Banks today are searching for ways to increase profitability while also navigating a growing number of regulations that require stronger risk management. The result is that banks are trying to pivot back into growth mode while simultaneously needing to manage their exposure more rigorously.
These pressures have created a paradox for banks — the customers who most want credit and are willing to pay for it are often considered "risky," therefore banks are hesitant to lend to these customers. However, these are the customers who are often the most profitable.
This paradox is particularly relevant in today's business climate, as so many banks are under pressure from investors to increase or maintain a healthy return on capital. So what is the answer for banks? Simple: Mine the existing portfolio, understand how much credit each customer can handle, make targeted offers, and grow the existing, profitable relationships.
The idea is to increase the share of the customer wallet — not just any customer, only those who will be profitable. The more wallet share a bank has, the better off the bank will be in terms of building a long-term relationship with preferred "profitable" customers.
All of this means that banks need to take a new approach. It’s not just about risk evaluation. It's no longer as simple as saying, "I will avoid customer X because he is high risk." Now, banks must evaluate risk and also profitability. Customer X may be riskier than customer Y, but he is also more profitable than customer Y. Banks must leverage this profitability opportunity while still complying with regulations that have become much tighter in recent years. Customer Y is not going to give the bank the return on capital that the stakeholders are demanding. Customer Y may not ever use his credit card. The return on the capital that is reserved for that "safe" customer may be zero!
This profitability paradox has created a new role for risk managers. Retail bank risk managers have not traditionally had to think much about capital management, but that is changing. Under regulatory and market pressures, many banks are now requiring risk managers to take into consideration how much capital is available for lending and what the return will be. At the same time, the more progressive banks are exploring ways to refine and optimize every operational decision to produce higher returns on risk-weighted assets and equity, which demands a different kind of risk manager.
Risk managers are also being tasked with driving growth, a role typically taken by marketing or portfolio managers. In the go-go years before the recession, risk managers were often ignored or were looked upon as naysayers. Now, risk officers are gaining greater importance and are being asked to support (and even enable) capital directives and to shoulder the burden of profitability management.
With the subprime crisis still fresh in regulators' minds, banks are required to hold a greater percentage of funds in reserve to protect against operating losses while still honoring withdrawals. Investors providing precious and scarce capital to banks want the highest return on their capital. The only way to meet the investors' expectations and still comply with regulators is to balance out some of the safe (i.e., not profitable) customers with risky (i.e., profitable) customers.
Banks need to find the ideal amount of credit to maximize profitability. With a pragmatic approach, banks can create marketing offers that are pre-approved according to the bank's risk appetite and the customer's credit capacity. The goal is to uncover additional opportunities for profitability by expanding existing customer relationships.
Daniel Melo is a senior director at FICO and runs solution consulting in Europe, the Middle East and Africa. He also writes for the FICO Banking Analytics Blog.