In past decades, the banking industry has moved through an age of asset management where banks could safely add loans to an era of liability management when banks could restructure their balance sheets to leverage themselves to ever better performance. In the 1990s, however, banks have refocused their efforts toward increasing fee income and managing their expenses toward a period that we call profitability management.

This emphasis on profits means greater emphasis on planning and control, the setting of quantitative objectives, and the monitoring of progress against them; much tighter expense control, particularly in labor-intensive areas such as operations and retail banking; more cut-and-run decisions for branch locations and marginal products; and a more aggressive pricing and collection procedure. All these things do not happen in a vacuum -- a totally integrated process of profitability management is required to provide the driving force.

WHAT PROFITABILITY MANAGEMENT MEANS

Since profitability management is essentially a new animal born of recent times, it should be defined. The following definition, based on the process used by twelve of the leading U.S. banks, appears to make the most sense: Profitability management (PM) is the planning, measurement and control, and interpretation of the prop lability of organizations, services, and account relationships.

There are several key elements in this definition. First, PM is a total management process, rather than just an accounting or analysis procedure. In contrast to asset and liability management, PM places primary emphasis on the profit and loss account and secondary emphasis on the balance sheet. With PM, profitability is not merely reported, it is planned, measured, and interpreted. Planning ensures that efforts are directed toward the achievement of corporate objectives; measurement checks and adjusts progress against plan by matching revenue received with related expense; and interpretation develops a valid picture of people and businesses, thereby serving as a basis for the next planning cycle.

Second, PM involves the monitoring of three distinct types of profitability statistics, making it a three-dimensional, as well as a three-phase, process The profits of a bank can be measured in three ways: by organization, by product, or by account. Organization profitability is the most familiar type, since all banks have some system for reporting the performance of their major organizational units. However, an effective PM system will also measure the performance of services and accounts.

This three-dimensional approach is essential if the bank is to carry out well-coordinated plans aimed at maximizing stockholder gain while keeping risk within acceptable limits. Measures of organizational profitability are needed because they help top management to allocate resources, spot problems, exercise cost control, and track the performance of senior management. Measures of product and account profitability are needed because they provide the basis for identifying problems, collecting fees, and pricing; they also help evaluate the performance of service and account managers. The principal objectives of each type of profitability are summarized in Exhibit 1.

The basic types of profitability statistics are frequently aggregated to make management assessment easier. Organizational units are frequently combined into geographical groupings, products into product lines, and accounts into relationships and then into customer groups or market segments. In addition, and more and more frequently, banks are being structured so that organizational units parallel product lines or customer groups. Where this occurs, a given set of profitability statistics can serve two purposes. For example, the profitability of consumer loans (product) may be the same as that of the consumer loan division (organizational unit).

An implicit element in the definition of PM is the use of transfer charging. Meaningful calculation of organizational profitability requires extensive transfer charging, particularly of processing costs and corporate overhead. The assembly of accurate product and account profitability requires cutting across organizational units to collect all the appropriate revenue and expense for a particular product or account.

MORE FICTION THAN FACT

Although the need for a fully integrated process of profitability management is clear, few banks have one at the present time. Major banks are beginning to accord top priority to the refinement of the profitability management process, with many devoting substantial managerial and financial resources to this task. Still, profitability reporting tends to be regarded as a tool for analysis rather than a force that drives the entire bank. As a result, banks often have weak or missing links in the process; the consequences of this can be serious.

The natural tendency of banks is to devote the majority of their effort to the measurement of profitability at the expense of the planning and interpretation phases. The decisions that influence profitability are made before events occur, and careful planning is the only way to have a better-than-even chance of being right. Intelligent interpretation is equally important because absolute profit figures do not differentiate between businesses requiring different degrees of risk or asset intensity.

Many banks do not have quantitative targets for organizations, products, and accounts built into their profitability management process. When targets do exist, they often do not support the underlying financial objectives of the bank. For example, there are a number of banks where the aggregate target return on earnings assets for all organization units does not equal the corporate objective. As a consequence, effort may be wasted or duplicated, and operating costs tend to spiral without any accompanying benefits.

When reporting principles are not established and communicated by top management, or when they are applied inconsistently, profitability reporting systems are more likely to confuse than help:

• Inconsistent application casts doubt on the validity of reported results and therefore on their utility in making comparisons and charting trends.

• Managers may squabble over transfer charges rather than focusing their attention on improving actual performance.

• More time may be spent resolving procedural questions than dealing with substantive issues relating to pricing, marketing, and resource allocation.

