaries in the interest rate environment to make long-term strategic and investment decisions. And, even if some management teams can get past the business unit accounting systems to make these important decisions, it is demoralizing to the people in the business to constantly see reports indicating that they are creating no value. For all these reasons, a different valuation method is needed.
The “Go Ahead and Sell it” Method.
Conventional wisdom would suggest that if a business is not generating sufficient returns, it should be sold. An argument can be made, however, that most banks would make little or no money without the retail franchise. It is virtually impossible and, as we have seen, certainly reckless to fund a bank in large part with wholesale deposits. Also, the retail business is, in many cases, the company brand. All those branches, with all those signs, create a market and brand presence that supports all business lines and provides a symbol of safety and soundness in difficult times. Most traditional commercial banks would have few, if any, commercial, wealth management, or mortgage customers without their retail networks. If selling the retail business would essentially destroy the company, then a case can be made that the value of the retail business is equal to the value of the enterprise. Doesn’t a business that important require significant investment to retain its viability and competitiveness, regardless of what the business unit P&L says?
The “Con Ed” Method.
Let’s say you’re running an electric utility company instead of a retail banking business. In order to make electricity you need raw material, such as coal. While we all know that customers are really the raw material in retail banking, for the sake of this analogy we’ll assume deposits as raw material. Now you need plants to turn coal into electricity, people and systems to run the plants, and power grids to distribute the product to consumers. Now, here’s the kicker – you not only don’t mark up your costs, you just charge your customers for the price of coal. Too often, isn’t that what we do? For those banks whose retail businesses are net funds providers, very few charge other business units for the all-in costs of generating those deposits or for supporting the brand. They only get paid for the coal. If you must rely on business unit profitability accounting to satisfy reporting requirements, then make it more accurate. Establish and agree upon an appropriate all-in cost of deposits (operating costs plus interest expense) and charge other business units the real cost of using those deposits.
The “Star Trek” Method
Another alternative is “To boldly go where no other bank has gone before”. That means eliminating business unit profitability accounting altogether. This alternative requires a major cultural shift in most organizations and a different way of developing managerial accountabilities and scorecards. The cultural shift is the more difficult challenge. It requires an acknowledgement and acceptance that only one bottom line number matters, and that’s at the enterprise level. It also requires an understanding of how each organizational unit contributes to the attainment of that number and the development of metrics that, if achieved, will ensure that the corporation in total achieves its overall financial goals. The beauty of this approach is that it’s simple. If someone asks you how you can manage the company if you don’t know how much each business unit “makes”, the proper response is, “True, I don’t know the profitability of each business unit, but I do know the company made $X million more than if we had spent the time, resources and expense to come up with a number that is probably wrong.” The key here is that the internal accounting methodologies are a reflection of the corporate culture, not separate and distinct from it. Many banks have a silo-driven culture that makes it difficult to work across organizational lines seamlessly. The accounting systems in many cases not only support but enable this culture. Without an enterprise-wide cultural focus this type of radical approach won’t work.
With Great Power Comes Great Responsibility
Now that we have shown the true value of the retail business, does that mean it should be given unlimited resources to invest in needed transformational initiatives? Obviously not. There are clearly a lot of things retail banking executives could do from a technology, facilities, and people perspective, but only a few that they should do. Therefore, it is critical to align funding requests and investment decisions clearly with the bank’s retail and overall strategy and employ techniques that allow for testing key program elements and concepts before a full organizational and financial commitment is made to full implementation. Remember, just because something is new, doesn’t mean it’s good. And just because something appears to work for one bank, doesn’t mean that it will necessarily work for all.
Please contact author Rolland Johannsen for more information.
