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Journal of Performance Management, 2006 by Karr, John

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 significantly expanding their branch networks, either de novo or via acquisition. Some banks consider their branches to be "stores", and speak about store sales performance as other retailers would. 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 . http://www.allbusiness.com/finance/298439-1.html

A better way to access branch profitability.

By Schweikart, James A. Publication: ABA Banking Journal Date: Wednesday, April 1 1992 The focus of profitability measurement has traditionally been on return on assets and return on equity. This has led to banks and thrifts emphasizing hurdle (cost plus) spread rates on loan assets to ensure desired levels of profitability. These two measures, however, do not help in the analysis of internal performance of operations, particularly at the branch level. it is difficult to attribute assets and net income to particular branches, so other means of evaluation must be used. Traditionally, most branch analysis has involved measurement of performance against a branch budget. Two difficulties arise with this approach. first, those items that a branch is responsible for are not always within its control. Second, budget analysis is a line-by-line approach often with an emphasis on expenses rather than overall Profitability. Return of responsibility. Management should be concerned with measuring the branch profit that is under branch control. The best measurement Of Performance is the contribution approach, which can also be motivational. This approach is consistent with the changed role of branches. The old role was simply to be a provider of funds for institutions. The new role is to take in as many deposits as possible and to lend out as much money as possible in an efficient manner. Direct revenue. Many types of revenue to a branch are clearly direct. These include loan income and fees from safety deposit box rentals, service charges, overdrafts, travelers checks, and loan application originations. Most of these, however, are small amounts of total branch revenue. Currently, the major source of branch income is that derived from "excess funds"-funds not loaned by the branch but sent to the home office. Many institutions derive a pooled rate Of return that those funds earn on a variety of loan assets and assign this return back

to the branch. This pooled rate of return is calculated using a weighted average from the various assets. Departments such as real estate investment, which use these funds, should be required to "buy" the funds at a market price. This provides a fairer return to the branch. Of course, this is a transfer pricing problem, and, as such, a market price is hardly pure. The buying department can only purchase funds from either the branch or wholesale operations. Normally funds from wholesale operations are for short-term purposes and are more expensive than similar funds received through branches. Accordingly, wholesale funds cannot be viewed as a true alternative to buying from the branch, and their cost cannot be considered a market rate for branch transfers. The focus of profitability measurement has traditionally been on return on assets and return on equity. This has led to banks and thrifts emphasizing hurdle (cost plus) spread rates on loan assets to ensure desired levels of profitability. These two measures, however, do not help in the analysis of internal performance of operations, particularly at the branch level. it is difficult to attribute assets and net income to particular branches, so other means of evaluation must be used. Traditionally, most branch analysis has involved measurement of performance against a branch budget. Two difficulties arise with this approach. first, those items that a branch is responsible for are not always within its control. Second, budget analysis is a line-by-line approach often with an emphasis on expenses rather than overall Profitability. Return of responsibility. Management should be concerned with measuring the branch profit that is under branch control. The best measurement Of Performance is the contribution approach, which can also be motivational. This approach is consistent with the changed role of branches. The old role was simply to be a provider of funds for institutions. The new role is to take in as many deposits as possible and to lend out as much money as possible in an efficient manner. Direct revenue. Many types of revenue to a branch are clearly direct. These include loan income and fees from safety deposit box rentals, service charges, overdrafts, travelers checks, and loan application originations. Most of these, however, are small amounts of total branch revenue. Currently, the major source of branch income is that derived from "excess funds"-funds not loaned by the branch but sent to the home office. Many institutions derive a pooled rate Of return that those funds earn on a variety of loan assets and assign this return back to the branch. This pooled rate of return is calculated using a weighted average from the various assets.

Departments such as real estate investment, which use these funds, should be required to "buy" the funds at a market price. This provides a fairer return to the branch. Of course, this is a transfer pricing problem, and, as such, a market price is hardly pure. The buying department can only purchase funds from either the branch or wholesale operations. Normally funds from wholesale operations are for short-term purposes and are more expensive than similar funds received through branches. Accordingly, wholesale funds cannot be viewed as a true alternative to buying from the branch, and their cost cannot be considered a market rate for branch transfers. Wholesale funds' cost, however, can be a benchmark and a ceiling for a transfer price. A good compromise is to use a, transfer price for excess funds at an average "pooled" cost of funds available from short- and long-term sources-from the branch plus one percent. Thus, if the average cost of savings deposits, certificates, and the like is 7%, then the charge for use of excess funds to the buying department and revenue to the branch will be 8% of those funds. Transfer pricing can encourage a shift to more local lending. Branches, not other departments, should be lending more of their deposits than they currently are in smaller, safer loans. Such a policy shift moves money away from huge real estate projects and other large investments that have hurt banks and thrifts. The transfer pricing method provides an incentive for branch managers to lend locally. The yield on any loan made directly from the branch will be greater than the credit for excess funds. This increases branch contribution from funds and encourages managers to reduce sales of funds to other divisions. The branch's loan capabilities are limited by reserve: requirements. Currently, the law requires a 20% reserve for all liquid deposits and 6% for all others. Each branch may have its own distinct reserve requirement based upon its deposit mix, a mix over which the branch will probably have little influence. The branch profit system, while encouraging branch lending, may lead a branch to accidentally lend beyond its reserve requirements (mortgage portfolio included). This is not a problem if one branch does this, but it may become a corporate problem if all branches lend more than the deposit base. To prevent this from happening and to continue to reward branch performance, the excess credit income should be tiered so that when loans approach reserve requirements, the excess credit must become larger. This way, the branch, trying to maximize its contribution, will sell funds deliberately to other divisions to achieve a higher rate, even though this rate may appear a bit unfair to the buying division. Additionally, this assured high rate encourages further intake of deposits or funds available for the reserve requirement. Hence, funds for direct lending will again become available.

