2010, Profitability and Managing the Bottom Quartile

“Success is simply a matter of luck. Ask any failure.”
–Earl Wilson

GonzoBankers, as we enter 2010, we all seem to be peeking our heads out of the foxhole in hopes that most of the economic bullets aimed in our direction have already been fired. Many of you are expressing cautious optimism about credit quality, earnings, customer relationships and overall industry stabilization.

What many of you are realizing at the same time is that there will need to be a change in focus relative to how profitability and performance are managed. To understand the change, let’s look at three factors that in tandem tell the story.

1. We have seen a very fundamental change in strategic focus with many of our clients. Most bank strategic plans focus on profit rather than growth. Events of the last two years have changed most of these plans. Five years ago, many plans focused on growth opportunities (more branches, new markets, new lines of business) with the acceptance of the fact that profitability from these investments might be longer term. No more in 2010. Nyet. The themes of growth and diversification that were overweighted in bank thinking have been replaced with the new overweights of credit quality, capital preservation and efficiency.

2. This change in focus has altered the way banks need to look at low performance. In a growth environment, there is more tolerance for unprofitable investments that have the promise of future payoff. Examples:

• The branch that didn’t hit the initial deposit/fee goals but has the promise of checking and core relationship growth
• The commercial relationship manager with a small portfolio making little or no profit but whose industry contacts could pay big dividends or who at least provides some geographic coverage
• The product that has not produced the numbers in the ROI but that could, with one more marketing campaign, break out
• The customers who aren’t profitable today but who would be with the right cross-sell campaign

In a growth and diversification environment, these types of investments might be subsidized and justified based on promised future profitability. In a profit and efficiency environment? Nyet. In a profit environment, these people, places or products get judged on run-rate profitability with a very short “future profitability” leash. In 2010, a hard bright light needs to be shone on low performance.

3. What has not changed is the 80/20 rule, or some variant. The first thing I heard when I started in banking way back when is that 80% of the profitability is produced by 20% of the customers. With some adjustments to the two numbers, that rule has never changed. Ever. Nyet. We have been looking at benchmarks and performance at Cornerstone for many years. Based on the studies we have done and the clients we have worked with, we can tell you that in almost everything we observe, a bank-level performance number masks the fact that the top third of performers is covering up for the lower third. Back to our examples:

• If a bank has an average commercial relationship manager/lender portfolio of $60 million, there will be at least three managers (based on size) with more than $90 million that are very profitable and three with portfolios under $25 million that are not. A CEO I greatly admire once said it better than I will when she said, “If the bottom 10% of my commercial relationship managers quit tomorrow and I wouldn’t notice anything on my production reports, I have a problem.” Duh and double duh.
• If the average branch size is also $60 million, same thing. Three $100 million branches with lots of core balances will be offset with three $15-10 million offices with too many CDs.
• Most bank profitability systems show that the bottom third of customers are unprofitable and the top 10% account for most or all of total profit. These numbers are subject to some very significant changes once the new overdraft laws take effect, particularly since so much of checking account profitability was based on these fees (talk about the 80/20 rule – a study by the Center for Responsible Lending concluded that one-half of checking account customers paid all bank O/D fees and 9% of customers paid about 40% of them). The 80/20 rule could be 10/120 after fee changes. One note: any investments that banks make to help low-income customers, help the unbanked, or otherwise reflect a social investment in communities get a complete pass from this commentary.
• The top third of mortgage originators will outperform the average by 25-30%. The bottom third will underperform by the same amount.

Without beating this to death, the same rule will be true in wealth management, investment sales, insurance, call center or any other production group – the top third is offsetting the bottom third. Duh.

Taken together, these three issues point to a key management issue for 2010 – getting to the profitability and efficiency we focused on previously can only occur if banks start aggressively and objectively managing the lower third quartile we outlined. Managing to raise the average or overall number won’t do it.

To do this, we think banks have to institute some rules of engagement that set a tone for 2010:

1. Profitability information and systems must have a front and center focus. More importantly, profitability information has to go from being informational to actionable. No more yabut profitability (that’s where the entire management team looks at the information and says, “Yeah, but…..”). “Actionable” means that the management team will change price, eliminate an initiative, or base employee performance analysis and pay on it. That can be a tall order, but the management of the bottom third cannot happen unless there is agreement on objective information that can drive an objective analysis.
2. ROIs and future promises need hard debate and close tracking. Everybody will still have the new branch, new commercial relationship manager, new broker, or new product that isn’t break-even day 1. That’s the nature of the banking business. However, the timeline to profitability will need to be more closely tracked, and the hard decision to stop the investment when that timeline isn’t met will need to happen faster.
3. Compensation will need to more closely reflect differences in contribution. In most banks, the difference between what the top third of performers make and what the lower third make is much less than what we might think. Too many years of tenure raises and incentive plans that start at 5% and top out at 15% have in many cases produced rewards that don’t reflect high performance enough and safety nets for the lower third quartile. In the long run, any bank that wants to be entrepreneurial needs to challenge this practice.

There are conversations to come that won’t be easy and decisions that will be hard to make. But, residents of Gonzoville, we’re in profit mode. We’re in for the long term. Just ask yourselves this – if all lower quartile performers could get to median performance and lower percentile businesses to average/median profitability, what would the impact on your bottom line be?

It’s time to manage the lower third of the quartiles. Duh, baby.
-tr

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