On Monday, September 23, 2013 Jeff Marsico and I unleashed our presentation and white paper “Product Profitability - Out of the Shadows" at the 2013 ABA Marketing Conference in San Antonio, Texas. In our presentation, the first part focused on "How is Product Profitability Made." Jeff and I are going to keep the conversation going by talking about one of the critical components of product profitability, Funds Transfer Pricing (FTP). We will share the why you need FTP, some challenges of using FTP and some recommended marketing and management uses of FTP data. The format of our dialog will be an interview format.
Question: Jeff, how long have you taught profitability at the ABA Bank Marketing school?
Answer: I’ve taught at the school since 2008. When I was first contacted to do it, I was a little surprised at the interest. It was the first step in the process of breaking my stereotype regarding bank marketers.
Why were you a “little surprised?”
I held the tried and true stereotypes of the differences between finance and strategy wonks (i.e. me), and marketing/creative types. But the school was dedicated to improving marketer’s ability to speak the language of the C-suite. And I applaud them for it.
Would you say that most of the students are shocked that they have to dust off their math skills?
I would say, that at least initially, I was the least popular instructor because my course could be taught in a spreadsheet versus a desktop publishing application.
Before you started teaching bank marketers, do you think you had your own set of biases as to what a marketer is?
Yes. I thought they ran the ad budget. Although true, it is a myopic version of the function. But if marketers were honest with themselves, I think they would admit they are more comfortable developing a business banking flyer than improving the profit trends of a business sweep account. When you are uncomfortable with the subject, that’s where growth begins. For both me and the students.
When these marketers start your course, what percentage of the class has ever heard of FTP? Know what FTP is?
Somewhere close to zero percent for those banks with less than $5 billion in assets. The larger banks have greater resources, both personnel and software, to deliver profitability information. And the marketing function has more specialists versus the generalists typically found in a community bank.
Wow! “Somewhere close to zero percent for those banks with less than $5 billion in assets” do not not know what FTP is? That assessment seems alien to me. My entire marketing career has always dealt with the math of profitability. My background is mostly non-banking. Do you think the financial services industry has typically devalued profitability in the marketing ranks?
I think profitability is devalued in all ranks because it is part art and part science. Sure we can calculate bank-level ROA, but do we drill down to the products that are most/least additive to ROA? Do we cross-reference to our customers and the products they use to identify profitable cross-selling opportunities? Profitability in community banks is starting to get some wind in its sails. But slowly.
WHY BANKS NEED FUNDS TRANSFER PRICING
Jeff, it has been my observation that many bankers look at deposits as an expense due interest paid customers on their deposit accounts and loans as income due to the interest collected on loans. Let’s get to the bottom of this misconception. So Jeff, what is Funds Transfer Pricing (FTP)?
You described the fundamental need for FTP. If you are a slugger for the NY Mets, provided they have a slugger, would it be fair that your performance bonus be based on the pitching staff’s ERA? No.
Therefore it’s not fair to credit the branch manager for how well the commercial lender performs. If you credit the branch manager the bank’s yield for the deposits they gather, you are effectively letting the commercial lenders’ performance impact the branch manager’s bonus.
In comes FTP, that isolates the performance of various contributors to the balance sheet. The branch manager receives a market rate credit for the deposits she gathers, and the commercial lender receives a market rate charge for the loans he makes.
Are there different types or methods of FTP?
Yes. The simplest FTP method being the single rate or pool method. Suppose your deposits have an average duration of 3.5 years. You then credit those deposit gatherers for a pool rate for a 3.5 year market instrument.
The best practice FTP method is matched maturity, or coterminous FTP. This transfer prices every instrument, at the account level, on the balance sheet for a market instrument of the same maturity. So if I’m a branch manager, and I book a 1-year 0.50% CD today, and a market rate such as an FHLB borrowing rate, for a 1-year instrument is 0.80%, then I book a 30 basis points spread for the life of that CD. Using this method, you isolate each instrument, and exclude interest rate risk from the equation.
What type of banks or credit unions do not need to have a FTP process?
Small banks and credit unions, perhaps under $300 million, that are not rapidly growing can effectively manage their institution using “top of the house” financials. But if the institution’s plan is to grow, they should consider implementing an accountability culture that delivers profitability information to business unit managers. If you want to measure performance at a granular level, then FTP is one of the tools to get you there.
Can the profitability of branches, business units, products, relationships, households, individual customers, etc. be calculated accurately without FTP?
Profitability information is part art, part science.
Can applying a bank’s cost of funds to the commercial loan portfolio be used to make decisions in that department? Probably, if it is consistently applied and the focus is on trend. But, as mentioned, you could be disguising performance issues in this department by using a superior low-cost deposit base in the measurement mix. Plus, what of the interest rate risk… i.e. borrowing short and lending long?
By not using FTP, you could be providing attaboys to your commercial team for the hard work your branches are doing, and the interest rate risk inherent in the balance sheet.
Jeff, you mention “disguising performance issues” and commercial lending team “attaboys.” Talk about that further. If the risks you mention are not being properly measured, what is the potential impact to a bank’s Return on Assets (ROA) and Return on Equity (ROE)?
Look no further than 2008 - 2011 where the trials and tribulations of the loan portfolio played out. Lenders were rewarded when they booked those loans in 2006 - 2007. If lenders were subject to profitability information, FTP that isolates their loan yields compared to a market rate, equity allocation based on risk of loan to calculate ROE (Risk Adjusted Return On Capital or RAROC), and a robust provision allocation based on Allowance for Loan and Lease Loss (ALLL) methodology, perhaps those loans would not have looked so good in 2006 - 2007.
TOP 3 STRATEGIC USES OF FTP DATA
What are the top three strategic capabilities a bank gains when they fully embrace the power of a FTP system into their financial DNA?
1) Pricing and operational discipline in day to day business development activities
2) Accountability at the business line level
3) A focus on the most profitable customer segments and not solely the ones with the highest balances.
Thank you Jeff. How would you like to summarize what you have shared?
Funds Transfer Pricing is one of the tools in an overall profitability reporting methodology. It does not stand alone. But those that use FTP, pushing institutional knowledge of precisely where their financial institution does and does not make money, and promotes an accountability culture for front-line employees to deliver profitable relationships and support staff to deliver efficient internal service to elevate profits at the account level, than how is this a bad thing? It’s not. But it is difficult to move from where you are to such an accountability culture. Bankers have to ask themselves, “is it worth the journey?”
Funds Transfer Pricing is a necessity for banks today. Size does not matter anymore. Every area of the bank needs to understand the basics of how a bank makes money from each dollar of a deposit and a loan. For today’s relationship managers and branch managers, profitability can no longer be “devalued.” The same goes for commercial lenders.
It is great that Jeff teaches profitability at the ABA Bank Marketing school. Marketers need to embrace the power of profitability and the power they wield in improving the bottom line of banks. Marketing should no longer be considered an expense but rather an investment in improving the value of a bank. Jeff put it best when he said “Profitability in community banks is starting to get some wind in its sails. But slowly.”
If you want to know more about how bank profitability is made and learn more about strategic marketing uses of this information, download and read the white paper that Jeff Marsico and I authored, “Product Profitability - Out of the Shadows”.