As pressure mounts to increase the profit contribution from investment sales to the parent banks bottom line, it is useful to examine bank broker-dealers expense structure to see where earnings enhancements might be available.
We analyzed the expense ratios of midsize bank broker-dealers, drawing on data from the Kehrer-Essex Bank Investment Program Benchmarking Study, which we have done annually since 1991. The 2000 study covered 666 financial institutions, which collectively accounted for 59% of bank investment sales that year. 
The largest expense for a bank investment sales program, of course, is its sales force. At bank broker-dealers with $20 million of annual revenue the typical midsize brokerage unit sales force compensation, including sales assistants, and other sales expenses average $7 million, or 35% of revenue.
Management expenses average just over $1.8 million, or 9% of revenue. Direct sales management accounts for 44% of this total, with program management and administration consuming the rest. The smaller the bank broker-dealer, the higher are management expenses as a share of revenue because the fixed management costs are spread over lower sales revenue. For example, management expenses at bank broker-dealers with only $10 million of annual revenue account for 12.5% of revenue.
Midsize bank broker-dealers spend $3.8 million, or 13%, of their revenue on processing and related functions. Clearing expenses are about $1.2 million, and just under $1 million goes for operations order entry, account reconciliation, and commission accounting. Compliance expenses are an additional $232,000, or 1% of the midsize bank broker-dealers revenue.
Bank broker-dealers spend very little on marketing and advertising about 1% of revenue, on average.
This leaves a profit margin for the average midsize bank broker-dealer of 35%, which is very high by broker-dealer standards. According to the Securities Industry Association, the average broker-dealer had pretax earnings of only 9% of revenue in 2000. Nonetheless, bank management typically is dissatisfied with the profit contribution of its broker-dealer. Though the average bank broker-dealer has a high profit margin by securities industry standards, it contributes only about 2% of the banking enterprises pretax income. And investment sales heads report pressure from their banks managements to increase profit contribution by 15% to 20% a year.
One way to augment this contribution would be to offload the broker-dealer functions to a third-party broker-dealer. Our analysis suggests that a midsize bank broker-dealer could reduce its expenses by almost $2.8 million if it could offload all operations and compliance expenses.
This restructuring would give the bank several other important benefits:
For instance, it would reduce the bank broker-dealers head count. In todays cost-cutting milieu, any contribution the broker-dealer can make to reducing the overall banking enterprises payroll would be embraced by senior management.
In addition, the bank would gain access to the more robust technology platform of the third-party broker-dealer without having to invest in the technology to keep up in processing the business. Securities processing is a low-margin business, so an organization needs a large volume of securities transactions to justify the investment in technology.
Offloading operations would also let bank broker-dealer management focus on enhancing sales by expanding and upgrading the sales force, rebuilding referrals from the bank, and developing new distribution channels, instead of being distracted by operations and compliance hassles.
Finally, the bank would be shifting liability for securities sales and operations to the third-party broker-dealer, reducing the risk profile of its investment sales business.
Why would midsize banks, then, even want to own their own broker-dealer? Two primary reasons emerge reluctance to part with the share of broker-dealer commissions that the third-party broker-dealer keeps in payment for its role and the belief that the bank has more control over its investment sales program through its own broker-dealer.
The typical third-party broker-dealer retains 10% to 15% of the broker-dealer commissions. At the upper end of that range, there is no financial justification for switching from an internal to a third-party broker-dealer; our analysis indicates that it would be a wash. A bank could offload expenses amounting to 14% of revenue but pay the third-party broker-dealer 15% of revenue to perform the same functions.
At the low end of the range, the reduction in expenses and concomitant increase in profit contribution has not seemed large enough to encourage midsize banks to abandon their own broker-dealer operations. On the other hand, the small financial advantage offered by a 90% payout has dissuaded many banks using third-party brokerage services from setting up their own broker-dealer.
If banks were able to negotiate a more attractive third-party revenue sharing arrangement, they would still have to confront the control issue. How much lost profit opportunity is control of the broker-dealer worth?
For example, if a third-party company retained only 6% of the dealer commissions, a midsize bank investment sales program would in effect be paying only $1.2 million for operations and compliance functions that would cost it $2.8 million to perform for itself. The cost savings of $1.6 million would translate into a 23% profit increase. If the bank could negotiate a 98% payout from the third-party firm, the cost savings would be $2.4 million, which would improve the bottom line of the investment services business by 34%.
The actual cost saving from offloading back-office brokerage operations will vary from bank to bank. A bank that spent only 5% of revenue on operations and compliance would not gain financially from outsourcing its securities back office to a third party broker-dealer that retained 6% of the commissions. But if that bank could negotiate a 98% payout with the third-party company, it would save 3% of revenue, or $600,000, in expenses. And when this saving dropped to the bottom line, the profit contribution of the banks investment services business would rise 9% a meaningful, though not huge, increase.
In recent years a major consolidation has affected third-party broker-dealers. If they could parlay their greater size into bigger back-office efficiencies and greater leverage over product providers than the broker-dealers of midsize banks, third-party companies could offer midsize banks an attractive alternative to owning their own broker-dealer.
Mr. Kehrer is the principal of Kenneth Kehrer Associates, a consulting firm that does research on bank distribution of insurance and securities.
