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Echo Partners Community Bank Blog

    Howard Lothrop

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    The Basics of CECL

    math simple equation on chalk board-1

    CECL only has 3 main parts…

    1) Historic loss rates, plus adjustments for

    2) current conditions and

    3) expected future conditions.

    The biggest part of CECL, historic loss rates, is very similar to the loss rate calculations that bankers have been performing for the past 40 years. What’s different is the timeframe.

    Bankers are used to looking at annual loss rates but CECL requires us to examine lifetime loss rates. Same concept, different perspective.

    Here’s the point many bankers miss…

    Total CECL loss is the same as total incurred loss. It just happens sooner. It’s a timing difference.

    The adjustments are where we get to apply management’s judgment and good old fashioned common sense. You can fill in loss curve gaps using peer data, or shade your results with Q-factors.

    As with most regulatory items, a consistent process with thorough documentation trumps fancy analytics and statistical techniques.

    Conventional wisdom says you need a complex and expensive process. That’s just wrong.

    If you use a simpler process with today’s incurred loss method you can still use a simpler process with CECL.

    Do you have CECL questions?

    What's the Problem with CECL?

    What’s the problem with #CECL ?

    How do I Start? card with a urban background


    Most bankers understand that CECL is on the horizon but they’re not focused on what to do about it.

    Maybe they think if they ignore it, it might go away...

    Put their head in the sand like an ostrich

    ...Especially if they’re from a credit union.

    But you better stop right there and accept it as if it were an unchangeable law of the universe.

    Here’s the reality…

    CECL is happening.

    FASB is not beholden to Congress.

    Ignoring CECL will not help.

    It’s time to get serious about understanding CECL, planning for it, and starting to run parallel.

    How is your board going to develop approved policies procedures and limits if you’re not even running your numbers?

    How will you prepare for CECL reserve levels if you don’t even know what they are?

    Where are you on CECL?

    3 parts of deposit profitability

    3 parts of deposit profitability.

    Deposit profitability requires you to adopt 3 main components.

    • The concept. Deposit profitability presents a different concept than what we have traditionally learned as bankers. Deposits aren’t just fungible funding sources but have different levels of profitability that we can manage and optimize. We can’t just measure the quantity of deposits. We must measure the quality of deposits.
    • A measuring tool. Starting to measure deposit profitability requires an instrument-specific measurement of every transaction from our core system. We can no longer rely on simple aggregate measures if we wish to calculate detailed and accurate P&L statements for each and every account.
    • Strategies. Applying strategies to grow deposit profits is the bridge that connects the concept and tool with our bottom line. Effective strategies require setting a profit target and changing account terms or behaviors to result in more profitable deposits. Typically this will require customers to hold larger minimum balances, pay more fees or reduce the volume of included but expensive transactions.

    Bankers grasp the basic concept quickly. The measurement process once fully vetted is widely accepted. Most uncertainty arises over requiring more profitability.

    Don’t listen to the naysayers

    Don’t listen to the naysayers.

    You know who I mean…

    …Those purportedly well-meaning colleagues and coworkers who have myriad reasons why your profit building initiatives will never work out.

    This is especially true with respect to strategies to grow your deposit profits. They’ll give you endless feedback why it won’t work and it almost always boils down to fear of losing customers.

    Let me ask you a question. Isn’t there a bank in your market that pays the highest deposit rate? But they don’t get all the business do they?

    Similarly there’s a bank that pays the lowest rate in your market yet they still manage to gather deposits. Don’t you think that’s evidence that customers bank for reasons that don’t begin and end strictly with dollars and cents?

    Especially when you consider what a hassle it is to change banks. That’s a good thing as it makes your deposits “stickier”. Surveys show less than 11% of depositors would change banks for any reason.

    Or think of your Q3 (low balance but hit profit targets) customers. They’re proof right inside your bank that this approach works.

    So why don’t you take a chance and run a smart test case on Q1 (small balance, subpar profit) deposit profitability. Experience shows that done properly you won’t lose customers but you will grow profits.

    Apples to apples deposit comparisons

    Apples to apples deposit comparisons.

    It’s inevitable once you start measuring deposit profitability. You need a framework for comparing similar accounts with different profitability.

    Why? Because those comparisons give strong evidence on the best paths to improve profits. Think about it. Would you rather try and build profits based on your own best guess or would you rather have solid evidence of what actually works?

    Start with grouping accounts based on balances (horizontal axis) and profits (vertical). 4 simple quadrants are all you need. Now compare accounts vertically so that you compare profits based on similar account balances. Here’s an example.

    Consider Q3 (small balance accounts that meet your profit targets) in the upper left quadrant. Compare Q1 (small balances but fail to meet profit targets) accounts in the lower left quadrant with Q3 to gain insights into how best to improve Q1 profitability.

    Comparing like-sized balances helps you zero in on the critical behaviors that result in different profit profiles. In this case (Q1 vs Q3) Q1 accounts are apt to have lower revenue components (fewer fees and less interchange) and similar delivery channel costs. But by limiting your comparisons to similar balances you quickly learn what’s realistic for these profit laggards.

    Two sides to the 80/20 story

    Two sides to the 80/20 story.

    There are really 2 sides to 80/20 deposit profitability.

