One of the most difficult challenges facing bank management is to align individual employee goals with broader organizational goals.
One particularly difficult organizational goal to align with is profitability. It is a rare organization that is able to devise the crucial combination of incentives and understanding that leads to superior profitability. I have learned that companies that succeed in this effort invariably share one characteristic: They articulate profitability goals in very clear and unambiguous terms.
Therefore, my first suggestion is to define the profitability paradigm in stark terms. Three ways exist to improve bank profitability: increase net interest margin, add to fee income and/or control overhead expenses. Every employee should be able to relate to one of these three factors and understand how they relate to the goal.
Any employee who is not part of improving interest margin, increasing fee income or controlling cost is, by definition, strictly overhead. This may sound unduly harsh, but there is more than a grain of truth in it. Expressed incorrectly, however, it can be both inaccurate and unfair.
Lenders with target hurdle rates on loans can easily relate to this goal, as can those involved in product design or the sale of fee-generating products. Systems people who focus on streamlining work flow readily relate to the goal. But to employees who, for example, work in compliance, a general counsel's office or operations, the link is not nearly so clear. Even loan administration people (because the loan-loss and loan-loss-provisioning functions have some degree of separation from loan pricing) may not feel directly involved with profitability. So in addition to clearly defining the paradigm, it is important for the bank to add the following clarifications:
- First, we are working to achieve long-term, sustainable profitability, not profitability for the next 90 days or the next reporting period.
- Second, we will not try to achieve short-term profitability goals by starving necessary support functions. These crucial functions contribute in a meaningful way to consistent, long-term profitability.
- Third, appropriate operational and risk management controls are as crucial to long term profitability as is the more obvious category of loan quality.
- And fourth, we will invest as appropriate to avoid the low probability/high impact risk exposures that, though unlikely, can potentially endanger our survival.
Having now defined profitability in broader terms, what are the strategic decisions that can support the goal? Let us start with improved interest margin. The most obvious way to improve interest margins is to make loans with higher interest rates. But it is axiomatic that higher interest rates attach only to loans with higher risk or higher maintenance costs. Therefore, the interest margin improvement goal should be equally embraced by loan origination, loan administration, and loan review employees. Rather than perceiving themselves as on opposite sides in a tug of war, all three groups should recognize they are working from different perspectives on the same issue — even if the line-item quantification of their work product appears in a different part of the income statement. When a bank develops a highly profitable loan culture, the components include thoughtful underwriting. But a loan administration function that minimizes loan losses is as important a part of the team as origination.
Another key is to determine the right mix of fee income versus net interest income. In times like these, when banks' interest margins are being squeezed, a natural inclination is to look for fee income to offset declining margins. But when bankers take that approach, they quickly learn how difficult it is to substitute fees for margin.
An example could be a bank with a $1 billion match of loans and deposits seeing its margin shrink by one-tenth of a percentage point — in other words, a small fraction of its net interest margin.
It would be required, however, to generate $1 million in new fee income to offset this loss. That much in fees cannot typically be generated quickly or without investment.
Over the years, banks have had periods where fee income was a major source of profitability. But not always for positive reasons. For example, in the late 1970s, when inflation pushed interest rates through the roof but Reg Q kept a cap on the rates that could be offered, many banks found to their consternation that penalty fees charged for early withdrawals from long-term CDs made up a large percentage of that year's earnings.
Today, bankers need to be aware that the renewed focus among regulators on consumer protection issues will also generate a heightened awareness of how fees are assessed and communicated. Banks that rely on penalty fees will be under tougher scrutiny than those that generate fees from investment in new services.
As the banking industry slowly but surely moves out from under the burden of historic loan losses and returns to profitability, an important management objective will be to effectively align individual goals with the broader goal of bank profitability.