Direct expenses. The income statement section of the application for a federal or state branch charter lists a series of expenses that can be categorized as (1) interest expense or cost of funds, (2) personnel expenses, (3) occupancy expenses, (4) equipment expense, (5) marketing expense, and (6) miscellaneous expenses. Most institutions use similar categories. These expenses must be viewed within the contribution format. Interest expense is probably the easiest classification, because it involves only one item. It is the interest paid on the deposits a branch takes in over a period of time. This obviously meets the most important criterion of responsibility accounting. It is directly associated with the production of deposits available for loans. But is interest expense controlled by the manager? Different demographics produce different types of deposits, which vary in cost. A branch located in an affluent neighborhood with a mean household age greater than fifty will usually have a heavy concentration in certificates of deposit. Interest expense on CDs is higher than any other deposit account. Thus, the location of the branch can make a difference in the deposit expense for that branch. Since the manager does not decide where to build a branch, there is an argument that the interest expense of each branch should not be charged directly, but pooled together and averaged so each branch is assigned the same cost for deposits. The only variation between branches would be from the total dollar amount of deposits. The trouble with that argument is that it hides a real expense that is necessary to judge branch performance. If a branch only attracts expensive deposits, the management of the institution should know this in evaluating the strategic position of that branch in the corporate system. Also, it is important to track trends in branch deposit mixes. Additionally, an argument can be made, albeit a weak one, that a manager does have the ability to control the deposit mix of a branch. Product knowledge, better service techniques, and cross product selling have proven to be successful in promoting deposit products that previously have not been sold in certain demographic areas. Finally, expensive long-term deposits allow more loan creation, as they have a smaller reserve requirement. For measurement of branch performance, then, we choose the individual branch cost of funds. Personnel expenses, including such benefits as providing food services and education, are easily traced to a particular branch of origin. They are controlled by the manager of the branch. Therefore, all personnel costs are included in the expense of the branch. Occupancy expense is a broad category that usually includes both real and intangible expenses associated with the physical location. It includes such items as rent, maintenance, taxes, utilities, and depreciation. The question of control of these expenses is a bit more difficult. However, these expenses are necessary to the daily operation of the branch and are included as branch expenses. The same logic applies to the category of equipment expense.

Marketing costs can be specific or general in nature, depending upon the purpose. Image advertising for the institution as a whole may or may not have a specific benefit to branch production. The contribution approach says that if the costs are not clearly traceable to a particular segment, they generally should not be allocated. Because of the difficulty in tracing them, and because the decision for marketing expense is made by executive management, these costs are not allocated to branches. Miscellaneous expenses should be reviewed to determine which ones are directly associated with production in the branch. Any expenses previously allocated from other divisions should be eliminated as well as any expenses that cannot be directly awed to the branch. Some costs are associated with a particular branch product but are not generated by a branch. Automated teller machine cards are a prime example. The cards are distributed at branches and generate an expense each time they are used. All card expenses should be grouped by machine and summed together. The total is then allocated back to the branches on a percentage-of-machine-use basis. Those branches without machines are not responsible for any expense, even though they give out cards. The costs are allocated this way because the expense of tracing each transaction cost to a particular card is prohibitive. Early results. Investors Savings Bank, Richmond, Va., began using this branch contribution system in the third quarter of 1989. When the system was first introduced, it was feared by many branch managers as a means of judging annual performance through a complicated procedure they would never really understand. Fortunately, those fears were eased by a thorough education process of all branch managers and other key staff members. The result has been corporate-wide acceptance of the contribution system. The immediate impact of this was an increase in branch lending and loan fees. This happened during a quarter that is typically low in lending. Other fee income increased dramatically, as branch managers became more aware of the impact of their daily decisions. The approach has given managers more of a sense of control over their branches. From the standpoint of executive management, there have been two other benefits from the contribution system. First, the system has been modified to include information that previously was contained in five other separate reports. This has not only saved time of branch managers who previously had to piece reports together to gain insight into their own earnings but has saved time and expense in the preparation of reports. Second, the new report identifies potential declining markets that were previously undetected and helps management decide which branches may not be worth holding. As branch banking becomes increasingly more difficult, more financial institutions will find this kind of management accounting analysis imperative. We certainly recommend it.

Mr Smith is senior vice-president of Investors Savings Bank, Richmond, Va Dr Schweikart is a professor at the University of Richmond