The Value Of An Account To A Bank

Overview

This simple topic is really the basis for at least a semester long course in the Fundamentals of Banking. To understand the value of an account to a bank is to first understand the essence of banking. Traditionally, banking has been about taking in funds (deposits) at X% (including servicing costs) and investing or lending out those same funds out at Y% (with the hope that Y is always greater than X!). The only reason that commercial banks have checking and savings accounts is that these have generally been perceived to be the lowest cost sources of pools of money to lend. The lending side (the asset) of banking is where banks traditionally make the majority of their profits.

Investment banking and mortgage banking operations have existed for years without having deposit accounts. They simply look for other sources of funds rather than consumer and business accounts. This competition puts further pressures on commercial banks in competing for lending opportunities. Consequently, recently the best managed banks, in order to avoid fluctuations in interest rates and competitive pressures that are shrinking the difference between X and Y above, have begun to look for new sources of fee revenues and have shifted their income sources to be as much as 40% from fees instead of interest rate margins.

Account Value—Qualitative Definition

Most banks have struggled for years to answer the question of what is the value or profitability of "an account", and many large consulting firms have been paid royally for trying to help banks solve this riddle. A lot depends on what type of account that one is talking about: a deposit account or a loan account. As mentioned above, deposit accounts have no intrinsic value in and of themselves. They are merely a source of funds for lending and investing purposes. This perception is slowly changing as these deposit accounts are also viewed as potential fee revenue generation opportunities.

The way most banks are trying to deal with the question of account value is to approach the answer at a more macro-economic level. They are trying to measure the value of the entire relationship, even at the household level rather than the individual level. In this fashion, some accounts may be "loss leaders" but serve as lynchpins to get the customer to use other more profitable services with the same bank.

Account Value—Quantitative Definition

Whether you are talking about measuring the value of an individual account or a total household relationship, the starting point is in understanding a bank’s costs structure. The single best source for this information is the annual Functional Cost Analysis (FCA) Report published by the Federal Reserve Bank. Participating banks gather their own cost data, and the Fed produces aggregate benchmarks upon which individual banks can measure their own performance. The FCA segregated deposit accounts and various loan accounts so banks can look at asset and liability product lines separately.

The major components of this financial analysis are related to Account Acquisition Costs (Marketing) and Account Servicing Costs (Operations). These costs are deducted from the Earned Revenue or the Revenue Potential of the Account to come up with its Value. Obviously, the lower the costs or the higher the Account Balances, the greater the Profitability. Rather than concoct a fictitious example, I will defer to the FCA for real-world numbers if you want to get a more in-depth analysis of the industry’s numbers.

Banking 101

Unfortunately, the cost accounting analysis of a banking operation is not as simple as one might find in retailing or manufacturing, for examples. There is no simple Cost of Goods Sold to subtract to figure out a Profit Margin. There are some fundamental concepts concerning commercial banking that must first be understood in order to make sense of the financial performance potential of a banking institution. These basic concepts are components of the US Government’s Monetary Policy, and revolve are Reserve Requirements, the Multiplier Effect, and the Accelerator Effect.

As stated above, in simplistic terms, banks take in deposits in order to make loans. But a bank cannot lend out all of its deposits in the form of loans. The Federal Reserve Bank places a Reserve Requirement on deposits, the percentage of an Account Balance that cannot be lent out. For example, on most checking accounts, the Reserve Requirement is 10%, so that an account with a $1000 balance gives the bank $900 that it can lend out and earn interest on.

The Multiplier Effect and the Accelerator Effect are economic descriptions of the reality of what transpires in the marketplace when this kind of deposit and lending activity occurs. Continuing on the example above, the customer of the bank that has just borrowed the $900 must do something with those loan proceeds. Either this customer or someone that he pays the money to will deposit this $900 into an account. Thus, this financial institution, which could be the same bank, now has an additional $900 on deposit, which gives it $810 ($900 times 90%, or 100% minus the Reserve Requirement) to lend out to the next customer. This process goes on and on, creating additional lending opportunities, and hence sources of revenues, all from one initial $1000 deposit. This is the Multiplier Effect and is part of what makes banking viable as an industry. By adjusting the Reserve Requirement, The Fed can control the Multiplier Effect as a component of its Monetary Policies. However, the Fed does this infrequently, and instead tends to concentrate more on the interest rates that it charges to banks to impact economic growth rates.

The Accelerator Effect is similar to the Multiplier Effect, but it has to do with the frequency and the speed that these deposit and loan transactions occur. Rather than go into a further exposition on these facets of Monetary Policy and their impact on banking here, I will explain a little more about these topics in separate documents.

Summary

The value of an account to a bank is dependent on all of these factors, ranging from understanding the costs of acquiring and servicing an account as detailed in the Federal Reserve Bank’s Functional Cost Analysis to comprehending the potential income that can be derived from an account, or more accurately, a combination of accounts. Looking at the revenue potential of a bank income from a micro-economic perspective first requires a more macro-economic view of how the Banking Industry functions and how its Regulators position its policies towards the overall health of the US economy.