A Large National Bank

Customer Value, Relationship and Profitability

The Robert E. Nolan Company completed an assignment for a major U.S. financial institution to help develop a system-wide approach to developing and interpreting customer profitability information and implementing service, retention and cross-selling strategies.

This challenge is not unique to this particular client. Despite their best efforts, most banks have not successfully made customers more profitable. In fact, most customers are at or near the break-even point. Profitable customers continue to subsidize non-profitable customer’s years after the implementation of customer profitability systems. Banks are not succeeding in bringing in only profitable customers, cross-selling existing relationships, or focusing retention efforts on their most profitable customers.

Profitability Information Systems

The use of profitability information has faced two major cultural hurdles: (1) confusion about the purpose and use of the information, and (2) perception that profitability information conflicts with traditional customer satisfaction values.

Profitability information systems have erroneously been held to impossible standards of accounting accuracy with the weighty expectation of labeling customers as profitable or unprofitable. These systems, however, are intended to be a guide to create more profitable customers rather than a precision tool to select them. Bankers make customers and products profitable; profitability is not the responsibility of customers.

Most banks lack a clear vision for the use of profitability information and fail to plan effectively for its introduction and use bank-wide. The reason that actual results from using profitability systems have not lived up to expectations is more the fault of execution than of system design.

Service Strategies

Many institutions have found that traditional service tiering — simply applying a higher cost resource against a more profitable customer — has not done enough to reverse the profit skew that has persisted across time. Banks also continue to operate under customer strategy assumptions that are based more on myth than fact, such as:

  • More products make a customer more profitable;
  • High growth industries are more profitable;
  • Customer satisfaction leads to loyalty; and
  • A lower number of relationships per relationship manager equals higher profit.

For a customer profitability system to be used properly, banks must not overemphasize volume or improperly align incentives. It is also important to safeguard so that relationship managers are restricted from entering data into the system.

Determining Profitability

Three sources of strategic profitability are current profitability, growth potential and non-financial benefits (or lateral value). Lateral value means that many customers possess value to the institution beyond their financial contribution, such as:

  • Good source of referrals;
  • Legal, moral or regulatory reason to maintain the relationship;
  • Management reason to maintain the relationship (friend of the CEO);
  • Marquis name or community leader.

The key is to balance over serving certain customer — seven if unprofitable — while guarding against using non-financial value as an excuse to carry unprofitable relationships.
Project Methodology and Findings

This particular financial institution has two profitability databases. The first is the Customer Profitability System (CPS) that warehouses electronic customer information for multiple paths of extraction and review. The second is the Relationship Profitability Management (RPM) system that extracts data from CPS to view profitability information of a total relationship, as well as those relationships in the care of a relationship manager.

A committee with representatives from different departments and lines of business was assembled, in conjunction with consultants from the Robert E. Nolan Company, to develop recommendations to improve profitability and service for customers by finding the best ways for the Bank to incorporate new information coming from these two databases.

This committee reviewed Best Practices to generate ideas for:

  • Improving current value,
  • Recognizing growth potential,
  • Determining lateral value, and
  • Improving bank offerings.

To help determine customer profitability, the Robert E. Nolan Company developed a formula to calculate a "Lifetime Value" based on a point-in-time valuation of the customer’s relationship. This calculation in its simplest form is as follows:

  • Lifetime Value = PV (PMT, N, I), where
  • PV = the present value of the future cash flow anticipated from the customer
  • PMT = amount of the monthly "snapshot" of customer profitability
  • N = the greater of the actual number of periods the customer has kept his relationship with the organization, or the expected life of the customer
  • I = the discount rate, represented by the organization’s assumed marginal franchise value, or premium over book value

The most difficult issue for this institution in the calculation was the accurate determination of expected customer life. Nolan therefore conducted research using a sample of the Client’s customer-level data, which revealed that the life expectancy varies significantly based on the first product purchased and the total makeup of the customer’s relationship at any point in time. Specific products not held in the relationship were also found to affect customer life expectancy.

For lifetime value to be accurately calculated, an institution must look not only at the length of customer relationships but also consider the multiple variables having an impact on the outcome. Without a thorough evaluation of the factors that influence lifetime value, the institution risks inaccurate measurement of customer profitability, which could result in poor customer relationship management.

To aid in relationship management strategies, customer accounts were classified into four general profitability categories:

  • Super Winners – highly profitable, but vulnerable to leaving for a better deal
  • Winners – the Bank’s bread and butter
  • The Masses – lots of relationships but not much profit; may have potential for growth or re-pricing
  • Negative Profits – opportunity to grow, re-price or close

Relationship management actions were then developed to correspond to these categories.

Next Steps

Taking the culture of the Client into account, Nolan refined ideas into recommendations, identifying steps and ideas for immediate implementation.

Responsibilities were divided between Client committee members to communicate procedures bank-wide, as well as to set up processes for improved data query and uniform delivery. Marketing actions were then identified to improve profitability for customers with similar characteristics, as well as for cross-selling.

Summary

Modeling customer relationships allowed the Client to identify the variables that "counted" and to examine their effects in combination. The models provided the Client an immediate return by allowing them to more accurately calculate the value of a customer. As a result, this institution has more accurate information on which to base marketing and service decisions.

Customer profitability should be the basis for customer relationship management. To be accurate, customer profitability should be measured based on lifetime value. Safeguards and ongoing communication efforts should also be established to ensure that these profitability measures and their respective service directives are practiced uniformly bank-wide.