Best Practices - Treasury Services

Recent developments in the Financial Services' industry, such as spread compression and an inverted yield curve environment, continue to put pressure and renewed emphasis on non-credit related product offerings. As a mature industry, Treasury Services (a.k.a. Cash Management) plays an important role

in providing a stable, predictable revenue annuity stream to many large financial institutions and are relatively immune to volatile interest rate movements. However, viewing Treasury Services as potential additional revenues and/or cost reductions can be difficult. Experience has indicated that some institution's Treasury Services do not fare well in this light for the following reasons:

- The variety of Treasury Services' products available and the delivery mechanisms are constantly evolving, requiring ongoing capital investments.

- The costs of providing sophisticated systems and technology required to remain competitive are high and continue to rise sharply.

- Treasury Services' pricing has not been demonstrated consistently to cover costs due to the hyper-competitive environment and a reluctance to offend customers.

These negative impacts beg many bankers to ask the question, "Why are we in this business?" The result is more and more costing and pricing scrutiny around providing and delivery these services. But how can we take this situation and make it beneficial to us? The answer is in understanding the pricing, costing and profitability components of your Treasury Services platform.

From a cost perspective, delivery, sales, product development, relationship management, implementations, operations and risk management must all be understood at the micro level. That includes a working understanding of variable costs, semi-variable, fixed and available capacity costs.

At the pricing level, knowledge of the competitive landscape is crucial. Also determining what pricing strategy to employ is important. Most financial institutions use a combination of cost-based and market-based pricing strategies incorporating and considering product life cycles, market leadership, customer segmentation and discounting.

Arguably, more important than understanding one's pricing and cost structure is how to measure and report profitability for Treasury Services. Answering the following questions is critical:

- Which products, if any, to offer as a loss leader?

- How to incorporate the value of compensating balances?

- How to incorporate the value of excess balances?

- What impact does the earnings credit rate (ECR) have on profitability?

- Who are considered Treasury Services customers?

Those institutions that understand these three components (price, cost and profitability) thoroughly will have a competitive advantage in the industry. With this in mind, what exactly are the best practices in the industry with respect to these variables? We set out to find the answers. What follows is a comprehensive survey, sanctioned by AMlfs, compiled and summarized for presentation at the 2007 AMI/j/BAI Profitability and Performance Measurement conference, and recapped for this article.

I. Introduction: Best Practices - Treasury Services

A. The Survey Instrument

In November of 2006, AMIfs drafted a Treasury Services Financial Questionnaire for distribution to finance/accounting managers and treasury management professionals at North American financial institutions. This research was intended to be the foundation of continuing research in the area of costing, pricing and profitability for Treasury Services (a.k.a. Cash Management). Sixty-four North American financial institutions [See Appendix A] participated in the study. Participants ranged from less than $10 billion to over $150 billion in assets and represented a diverse group geographically, organizationally and financially. The survey was divided into three sections. The first section asked participants to comment on costing methodologies and cost distribution practices. The second section addressed participants' pricing practices. The third section of the survey asked respondents to describe various profitability components.

B. Survey Methodology

The questionnaire was distributed by AMlfs in December of 2006. Prior to distribution of the survey, AMlfs conducted several phone interviews with member institutions to refine the scope of the survey and the questions. Financial institutions submitted their responses by the end of January 2007 for in-house analysis. During the next month, staff at AMlfs analyzed the results and contacted members for validation purposes and follow-up questions in order to finalize the results.

C. Participant Profile

The participants in the Treasury Services Financial Questionnaire represented a wide cross section of financial institutions. Participating institutions ranged from less than $ 10 billion to greater than $ 150 billion in assets [Graph 1 ]. While most Credit Unions and Savings and Loan institutions do not offer the breadth of Treasury Services as commercial banks, it was decided to include them in this survey as many questions did not directly relate to Treasury Services [Graph 2].

