DMA - Profit Risk, the Third Leg of Risk Management

"PROFIT RISK": THE THIRD LEG OF RISK MANAGEMENT AND A KEY TOOL FOR SIGNIFICANT EARNINGS IMPROVEMENT

Let’s face it, banking is all about managing risk. Risk management allows the industry to determine who is qualified for credit, and how much to set aside for potential bad credit and tough economic times. It lets us know how to set rates, how to identify what the appropriate mix and tenor of our loan and deposit portfolios should be, and how to determine which types of products we should be developing and selling. Ultimately, it allows us to sleep at night, knowing that we’re okay if things go sour because we’ve prepared for both the good and the bad that may come our way in the future. Ahhh, we can lay our heads down on the pillow with confidence and have pleasant dreams…we’re safe.

Wake up! That dream of managed risk can become a nightmare more quickly than you expect. Like a bad dream where everyone else is dressed while you’re naked and can’t seem to find your clothes, the fact is that our banks are naked as well. They are missing a critical component in the risk management business: “Profit Risk.” The banking industry has to date operated with two important risk management stages, Credit Risk and Asset-Liability Risk, but they make for a wobbly stool if you miss Profit Risk, the third and vital supporting leg.

Even better, banks will find that successfully managing Profit Risk can add directly to the bottom-line, because there is a direct correlation between improvement in Profit Risk measures and earnings growth.

The first and oldest risk management concept is Credit Risk. From risk ratings for businesses to scoring for consumers, developing methods for evaluating Credit Risk was an important advance in creating tools that assessed credit criteria and potential losses. From these, the ability to manage loan rates, loss provisions and capital was significantly enhanced. By putting credit forms and review committees in place, and with credit bureaus and Fair Isaac in hand, banks had a much better handle on credit worthiness and losses.

The second and more recently developed leg is Asset-Liability Risk management. Certainly, the S&L debacle taught us a lesson. We can’t lend at 30-year terms and source those loans with six-month deposits – the rate environment is just too volatile. From this experience, banks learned how to manage interest rate risk through a variety of techniques, including matched funding, secondary market sales, participations, and swaps/collars/caps. With treasury and ALCO functions in place, we have a far better handle on the asset-liability mix.

Even better, by implementing Credit Risk and Asset-Liability Risk management, your bank will have met the regulatory requirements for safety and soundness. So you’re all set, right? Unfortunately, you might be in for a rude awakening…

Pinpointing risk in a way not considered by Credit Risk and Asset-Liability Risk, Profit Risk refers to the concentration of the income statement that is housed in a small group of customer relationships, as well as products. In its simplest form, Profit Risk can be defined as a ratio of net income (profit) generated by the top 10% of customer relationships divided by the total net income of the bank. The higher the ratio, the greater the concentration of income within a limited number of relationships or products – and the greater your “Profit Risk” potential. Having a large portion of the income statement housed in a small group of customer relationships or products means that this small group dominates the income statement. If they are not retained, and retained at current profitability levels, then the overall net income of the bank is at serious risk. This small group “owns” the bank’s profits, and this is not a good position in which to be.

One would expect that the old “80/20” rule might apply, but is does not. There are real-life examples where banks have seen Profit Risk ratios as high as 300%. Their top 10% of customer relationships accounted for three times net earnings – a “300/10” rule! Better managed banks have a Profit Risk ratio closer to 150%, but even this is a whopping number and needs to be brought down significantly.

Profit Risk is different from balance sheet concentration. Typical banks may find themselves with a balance sheet concentration of between 60% and 80% of all loan outstandings, and between 70% and 80% of all deposits housed in the top 10% of their customer relationships. But, when assessed on a Profit Risk basis, the ratios can well exceed 150% or 200%. Simply relying on balance sheet concentrations does not measure Profit Risk or give you the tools to account for it.

Effectively addressing Profit Risk takes time, but it is essential, and the earlier a bank starts the better. The initial step in minimizing the risk is to understand what all of the Profit Risk metrics mean. These are measurements which can show how a very small group of customers and products are generating more than the total earnings of the bank. If just a few of them are priced inappropriately, or if just a few of the top customer relationships leave, then a bank’s earnings are seriously impacted. With high ratios like in our examples, a loss of just 1% of the top profitability tier can severely damage the earnings of the bank and even jeopardize its future. That thought will make you lose some sleep!

Examples of three actual banks that have used and implemented the concept are highlighted in the table below. Each bank decreased its concentration of earnings among the top 10% of its base over a 7-quarter period (the “Profit Risk Decline” percentage). As the chart shows, earnings increased at a multiple of Profit Risk improvement during the same period. Mind you, it doesn’t follow a perfect linear relationship, as it depends on how high the initial Profit Risk ratio is to start with, how large the bank is, and other factors, but the results are clear – if you reduce Profit Risk, improved earnings will follow at significant multiples.

	*Bank A*	*Bank B*	*Bank C*

*Profit Risk Decline*	*19%*	7%	5%

*Earnings Increase*	*40%*	*52%*	*47%*

*Increase in Earnings*
*for Each 1% Profit*
*Risk Improvement*	*2.1*	*7.4*	*9.4*

The good news is that there are ways to minimize Profit Risk, such as the step-by-step process developed by DMA based in Portland, Oregon, which provides database-driven Profit Risk services to client banks around the country.

The first step is to quantify a variety of Profit Risk ratios, including those noted previously. These ratios are then broken down into very specific customer relationship group metrics. This shows exactly where the risk is heaviest and also identifies where the break-even points are. Second, a bank needs to understand the relationship between product profitability and customer relationship profitability, and how these come together in creating Profit Risk levels.

The next step is actually developing specific programs aimed at each risk group and product. The objective is to implement programs at two levels. The first level is to retain the most profitable customer relationships and to ensure their continued contribution to the income statement. The second level is to move Profit Risk down, and to target specific groups and products for movement up in profitability. This spreads profitability among a larger base and brings your Profit Risk ratios to more acceptable levels. Finally, a bank should set regularly-reviewed Profit Risk goals and metrics, tracking them monthly to closely assess progress and refine programs.

Considering the key component of risk management that Profit Risk addresses, it could simply be a matter of time before the concept becomes officially recognized. Regulators may soon start demanding that banks formally manage Profit Risk, requiring committees, reports, and very clear action plans. Profit Risk may be a relatively new concept, but in today’s competitive financial services environment and the current economic uncertainties it’s a crucial 3^rd leg of a bank’s overall risk management. Once you know what your institution’s Profit Risk ratio is and have taken the steps to bring it into line, those nightmare “worst case” scenarios will be nothing to lose sleep over any more.

“Profit Risk” was first coined by Rich Weissman, President and CEO of DMA. DMA helps clients manage Profit Risk as a national systems and service provider to financial institutions throughout the U.S., providing sophisticated profitability, marketing and sales support through DMA’s award-winning IDM™ (Integrated Database Management) system. Since its founding in 1996, DMA has successfully grown to become the premiere database agency in the industry. (www.DMAcorporation.com)

Rich holds his undergraduate degree (summa cum laude and Phi Beta Kappa), and two masters degrees in the social sciences and research, and completed his Ph.D. coursework in Statistics and Quantitative Analysis from New York University in the school of social sciences and in the business school. He also completed the Marketing Management program from Stanford University. Prior to founding DMA in 1996, Rich was Marketing Director at National Westminster Bank USA (Fleet Bank, purchased by BofA), US Bank and US Bancorp, and Bank of America. To reach Rich, call DMA at 503-736-9490 or rich.weissman@DMAcorporation.com.

Author: Rich Weissman

President and CEO, DMA

Portland, Oregon