• Lacking faith in profitability reports, managers may disregard poor results.

Many banks rely extensively on organization profitability as a basis for decision making, and only slightly on the other profitability dimensions. Such neglect can lead to serious market and operational consequences. Market share may be lost because inadequate attention is given to marketing and pricing profitable product lines or to the retention of profitable customer groups. Inappropriate decisions to add or drop a product line or customer group may be made because organizational profitability does not cover the relevant income and expense.

Furthermore, no quantitative basis exists for evaluating the performance of product and account managers.

In banks that do not have a clearly defined PM process, with the objectives of each component clearly thought through, there is a danger of misrepresenting the reported results; for example:

• Incremental analyses may be ignored - the shifting of accounts from one branch to another the marginal revenue gained from a price increase, etc.

• Short-term profits may obscure longer term threats. The bank may become saddled with decisions that maximize short-term profits, but endanger long term stability.

• Inappropriate personnel decisions may lee made since managers rarely control all the income and expenses on their profitability reports.

In spite of these caveats, the PM process has great value in determining the priorities of top management.

To prevent these problems from occurring and maintain overall financial health in these economically difficult times, banks must establish a sound, tightly controlled PM process. Clearly, no single system is suitable for all banks. Each bank must tailor its own in light of its objectives and the economic environment it faces. Nevertheless, some lessons can be learned from the successes and failures of the past few years.

Basically, PM should consist of a recurring three-phase approach: planning, measurement and control, and interpretation (Exhibit II), with total process no stronger than its weakest element. All levels of management should participate in each phase, and be totally committed to achieving the planned results.

Without exploring the infinite complications of long-range planning, budgeting, and assignment of responsibility, it is clear that top management must set the overall direction of the bank's strategy and encompass it in a formal statement that specifies the overall corporate profit objectives. This should specify consistent operating and financial policies which are practical in view of the anticipated economic environment. Only when this series of inter-linked and viable profit objectives for all organizational units, product lines, and customer groups is set can the lower levels of operational planning take place.

Naturally, the budget is a bottom-up as well as a top-down process. Once top~level objectives have been set, bottom-up response may lead to some revisions. Throughout this interactive process, the underlying corporate objectives remain the common denominator.

Many banks have an elaborate budget process, but few actually convert their organizational responsibility budgets into profitability budgets. Typically, there are no transfers of processing cost, overhead, or interprofit center expenses or income within the budget cycle. As a consequence, the first time an organizational manager sees the bottom line, the costs have already been incurred. The lack of profitability budgeting is even more noticeable for product lines and customer groups.

The lessons of the past few years point out the need for greater profit emphasis in budgeting. While it may not be practical, or perhaps even desirable, to assemble profitability budgets for individual accounts or lower-level products, there is a clear need to anticipate the services and attendant costs associated with each significant revenue-generating responsibility center. Only by so doing can line managers with responsibility for pricing and collection of fees be fully aware of the economics of their decisions before they are made.

Prior to the beginning of a new year, top management must set and communicate the basic rules of PM. These consist of the principles of measurement, including its scope, and the control procedures to be followed.

Principles of scope and measurement. In terms of scope, top management must decide such issues as: (1) What level of organization units will have profitability reports, i.e., should transfer charges be made at the branch level? (2) What level of product will be measured, i.e.' does it make sense to estimate the profitability of an import letter of credit, or is a letter of credit sufficient? (3) Which accounts will have profitability reports, i.e., are large domestic corporate accounts sufficient? Should worldwide profitability be assembled?

Top management must also decide, communicate, and consistently apply the principles of measurement. These include such questions as:

• Whether to use prop lability or contribution reporting? This means the way corporate overhead will be allocated for organizations, products, and accounts.

• Whether or not to differentiate the degree of control exerted over overhead costs? One major New York bank specifically identifies three types of overhead: discretionary, dedicated (i.e., specifically attributable to some organization unit, but not discretionary), and shared (i.e., corporate burden). Each type is treated differently in profitability so that the levels of profit influenced by management are clearly differentiated.

• Which funds transfer rate to use and how it should be calculated? The method for calculating credit or charge for funds is central to reported profitability. Reported profitability can be changed by as much as 500 percent merely by selecting a different funds transfer rate, or even by computing the same rate differently Many banks use a single uniform marginal cost of funds for organization, product, and account profitability. However, many retail-oriented banks (particularly in California) use a twin-pool concept, with longer-term funds (savings and fixed-term deposits) financing longer-term assets (principally real estate loans), and purchased or interest-sensitive funds financing all other earning assets.