IMAGE GRAPH1

Graph 1

Participating Financial Institutions by Asset Size

(64 Total)

Graph 2

Participating Financial Institutions by Type

(64 Total)

II. Analysis

A. Costing & Cost Allocations

In this section of the survey, financial institutions were asked a series of questions regarding costing methodologies and cost distributions. When asked about costing methodologies, approximately 75% of the large institutions (tier 1) used more than one costing method, while only 30% of the financial institutions with assets less than $ 150B (tier 2 and tier 3) utilized more than one method. Not surprising, tier 2 and tier 3 institutions utilized standard costing less than tier 1 institutions [Graph 3]. Of the respondents that utilize standard costing, the most popular areas were Operations, followed by Branches, IT and Call Centers [Graph 4].

IMAGE GRAPH2

Graph 3

% of Respondents Using Standard Costing

IMAGE GRAPH3

Graph 4

Where Standard Costing is Used

When using standard or established costs for cost allocations, a residual is created each period. As a result, the cost pools will either be over-allocated or under-allocated. For the tier 1 financial institutions, 67% create a residual when running cost allocations. For tier 2 institutions responding, 50% create a residual and for tier 3, less than 30% [Graph 5]. When asked whether calculated residuals are distributed, two thirds of the tier 1 institutions said yes, 57% of the tier 2 institutions and half of the tier 3 institutions said yes [Graph 6].

IMAGE GRAPH4

Graph 5

% of Respondents Creating Residuals

Graph 6

% of Respondents Allocating Residuals

For those institutions creating a residual each period, another question was asked about analyzing that residual. Analyzing the residual helps to answer the why question such as the volume and/or spending components of the variance. If the residual is greater than a pre-defined management threshold and demonstrates a consistency over a number of periods, it might be a signal to adjust the rates as they no longer appear to represent the area studied. For the tier 1 institutions, 63% evaluate residuals monthly. For the tier 2 institutions, it was 50% and for the tier 3, it was 29% [Graph 7].

IMAGE GRAPH5

Graph 7

% of Respondents Evaluating Residuals Monthly

A follow up question for those institutions that allocate the residual each period was to what level, including:

* Line of Business (LOB)

* Product

* Customer

* Customer Account

Across all three tiers, 13% allocate to LOB only, 21% to Product only and nearly two thirds to both LOB and product. None of the respondents allocate residuals to a customer or customer account level. [Graph 8].

IMAGE GRAPH6

Graph 8

Residual Distributions

A very interesting question asked for the most important determinant in choosing a cost distribution methodology. The participants were asked to rank from the following list in order from 1 to 5 with 1 being the most important:

* Fairness

* User Comprehension

* Cost Effectiveness

* Consistency

* Information Integrity

For the tier 1 and tier 3 institutions, information integrity was the most important. For the tier 2 institutions, it was fairness [Graph 9]. User comprehension was last across the board.

IMAGE GRAPH7

Graph 9

Most Important Derterminant for Cost Distribution Methodology

Always an interesting discussion is Corporate Overhead (COH), including: the criteria for COH classification, whether or not to distribute it, where to distribute it and how. Overall, 88% of the tier 1 institutions, 83% of tier 2 and 64% of tier 3 distribute corporate overhead [Graph 10]. For distribution across all tiers, 14% of the COH distribution goes to LOB only, 16% to Product only and 9% to customer. The majority is a combination of Product and LOB at 61% [Graph 11].

IMAGE GRAPH8

Graph 10

Corporate Overhead Distributions

IMAGE GRAPH9

Graph 11

Corporate Overhead Distributions

Capacity-Based Costing is a best practice methodology for high volume production type processing groups, such as Lockbox and Check Processing. When asked if available unused or idle capacity is measured, 38% of the tier 1 institutions said yes, one third of the tier 2 institutions and 14% of tier 3 said yes [Graph 12]. Of those institutions measuring unused capacity, more than two thirds of the respondents across all tiers do not include that metric in rate calculations.

