The Value Of An Account To
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.
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.
Whether you are talking
about measuring the value of an individual account or a total household
relationship, the starting point is in understanding a banks
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 industrys numbers.
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 Governments 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.
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 Banks 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.