Bank to Basics
Once upon a time not so long ago, sales people calling on banks large and small knew what to expect when meeting with executives: business leaders sporting predictable customer-driven, risk-averse, continuous improvement mindsets. They were ‘steady as she goes’ managers espousing conservative strategies for making loans, taking deposits, and generating fees. And they were cheerleaders emphasizing the virtues of maximizing ROA (Return on Assets), an indicator of profitability before leverage.
Oh sure, ROE (Return on Equity) was alive and well in the lexicon of banking executives, but ROE was considered an external metric more suitable for an investor audience. ROA, on the other hand, was almost universally accepted as the internal performance metric of choice when it came to rallying employees, driving decisions, and making investments. The key to ROA was maximizing net income for every dollar, euro, or yen of assets present and accounted for on the balance sheet. During the period from 2000 to 2006, ROAs rose across the global banking industry. According to the FDIC, ROAs reached historically high levels in the U.S., hovering near 1.4%. Life was good in the fairy tale world of banking.
During this magical time living amongst the happy bankers there appeared a gremlin – actually two. The first gremlin was very clever, innovative, and manipulative. This creature reverse-engineered the ROA formula and figured out how to “securitize” and sell mortgage and other loan assets. Word of “securitization” spread throughout the land. This innovation magically increased ROAs since assets were removed from the balance sheet of banks and cash and servicing fee income were generated in the process. “Securitization” was a virtuous circle money machine as banks could use the cash to originate new loan assets, “securitize” them, receive cash and then do it all over again … and again, and again. It was addictive because it helped ROAs to rise. Oh, did I mention that ROA was a common incentive compensation metric for many banking executives? I told you this villain was clever!
The second gremlin was equally smart, mechanically-inclined and cunning. This gremlin ignored ROA, but obsessed over ROE. He reverse-engineered the formula for ROE and discovered that financial leverage, or borrowings, had an outsized impact on this metric. He found that a generous portion of financial leverage magically caused ROEs to rise. After all, he was a math whiz and concluded that:
ROA x Financial Leverage = ROE
The proof for the ROE formula was obvious to this gremlin. He knew that assets ‘cancel out’ when ROA (net income ÷ assets) is multiplied times financial leverage (assets ÷ equity). In a moment of sheer brilliance that occurred sometime in the middle of the decade, the second gremlin convinced many banking executives that they should deploy more financial leverage in their capital structures than they had historically done in the past. He knew they would see things his way since there was the addiction angle; ROE was becoming a common incentive compensation metric along with ROA. And in a political coup, he got banking regulators to condone more financial leverage! I told you he was cunning.
During those days, sales people calling on bank executives were REALLY confused about the bank’s business priorities. The banking business was changing and sales people weren’t sure how to align their solutions. Seems all the banking executives wanted to talk about was “securitization” and financial leverage. Sales people longed for the good-old days when banks were boring, predicable, and focused on the basics of banking and serving customers.
At some point all good fairy tales come to an end, and you know how this story flamed out. It wasn’t pretty. The world will be dealing with the effects for years to come. But there’s a silver lining for sales people calling in the banking industry: banking executives are going back to basics! Although financial regulations are coming with major implications for banks and sales professionals (stay tuned for an upcoming blog on the implications to sales people), the securitization and financial leverage gremlins have departed. Importantly, ROA has re-emerged as the internal performance metric champion that it once was, and ROE has been relegated to its traditional role as an external metric.
Sales professionals, take note. The evidence abounds that banks are getting back to basics. Here are a few examples of funded, executive-sponsored business initiatives announced in 2010:
- Customer Service As A Growth Engine – Examples: Bank of America’s GUEST initiative for branch and contact center associates; American Express’ program expansion aimed at getting agents to build better relationships with customers
- Client Selection For Profitable Relationships – Examples: HSBC’s strategy for segmenting customers to offer differentiated propositions; Key Bank’s National Banking business unit initiative focused on gaining share in mid-market companies and targeted industries
- Core Funding to Reduce Liquidity Risk – Examples: PNC’s initiative to drive low-cost deposit growth; Fifth Third’s sales force expansion project to increase resources and branch hours
- Attract, Train and Retain the Right People – Examples: BB&T’s value system strategy; Capital One’s “people practices” program
- Underwriting Process Reforms to Lower Risk Profile – Examples: PNC’s loss mitigation strategy and underwriting centralization project; Santander’s geographic risk diversification strategy
- Global Self-Service Movement – Examples: Bank of America’s pricing policy to incent ATM usage; American Express’ contact center strategies to promote self-help resources
As Yogi Berra once said, “it’s tough to make predictions, especially about the future”. But from my experience working in and around the financial services industry, I’m willing to wager that banks are getting back to basics … you can bank on it. Sales professionals: restart your engines.