IMAGE GRAPH10

Graph 12

% of Respondents Measuring Available Unused Capacity

Another very interesting topic is planning or budgeting. Participants were asked about their approach. Across all tiers, 32% use a Bottom Up (responsibility center focus; developed by an aggregation of unit budgets), 11% Top Down (high level focus; middle mgmt develops budget to support organizational goals/objectives) and 57% U-Planning (both high/low level mgmt focus; budgets prepared within the context of organizational goals). See graph 13 below:

IMAGE GRAPH11

Graph 13

Budget or Planning Approach

Participants were also asked what form of planning/budgeting best describes the practices at their institution from the following list:

* Static Budgeting (budget remains unchanged all year)

* Moving Budget (one that is updated only for material changes)

* Rolling Budget (one that is updated in a continuous pattern, such as monthly or quarterly)

* Volume-Based Budgeting

* Zero-Based Budgeting

The answers are stratified by institution tier below [Graph 14]:

IMAGE GRAPH12

Graph 14

Budgeting Practices

Another question asked participants the extents to which costing efforts are integrated with the budget or planning process from the following:

* Fully Integrated

* Mostly Integrated

* Somewhat Integrated

* No Integration

The answers are again stratified by institution tier below [Graph 15]:

IMAGE GRAPH13

Graph 15

Costing Integrated with Budgeting Process

A calculated contribution margin is the difference between price and the variable cost. It represents how much is left to contribute to fixed costs and profits after covering variable costs only. The number of institutions reporting contribution margins was 59% for the tier 1 institutions, 27% for tier 2 and 25% for tier 3 [Graph 16]. Less than 1/3 of the respondents also have a semi-variable component, which is designed to account for personnel related expenses. Of those respondents, 1/3 took associated semi-variable with the variable classification for the contribution margin calculation and 2/3 split it into both variable and fixed [Graph 17].

IMAGE GRAPH14

Graph 16

% of Respondents who Report Contribution Margin

Graph 17

Semi-Variable Cost Treatment

Exception costs may be granted for certain high volume customers or key customers for other reasons, such as filling available unused capacity. In response to this question, 25% of the tier 1 institutions grant exception costs, 36% of the tier 2 and 18% of the tier 3 institutions grant exceptions [Graph 18]. For those that grant exceptions, a follow up question asked how often the rates were reviewed and 70% of the respondents review those exceptions on an annual basis. The balance of the exceptions review is split between criteria-based, monthly and quarterly [Graph 19].

IMAGE GRAPH15

Graph 18

% of Respondents who Grant Cost Exceptions

Graph 19

Exception Cost Update Frequency

Many institutions have different costs for different customer types (e.g. large corporate, commercial, small business). The response was 63% for the tier 1 institutions, 73% for tier 2 and 50% of the tier 3 respondents that have different rates by customer type [Graph 20]. Most of that differentiation was in Sales/Originations at 57%, followed by Operations at 32% and then Branches at 11% [Graph 21].

IMAGE GRAPH16

Graph 20

% of Respondents with Different Costs Based on Customer Type

Graph 21

Different Costs by Customer Type

B. Pricing Practices

In part B of the survey, financial institutions were asked a series of questions regarding pricing practices. When asked if price modeling tools were used, all tier 1 institutions answered in the affirmative with over 80% differentiating fixed and variable costs. Eighty percent of tier 2 institutions use a price modeling tool with about one half differentiating fixed and variable costs. Fifty percent of tier 3 institutions use a price modeling tool, yet only about 35% differentiated fixed and variable costs [Graph 22]. When asked about considering the value of balances when pricing new business, tier 1 institutions indicated they consider the value 100% of the time, while tier 2 and tier 3 institutions consider the value 70% and 35%, respectively [Graph 23].

IMAGE GRAPH17

Graph 22

Pricing Model Tool with Fixed & Variable Costs

Graph 23

Consider the Value of Balances when Pricing New Business

When asked the basis for most pricing decisions, 38% of tier 1 institutions indicated they used market-based pricing exclusively, while 62% used a combination of market-based AND cost-based strategies. Tier 2 and 3 institutions also predominately used a combination of the two approaches, but only 8% and 14% respectively, use just a cost-based approach [Graph 24]. The limited use of a cost-based pricing strategy was reinforced when we asked the degree financial institutions' relied on cost information when pricing new business. Seventy percent of tier 1 institutions said they had slight to moderate reliance on costs data when making pricing decisions while tier 2 and 3 institutions indicated that 50% have slight to moderate reliance on cost data when making pricing decisions [Graph 25].

