Profitable Paradigm - Through the Lens of Profitability in Covid times

Is it relevant to talk of profitability during Covid times some might ask? It is and HOW!! Healthy banks are  sine qua non to support pandemic induced distressed economy & customers whether it is retail, commercial/ SME or corporates in affected industries.

Connecting the dots across my previous  three blogs, the big picture is that banks themselves are experiencing compression of both Margin and Capital. This phase will continue for a while with increase in non-performing loans & repayment moratoriums leading to higher provisions, reduction in both interest and fee income not to mention the higher demand from customers for both financial and non-financial support.

While capital buffers and the regulatory relief will help, they are neither unlimited nor perpetual. The hard-won resilience will  preserve the financial system in near term. Industry is exploring ways of stabilizing the P&L and Balance Sheet in the medium term, while growing it for the long run.

The shape, structure and timing of the economy that would emerge is unknown given that the duration and extent of the pandemic is unknown  – factors largely outside of the control of banking industry. The brighter side is that there are aspects within their control that banks can start working on now, the  focus of this blog. Three broad themes come to mind

 Understand and address camouflaged Loss– As banks face lower revenues (lower interest rate regime plus compressed margins) and real pressure on productivity, it is imperative to have a closer look at profitability & performance.  The challenge is that Information systems, in most cases,  are not structured to intuitively make obvious either the problem or opportunity pockets at a granular level. If anything, they camouflage the unprofitable micro segments** under the aggregates umbrella and there lies the problem. The profits we see at aggregate level is an average and the truth of averages is that they are never real, they successfully mask both extremes.  

**“Micro segments” – Ability to create “micro segments”, as I call it, is central to the approach of “de- camouflaging” and breaking down the aggregated “Average Profit or Loss” to their elemental components. These are customer centric data constructs that enable sourcing an individual customer level fully loaded P&L in case of say Corporate or Commercial where it makes sense, because of the volume of operations, their demand on bank’s funds and resources. In case of retail portfolio where this approach is unwieldy,  a highly stratified small homogenous pool that does not suffer the “averages syndrome” is an option. Important to note here - When I say customer level P & L,  I mean customer’s contribution to the P & L of the bank. 

By identifying  and acting on the loss-making micro segments, banks can enhance   profitability substantially and shore up capital. The ability to segregate high/medium/ low and negative profitable pockets is critical.  In order to do that there are two fundamental requirements –

• Reliable information at the finest granularity that lends itself positively to Micro Segments creation– account/ customer level with relevant characteristics/ attributes  (multi – dimensional information related to the account/ customer) to enable meaningful analysis – essentially move product , accounting centric information constructs to customer centric ones. Strategize information beyond just compliance into business decisioning.

• A powerful lens (Analysis and visualization capability) that enables analysis of micro-segments to detect unprofitable pockets not just stand alone but embedded within an aggregate profitable group. One bank that analyzed profitability contribution of its customer base on “Deciles”  found that its first decile contributed to about 175% of the net income with decile 2 dropping to a dramatic 10% to a 4th decile that was near zero. The 10th decile was negative by about 65% with decile 5 down turning negative. Net effect, decile 5 to 10 eroded near 75% of value.

Note – For a realistic assessment of micro segments and their behavior in normal times, it is suggested to look at pre-covid data (Say end 2019). This helps banks identify and support those from the desirable customer groups  who are facing genuine pandemic  inflicted challenges. Make no mistake, the coming period will be a huge balancing act of allocating available finite resources to the right quarters responsibly to support affected customers limp back from despair to repair.

Manage Costs better - an important focus area with revenue under strain. Manage costs does not always translate to reduce costs or spends – It is more about making every penny count. To do that banks need to know where the penny is coming from (which is relatively doable) to where it is spent (This is where  robust allocation engines that can allocate operational costs to account/ customer level come in) Once the cost constructs are understood , identifying focused spend  areas for optimal returns can be derived- e.g. Marketing and Targeting strategy based on profitable or potential profitable customers/ segments. This flows from the previous theme of ability to create and maintain “Micro segments”.

Optimal Pricing - Optimal pricing is not higher pricing but “cost aware pricing” except where the bank , by design, wants to be a loss leader in a specific area to grow that portfolio.

In combination, the three initiatives of creating and addressing profitability at “Micro Segment” level,  effective management of costs plus optimal pricing ability will have a strong positive impact on the P & L . Moving on the continuum from stabilizing the Bank in the medium term to “Value Management” for growing P & L and Balance sheet for the long  run is the next step.

Will explore this theme with some pertinent use cases in the next blog – “From Profit Management to Value Creation”