Our recent work with banking clients and Nolan Bank Performance Study (BPS) participants is revealing a recurring theme: Optimism has increased relative to the financial crisis finally on its way to being behind us. Even with this positive outlook, there has been some hesitation to significantly reduce infrastructure expense in anticipation of planned growth. In many cases, this is occurring too slowly or not at all. As a result, revenue levels are not supporting expense levels to the degree needed. This contributes to higher efficiency ratios, stock prices, and other operating metrics.
Through our analysis and discussions with clients, we are finding that carrying too much expense may be due to a lack of a clear understanding about what is currently being spent to generate each dollar of revenue for each separate line of business. BPS participants gain new insights into this trend because we ask them to align expenses and revenues at each level of business. If internal systems and databases do not do this effectively, it can be challenging for management to appropriately allocate expenses, volumes, revenues, etc., at this level. Aligning expenses and revenues at each level of business, however, is a very worthwhile exercise because of the valuable insights that are gained. 

Using lending as an example, BPS participants gain insight and visibility into the overall efficiency ratio (total expense to total income), return on assets (net income to total loan $), loan unit cost, revenue per loan, productivity (loans per FTE), and several other measures in terms of how they compare with peer banks. These metrics begin to shine a spotlight on potential opportunities for improvement. If the expense component of a ratio is significantly higher than the benchmark or the average for the peer group, it could be indicative of a number of problems, such as inefficient or ineffective sales efforts,  job design,  structure,  processes, or  measure and reward systems. If we further drill-down and analyze a suspected opportunity area, it can reveal even more insights. In one case, we looked at the line of business expenses and revenues in conjunction with support areas; for example, lending in conjunction with loan documentation and servicing. In this case, we found that the end-to-end process cost made the line of business barely profitable. The end-to-end view brought a new, broader perspective to a process that was, as is typical, being managed strictly from a functional perspective rather than from an end-to-end process perspective. This was especially evident when one client’s organizational structure did not connect key functions within the lending process until the very top of the organization. This resulted in a classic organizational silo environment in which no one was accountable for the whole process.

We have also noticed that, in some cases, banks struggle to understand exactly where revenue is actually coming from. This may be driven by how certain roles are defined, how product groups are segmented (business banking vs. middle market lending), and the organizational structure around business units. For example, the lender role in one bank may encompass both consumer and commercial lending, while in another, the lender role may focus only on small or large commercial lending. Depending on how financial reporting systems are aligned with roles, products, and business units, there is potential for distortion in terms of how much revenue is really being generated by a particular line of business and what it costs to generate that revenue. 

Whether growth is occurring or not, it always makes sense to understand the relationship between expenses and revenues, where revenue is really coming from, and the cost of core end-to-end processes. As we approach the end of 2012 and prepare for the new year with a still sluggish economy, an important 2013 strategy for your organization may be to gain new insights into managing the always delicate balance between expense and revenue. Once this is clearly understood, a targeted and focused improvement effort can reap significant dividends on both sides of the efficiency ratio equation.