IMAGE GRAPH18

Graph 24

Market Pricing vs. Cost Pricing (or both)

Graph 25

Slight to Moderate Reliance on Cost Data when making a Pricing Decision

We asked the importance of the earnings credit rate (ECR) in the customer pricing process. The ECR is applied to balances that customers hold with an institution. Customers can then use this credit to compensate for service fees. We asked respondents to consider both large corporate customers [Graph 26] as well as middle market/ business banking customers [Graph 27].

IMAGE GRAPH19

Graph 26

ECR Criticality for Large Corporate Customers

Graph 27

ECR Criticality for MM/BB Customers

C. Profitability

Most respondents in all three tiers expected their Treasury Services' products to be profitable on a stand-alone basis [Graph 28], while the majority tier 1 and tier 2 institutions consider the value of negative float when looking at product / customer profitability [Graph 29].

IMAGE GRAPH20

Graph 28

Are TS Products Expected to be Profitable on a Stand-Alone Basis?

Graph 29

Is Negative Float Considered when Analyzing Profitability?

When asked whether or not the institution allocates DDA balances to Treasury Services' products that brought in the DDA balances, most tier 1 and tier 2 institutions indicated they did [Graph 30]. Of those institutions that did allocate DDA balances, 65% indicated they allocated to the DDA product only. Twenty percent of the respondents indicated they allocated to all TS products while only 15% allocated DDA balances to collection products only [Graph 31].

IMAGE GRAPH21

Graph 30

Do you Allocate DDA Balances to Products that Brought Them In?

Graph 31

DDA Balances Allocated to:

One of the hottest topics in banking today is the paper-to-electronic migration of payments. When asked what impact this will have on institutional profitability, most respondents agreed the impact would be either positive or neutral [Graph 32].

IMAGE GRAPH22

Graph 32

Impact of Paper-to-Electronic Migration of Payments on Profitability

Judging by the number of survey participants and the number of attendees for the session at the 2007 conference, the topic of Best Practice pricing, costing and profitability for Treasury Services' products is of great interest across the industry. With razor thin margins, intense competition and customers that are not afraid to shop around for the best deal, the burning question remains: What are the other institutions doing? We hope that we've captured some of the answers to share with you in these results. We are committed to monitoring this topic going forward and to sharing pertinent best practice management information and measurement techniques necessary for that competitive advantage.

APPENDIX

Appendix A Participants

ABN AMRO

AIB Bank

Associated Banc-Corp

BankAtlantic

BankUnited

Baxter Credit Union

BECU

BMO Financial Group

BOK Financial Corporation

Boston Private Bank & Trust Company

Capital City Bank

Capital One

Citrus and Chemical Bank

Comerica Bank

Commercial International Bank (CIS)

CommunityAmerica Credit Union

Compass Bank

Countrywide Financial Corp

Eastern Bank

Esan Peters

Evangelical Christian Credut Union

Federal Home Loan Bank of Boston

First Caribbean Bank

First Commonwealth Financial Corp.

First Midwest Bank

First National Bank of Arizona

FirstSask Credit Union

Frost Bank

Fulton Financial

Harris Bank

High Country Bank

IndyMac

Interbank

Interior Savings Credit Union

LaSalle Bank

Libro Financial Group

Meridian Credit Union

National City

National Penn Bank

Northwest FCS

NuUnion

Old National Bancorp

Provident Bank

RBC Centura

Regions Financial

Sky Bank

Southern Bank and Trust Company

State Farm Bank

Sterling Bank

Stillwater National Bank

Sunflower Bank, N. A.

SunTrust Bank

TD Bank

The Paducah Bank and Trust Company

The South Financial Group

Tropical Financial Credit Union

U.S. AgBank, FCB

Union Bank of California

University Federal Credit Union

US Trust Company

UW Credit Union

Wachovia

Washington Mutual

WSFS Bank