• Whether or not to allocate capital to organizations, products, and accounts? If so, how to charge for capital and what, if any, credit should be provided by funds implicitly provided? In some banks, the reported profitability of some relatively high-risk responsibility centers is actually improved by the allocation of capital.

• How to treat loan losses? Increasingly, each responsibility center accrues its own provision and is charged with its own loan write-offs. Occasionally' both the provision and the write-offs are retained at the bankwide level. Sometimes the formula portion is allocated while the judgmental component is retained at the corporate level.

• How to handle interprofit center transfers? At the present time, few profitability systems are sufficiently well-developed for the number of items transferred to become burdensome or controversial. However, there is a fear among leading banks that interprofit center transfers will become divisive if top management does not strictly regulate their use.

• Control procedures. Probably every bank in the nation measures monthly and year-to-date results against plans. Significant variations are brought to the surface through two kinds of face-to-face reviews: (1) routine executive reviews, and (2) firefighting exception reviews. Routine executive reviews occur at all levels of management to compare organizational, product, or relationship performance against plan. Short-term corrective actions are developed and responsibilities assigned. Fire-fighting renews are conducted whenever material deviations from budget occur, or when short-term strategy shifts are demanded by competitive pressure or changes in the economy. In these meetings, plans for corrective action are developed, budgets are modified, and responsibilities are assigned.

An effective control process used by several of the larger banks is the "rolling budget." This is intended to provide accurate predictions of the results for the next four quarters, together with a rough estimate for the following year. By this method, top management is kept informed of the current year's anticipated results and has a preliminary estimate for the following year. Since the budgets are revised quarterly, they accurately reflect the economic environment that actually exists, rather than that which was anticipated when the annual budget was assembled.

When the end of the current period is in sight, profitability results for all organizational units, products, and accounts should be assembled and reviewed. The interpretation of these results is the final link in the profitability management process, and provides a basis for evaluating economic performance, the financial input for the evaluation of performance of responsible executives, and helps in the formulation of targets for the next planning cycle.

The basis for economic evaluation should include longer (three to five-year) trends and comparisons of reported profitability, as well as the annual absolute reported profits and variations from budget. The most procedurally difficult aspect of interpretation may be finding a meaningful statistic from which to draw trends and comparisons. The most frequently used measures are:

• Return on earning assets. Perhaps the most convenient ratio because it is easy to compute and provides a measure that can easily be related to the original planning objectives. ROEA has found considerable acceptance among the largest U.S. banks. For example, a major New York bank uses an ROEA target of 75 basis points, and a major California bank uses 125 basis points. The variation is principally due to the different ways in which the targets are assembled.

• Return on total assets. A useful tool, but much more difficult to compute because fixed assets have to be allocated to all organizational units -- a difficult process since it implies, among other things, that leases be capitalized. Furthermore, it is not practical for products and accounts because the allocation of fixed assets cannot be made to components that cut across organizational lines.

• Return on capital. A sound measure, which is finding increased acceptance. However, it is frequently not credible to line management because of the difficulties in assigning capital. Where this is done on the basis of Federal Reserve guidelines, managers regard it as an academic exercise; where done on the basis of risk, managers hold little faith in the accountant's ability to assess risk -- an art that they believe cannot be quantified.

• Return on revenue received. A useful measure for fee-based products, particularly trust and automated customer services.

USING PM TO EVALUATE MANAGERS

Evaluation of personal performance is a key part of the interpretation phase. Quantifiable profit measures must be used if PM is to become a way of life. However, as we have seen, the figures should be used with extreme caution and never as the sole criterion. No individual manager, except at the very highest levels, has control over all revenue and expenses and, even there, profitability results are very much a function of actions of those who may have preceded the present incumbents. Furthermore, profitability results must be balanced against other desired objectives.

A FINAL WORD

Profitability management is only one of the management processes that coexists in banks. But it must become a primary driving force if banks hope to retain their recent profitability.

Fortunately, most banks have the capability of meeting this challenge. Managerial talent is available to design and implement the necessary procedures, and there is a recognition among bank employees that the internal management processes must be tightened. While there is a natural tendency to fear change, particularly if it means greater discipline and tougher performance evaluation, top management is usually totally committed to improving profitability, while middle and junior managers recognize that their future may depend on it. The implementation of PM, then, is primarily a matter of top banking executives recognizing the need and harnessing the talent.