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How best to model profitability for financial institutions?

Guest post by
Vandana Vasudev Nayak, Consultant, Infosys


Five years ago, most financial institutions saw dawn ahead of them with the bankruptcy of Lehman Brothers. The turmoil left few of them battling their way back, while few of the financial institutions having their basic C's - Cost management, Credit quality and Capital conservation, in right track have been able to sustain and grow in the financial markets.  Together, these factors are reflected in one key element - profits. The business model for any financial institution boils down ability to capture the market trends and ability to assess business impact, embed them in forecasting cash flows and measure consequences on profitability.

Profitability is a key criterion for measuring the performance of the financial institution. With the growing competition and intricate internal dependencies on building profitability model, financial institutions are seeking to enforce technology which best suits their profitability measurement requirements.  Typically, financial institutions can adopt risk adjusted performance measures including Risk adjusted return on capital (RAROC) alongside Economic Value Analysis (EVA) or Activity Based Costing (ABC) for profitability modelling with focus on decision making at account level data or ledger level data. The aim is to build a clean, single sourced solution catering to need of analysis of income and costs, considering the risks associated, with a multi-dimensional view of products, customers, entity and channel.

A good profitability model allows analysis for the key profitability areas which help in effective customer retention and addition necessitating identification and understanding its "profit areas". It is critical make fact based decisions answering few of the questions like

  • Where its profit comes from?
  • From which products and from which customers?
  • Why it comes from specific profit areas?

All of these questions need to be associated back to the bank's costs - operational (cost of business activities) as well as financial costs (cost of money) - with the various products it provides and customers it serves. Typically, financial institutions face challenges in assigning activity costs incurred in the process of operating, which need to be assigned to products and customers unlike interest expense component which can directly be linked to the product.

As financial institutions try to build best profitability model, it is essential they are supported by right technology and the right solution to meet their business requirements.

Keep watching this space to read more on factors that drive the selection of technology, followed by comparative study of Oracle Financial Services Profitability Management and Hyperion Profitability Cost Management on few key deciding factors.


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While profitability is certainly a key advantage in any activity-based costing system, a well-implemented ABC model also provides other benefits/knowledge well beyond profitability. These additional benefits include:
• Cost reduction opportunities,
• CPI/Lean event identification,
• Customer/client negotiation assistance,
• Outsourcing vs. in-sourcing decisions (Make vs. Buy),
• Internal transfer pricing amounts,
• Shared services assignments, and/or
• Awareness of support services – what can I control?

The banking industry has some unique issues when dealing with activity-based costing results. From a customer perspective, the low deposit, younger client is very cost-intensive, a loser should you take ABC at “face value.” Would it be appropriate to charge them a higher fee to recoup that loss, or would those fees turn that customer away from the institution permanently? Does a loss in revenue today ensure customer retention later? Does an early loss eventually lead to larger profits and product diversity (mortgages, construction loans, large deposits, etc.)? Simple ABC results would dictate that banks discourage younger customers and charge high fees for simple checking account services. Is that the right decision for a bank’s long-term financial health?

A consultant, well-versed in ABC models, software, implementations and the banking industry, would help negotiate these sensitive issues between short-term profitability and long-term wealth.

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