Branch Profitability Measurement: An Improved Framework

Consumer banking continues to be the crown jewel of many franchises. While internet and telephonic channels are important, branch distribution systems have regained favor as they appear to be the preferred mechanism through which customers buy financial products and services. Consequently, banks are

Given the importance of the branch channel, and the increasing competition among banks in specific geographic markets, understanding the performance of individual branches is essential. Sales effectiveness, service quality, operational efficiency, and employee morale and competence, among other items, are measured and reported. However, the mainstay of branch performance reporting is monthly branch profitability.

Most banks measure monthly branch profitability using a common framework. Essentially, they create an income statement for the branch, which includes revenues (spreads on assets and funds value of liabilities, net of credit costs, and fees), operating costs and allocated expenses. A stylized branch income statement is shown as Exhibit 1. The asset and liability balances attributed to the branch are based on the accounts "booked" to it when a customer originates the account.

Fees are also largely based on activities related to customer accounts booked to the branch, although some branch P&L's also include other line items, such as usage fees for ATMs located in the branch.

Under this profitability construct, it can take years for branches to be deemed "profitable". That is, customer numbers and associated balances attributed to the branch need to accumulate over time before spread and fee revenues exceed direct and allocated costs. Bankers undergo an anguished waiting game hoping that their branch placement "bets" will pay off.

Unfortunately, this manner of measuring branch profitability is inadequate, and certainly not one that any modem retailer would use. It credits the branch at which the customer first originated his account with the balances of the account, even if the customer has never again set foot in that branch. It impedes provision of high quality service in the time period it is most needed (when the branch is being opened), because direct compensation expense is charged to the P&L while balances are low. It muddies the contribution of other sales and service channels to overall customer satisfaction and profitability. Finally, it can delay decision-making about whether the branch is truly contributing value to the bank.

To counter this, a more accurate picture of branch level profit performance needs to be constructed. Such a picture should be more sensitive to actual performance during the reporting period, as opposed to prior periods. It should reflect the effectiveness of the branch as a sales and service channel. Finally, it should be more sensitive to the operational "levers" that management can push or pull to influence the performance of the branch. A more accurate measure of branch profitability would change the revenue and expense items on its monthly P&L. Exhibit 2 shows an illustration of what a new branch P&L might look like.

Revenues:

The largest change would be with respect to revenues. Instead of receiving the funds value of liability balances attributed to it, the branch would receive a one-time credit for the fair market value (FMV) of the liability accounts generated only in that period. Similarly, the branch would receive a one-time credit based on the FMV of the new asset accounts that it generated in the period. Essentially, the accounts would be "purchased" by a central customer management unit, the purpose of which would be to optimize the bank's relationships with its customers, irrespective of sales and service channels used. Fee revenues would be credited to branches based on sales and service interactions actually conducted with customers at the branch.

Expenses

Branch direct expenses would not change much under the new framework. Allocated expenses would not use attributed balances as a driver, but could remain the same in other respects. However, branch managers are likely to want expenses broken out by process (e.g., sales, service, compliance, etc.) instead of or in addition to by line item (e.g., personnel-related, facilities/rent, data processing, marketing/promotions, etc.).

This framework is more in keeping with retail store P&L reporting. For example, would McDonalds measure an outlet's current monthly profitability based on the cumulative number of hamburgers sold there versus the number sold that month? Would Wal-Mart wait for years to learn if one of its stores might break even?

Closer to home, a mortgage banking comparison is appropriate. In general terms, mortgage originators generate loans and then sell them to portfolio managers or conduits. They receive the FMV of the assets (including servicing rights) that they sell into the secondary market. Monthly mortgage banking P&Ls reflect the value of the asset sales during that period plus fees and charges related to the origination, minus expenses associated with generating the assets. Bank branches can be viewed through a similar lens.

Of course, a number of conceptual and practical challenges will need to be addressed in order to design an effective branch profitability measurement system using this framework. Accurately measuring and attributing FMVs is probably the most difficult issue to address. However, banks assign fair market values to a wide range of assets and liabilities today. Extending the efforts may be more difficult to achieve for political reasons rather due to lack of methodologies. By way of analogy, if banks can determine the appropriate funds transfer price for indeterminate maturity products, they certainly should be able to calculate FMVs. Determining appropriate branch sales/service credits, and ensuring that they are properly aligned with customer, product and channel strategies are important, but not insurmountable, issues.

The new profitability measurement approach summarized above could provide insights into the drivers of branch performance. Clearly, it would represent a different way of looking at branches, and would provoke intense debate. While implementing it may be difficult for cultural reasons, banks that get this right will have a much more powerful tool by which to determine which branches are profitable, and which are not.