Finadium published today the research report, “Measuring Bank Profitability in Financing and Derivatives: Challenges and Responses,” by Martin Walker. In this article, Walker discusses why measuring bank profitability correctly matters so much to bank executives.
Q. What does bank profitability actually mean? There seem to be many measures in the market.
A. There are many ways to think about the profitability of a bank, including Earnings per Share and Return on Equity. These measurements do not simply affect how the success of a bank looks from varying angles; they can also have a major impact on how decisions within a bank are made and how it ultimately performs. The most important measurement for line managers is the Cost Income Ratio: how much money are you making relative to your costs.
Q. How easy is it to find the Cost Income Ratio?
A. Some costs under the direct control of the trading business, for example market data vendors. These costs are obvious. Things start getting more complicated when it is not clear exactly what the relationship is between the charge and service provided. This can be the case for charges from functions such as Risk, Compliance or Finance, which have large centralized costs that need to be allocated. The idea is that you want to be able to understand what you are being charged for.
Q. Many banks have centralized their support functions. Does this make it harder or easier to identify costs?
A. Sometimes centralization helps in cost identification by organizing functions and processes. But just as readily, the centralized function can result in additional layers of management, change and control costs that have to be ultimately charged to someone in a revenue generating area. This in turn reduces the direct relationship between the cost center and the revenue generator.
Q. Where does process improvement fit in your thinking about improving profitability?
A. While sometimes effective, I am not a big fan of process improvement methodologies. An up-and- coming trend in many support functions is “Agile”. There are many positive ideas in the Agile family of techniques but they were designed specifically for software development and do not easily fit into other areas. Agile can now mean a host of ideas that don’t have much to do with the original concept.
Q. The report discusses 10 levers for improving profitability. Is there a common theme here?
A. The common theme running through our levers for improving profitability is the concept of “choice architecture”. In particular, we focus on changing the way choices are made then changing the assumptions that impact choices. It’s a multi-layered process that requires work, but the end results are worth the effort.
Q. How should regulators look at banks and profitability measures?
A. Banks, Central Banks and other regulators should work together to create a regulatory framework that allows collaboration on building a banking sector that is genuinely less complex with banks that are easier to manage and regulate. This should lead to greater trust and understanding between both regulator and regulated entities.
For more on bank profitability, see the Finadium research report, “Measuring Bank Profitability in Financing and Derivatives: Challenges and Responses.”