    We usually focus on the 20% who drive 80% (or more) of your profits. That’s a great common sense strategy and I’d encourage you to continue building personal relationships with your best customers.

    But what about the 80% of depositors that represent 20% (or less) of your profits? How do we best handle them?

    There are 2 important subgroups of deposit customers in this less profitable 80% group. One easy answer concerns the group that is the least profitable. In fact they’re the 20% that drives 80% of your deposit losses.

    You must identify these depositors and determine why they are causing such significant losses. Typically these sorts of losses are produced by excessive transactions via expensive delivery channels. It’s not uncommon to see 2% of your average collected balances driving as much as 50% of your entire deposit delivery channel expense. You must find and fix these super users.

    The other group is less obvious. They’re the less profitable depositors that can be motivated to become much more profitable. In fact your goal here is to convert them into more of the 20% driving your biggest profits. They’re the future of your bank and your deposit profitability segments can help identify them.

    Sir Isaac Newton and deposit profitability

    Sir Isaac Newton and deposit profitability.

    Newton’s 1st law of motion says that a body at rest will remain at rest and a body in motion will remain in motion. These properties are often referred to as inertia. While we usually think about it in terms of physical bodies, Newton also does a pretty good job of describing bank deposits.

    Consider bank deposits in motion. This is hot money in search of the highest yield.

    These deposits tempt us to offer them a higher rate to capture them. After all, the thought goes, once exposed to our service and customer experience we’ll break them of their rate-seeking habits and have them forever.

    Don’t deceive yourself. They’re hot now and they will stay hot. They’re ever in search of the elusive best rate and you won’t change them.

    Now consider bank deposits at rest. They’re our basic long term customers.

    Think about things from their point of view. It’s a huge hassle to change banks. Plus they actually are comfortable with us and our bank. The only problem is that 50%+ of them are unprofitable.

    You can fix this with minor finetuning of account terms and fee structure. They’re not going to move.

    The risk-reward tradeoff for correcting this profit imbalance is tilted heavily in your bank’s favor. Think about this scientifically. Just ask Newton.

    Unprofitable deposit accounts

    Unprofitable deposit accounts.

    Like most bankers you probably have a sense that some of your deposit accounts are unprofitable. Based on my experience I’d guess it’s about half. But let’s not get hung up on specific numbers. Instead let’s look at why you have unprofitable deposit accounts.

    There are many reasons for unprofitable deposits but the biggest reason is probably using aggregate measures (like balances) instead of instrument-specific measures (like actual transaction behavior) to judge profitability.

    What this boils down to is that if you can’t measure deposit profits you can’t manage deposit profits.

    Another big factor is failing to set a specific deposit profit target. We’d never consider not setting a profit target for loans or investments, but somehow when it comes to deposits (80%+ of typical bank balance sheet footings) we overlook it.

    It’s hard to hit a profit target that you don’t set.

    The third factor is pricing. Bankers do a poor job of setting prices based on objective factors and often default to rules of thumb or “competition” as a shortcut. But the truth of the matter is that without instrument-specific measurement and absent a specific profit target that’s often all we have left.

    Improve your measurement, goals and process and watch your deposit profits increase.

    Your deposit quality never gets better

    Your deposit quality never gets better.

    It only gets worse…

    …Until you implement deposit profitability.

    As banks near you start improving their deposit quality some of their lowest quality accounts will decide to change banks. Guess where these money-losing lower quality accounts will go?

    That’s right. They’re going to your bank.

    They’re going to reduce your profitability and water down your deposit quality. And this happens over and over again while banks in your market improve their deposit quality. Until you decide to join them and insist on earning a fair profit on your deposit services.

    But once you implement deposit profitability your deposit quality starts to improve. That’s a natural result of focusing time and attention on the issue of deposit profits. Here’s how it works:

    You have a base amount of quality profitable deposits that exist now in your bank. All remedial actions are focused solely on the lower quality, less profitable accounts.

    In response to your efforts these accounts can a) Change behaviors to avoid fees, b) Pay fees or c) Resist.

    Any account in the “Change” or “Pay” group automatically increases both your deposit quality and profitability. The “Resist” group will itself mostly change or pay, but any account losses will come out of this group.

    Why you don’t have deposit profitability

    Why you don’t have deposit profitability.

    Deposit profitability can add 30-50bps (or more) to your annual profits year after year. But if deposit profitability is such a great idea why don’t you already have it at your bank?

    There are 3 main reasons.

    1. Deposit profitability is a big bank project. Big banks engaged big consulting firms with big data experience to custom craft deposit profitability solutions. Until recently you just didn’t have the computing horsepower, algorithms and expertise to measure instrument-specific individual account profitability. Now community banks can have these same powerful and profitable insights.
    2. Legacy core systems held you back. All the data you need to calculate instrument-specific P&L statements for each and every account is tucked away deep within your core system. Core providers could have made this readily available for you but chose not to. Now we have templates that give a road map to the exact data needed.
    3. Deposit profitability is a new concept. We think we already know everything about deposits. It’s hard to shift from trusted aggregate measures (like balances) to a new instrument-specific focus on profits. We’ve successfully done it before with IRR models. Now we need to make the instrument-specific shift with deposits.
    Do you want to grow your bank profits with little to no risk? Click Here to  Discover How

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