Key Takeaways
In the banking industry, understanding the profitability of banks is not as straightforward as it is in manufacturing. While manufacturing operates on a margin basis, considering the cost of goods sold and revenue, banking is a bit more complex. It isn’t as simple as calculating a margin. The two main drivers of a bank’s profitability are the capital cost and the operational cost. In this article, we will delve into these aspects and explore how banks can manage these costs to improve profitability.
Understanding Capital Costs
Capital cost is a significant factor in a bank’s profitability. It is measured in two parts. One part is the cost of acquiring money to lend out. Suppose a bank can acquire money at a rate of 4% for ten years and grants a mortgage at 3.1%. In this case, the bank has a 0.9% margin. However, having a mortgage on the balance sheet incurs a capital cost due to regulatory requirements on cash reserves. These two aspects make up the capital costs that a bank cannot influence.
The Role of Operational Costs
While capital costs are mostly uncontrollable, the operational costs involved in granting a loan, which are primarily administrative, are within the bank’s control. These costs include the entire loan approval process, opening accounts, checking documents, and assessing the creditworthiness of the borrower.
There are also costs associated with servicing the loan, such as addressing changes in the borrower’s life circumstances, handling inquiries, and managing the loan account. Understanding and managing these operational costs is crucial for a bank’s profitability.
Measuring Operational Costs
Banks measure operational costs by breaking down the activities involved in granting and servicing a loan. For instance, the process of granting a loan involves checking documents, going through credit committees, and various other activities leading to the loan approval.
Each of these activities has associated costs. By measuring these costs at different stages and across different departments, banks can gain insights into their profitability. This approach allows banks to understand the cause-and-effect relationship between activities and costs, leading to more effective cost management.
Evaluating Default Risk
Another significant operational cost for banks is evaluating the default risk. Banks use sophisticated risk models to calculate the chance of default based on various parameters. The cost of updating and maintaining these models is a part of the operational cost that should be accounted for in the bank’s bottom line.
In conclusion, while capital costs are a significant part of a bank’s expenses, the only controllable profitability lies within the bank’s operational costs. By understanding and managing these costs, banks can improve their profitability and avoid the silent killer of profit – poor change management.
The profitability of banks is driven by capital costs and operational costs.
Capital costs, which banks cannot influence, include the cost of acquiring money to lend and the cost of maintaining cash reserves.
Operational costs, which banks can control, include the costs of granting and servicing loans.
By understanding and managing operational costs, banks can improve their profitability.
Evaluating default risk is a significant operational cost that banks should account for.