Cultivating profit in a low-rate world.

• Author: Sullivan, Mary Beth
• Position: Cover story - Company overview

In today's soft rate environment, customers have gained the upper hand. In response, banks need to generate new sources of revenue and to learn how to compete more on the basis of value rather than price. Here are five strategies to help banks adjust to this new business model.

THE INDUSTRY'S EARNINGS RECOVERED A BIT IN 2010 according to the FDIC's Quarterly Banking Profile released in late February. But a deeper drill into the report indicates a continued cause for concern regarding banks' abilities to produce core earnings growth. Much of last year's uptick in profitability resulted from decreases in loan loss provisions or one-time gains on asset sales. As FDIC Chairman Sheila Bair noted, if banks "want to have long-term sustainable earnings, you can only rely on reduced loan-loss provisions for so long."

In the past, core earnings growth was, for many banks, almost totally focused on net-interest income (NII). From the mid-90s until the recent banking crisis, many consumer and small-business banking managers viewed their primary responsibilities to be "deposit generation"--and specifically, direct-deposit account (DDA) generation. That seemed to make sense in an environment where DDA dollars could be put to work funding loans and producing NII growth. In hindsight, however, many bankers realize this profit model never worked well. Banks simply weren't adequately compensated in many cases for risk; customers had little loyalty, so churn rates were very high; and the lack of transparency in the old pricing formulas contributed to today's lack of trust in the banking industry.

Now faced with the daunting task of reconfiguring their business models for the new regulatory world order, bankers are finding themselves armed with too few profit drivers. With improved credit quality and economic prospects and recovering secondary markets, banks may be able to reduce provisions and shrink balance sheets in the short term to bolster profitability--but banks certainly cannot shrink their way toward longer-term prosperity.

Many banks are working to enact changes to product design, prices, compliance practices and the like to respond to new regulations and resulting changes to earnings dynamics. These changes are necessary, but the changes underway at many banks won't be enough to get income levels back to where they need to be to attract capital and satisfy shareholders and owners. In order to achieve success going forward, the earnings equation has to change--and banks have to start getting paid for delivering well-understood value for the prices they charge.

Set the stage to enable premium charges

Fortunately, there are opportunities today to build new earnings streams, but they require substantially different approaches to managing the business. Going forward...