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Commercial account analysis in banking : a comparison of the procedures of selected United States and… Thomson, James Robertson 1973

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C A COMMERCIAL ACCOUNT ANALYSIS IN BANKING: A COMPARISON OF THE PROCEDURES OF SELECTED UNITED STATES AND CANADIAN BANKS by JAMES ROBERTSON THOMSON B.A., Simon Fraser U n i v e r s i t y , 1970 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION in the F a c u l t y of Commerce and Business A d m i n i s t r a t i o n We accept t h i s t h e s i s as conforming to the required standard. T H E U N I V E R S I T Y O F B R I T I S H C O L U M B I A May, 1973 i i In presenting t h i s t h e s i s in p a r t i a l f u l f i l m e n t of the requirements f o r an advanced degree at the U n i v e r s i t y of B r i t i s h Columbia, I agree that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r reference and study. I f u r t h e r agree that permission f or extensive copying of t h i s t h e s i s f o r s c h o l a r l y purposes may be granted by the Head of my Department or by h i s r e p r e s e n t a t i v e s . It is understood that copying or p u b l i c a t i o n of t h i s t h e s i s f o r f i n a n c i a l gain s h a l l not be allowed without my w r i t t e n permission. F a c u l t y of Commerce and Business A d m i n i s t r a t i o n The U n i v e r s i t y o f B r i t i s h Columbia Vancouver 8, B.C. May, 1973 t i l ABSTRACT Banks o f f e r a wide range and v a r i e t y of s e r v i c e s to t h e i r commercial customers. P e r i o d i c a l l y , they analyse the s e r v i c e s being u t i l i z e d by a customer and subsequently enter into n e g o t i a t i o n s with that customer on the compensation to be provided f o r s e r v i c e s rendered. As a p r e l i m i n a r y to the major o b j e c t i v e of t h i s study, an argument is presented on the a n a l y s i s approach that should be u t i l i z e d by banks to determine compensation requirements and to negotiate these with the customer. The major, study o b j e c t i v e is to determine, assess and compare the commercial account a n a l y s i s procedures of s e l e c t e d United States and Canadian banks. While banks provide a wide range and v a r i e t y of s e r v i c e s to t h e i r commercial customers, t h i s study argues that these s e r v i c e s are l i n k e d by various q u a n t i t a t i v e and q u a l i t a t i v e f a c t o r s . As such, an a l l - i n c l u s i v e a n a l y s i s or v a l u a t i o n approach should be u t i l i z e d to determine compensation requirements (a t o t a l customer r e l a t i o n s h i p a n a l y s i s ) , rather than one which separates the customer into a number of s e r v i c e categories or areas with compensation requirements being determined f o r each s e r v i c e area s e p a r a t e l y (a s e r v i c e area a n a l y s i s ) . It is a l s o argued that an i n t e g r a l part of the a n a l y s i s process is p r o f i t computation over the t o t a l customer r e l a t i o n s h i p . Based upon a l i t e r a t u r e search, i t was determined that c e r t a i n United States banks u t i l i z e an a n a l y s i s procedure that computes p r o f i t over the t o t a l customer r e l a t i o n s h i p . T h e i r procedures ( p r o f i t a b i l i t y a n a l y s i s ) are o u t l i n e d and the strengths and weaknesses of the procedures are discussed. iv As only minimal published information was located on the a n a l y s i s procedures of Canadian banks, research took the form of personal interviews with s e n i o r o f f i c e r s of s i x banks. It was determined that the Canadian banks u t i l i z e separate s e r v i c e area analyses and that in no instance is customer p r o f i t a b i l i t y computed, e i t h e r by s e r v i c e area or over the t o t a l customer r e l a t i o n s h i p . Rather, the a n a l y s i s procedures focus a t t e n t i o n on the revenues received v i s - a - v i s the revenues that should have been c o l l e c t e d . While a s e r v i c e area approach is u t i l i z e d , s u b j e c t i v e v a l u a t i o n s of t o t a l customer r e l a t i o n s h i p p r o f i t a b i l i t y do occur, under c e r t a i n circumstances, which may decrease the compensation requirements for that s e r v i c e area by v i r t u e o f the value of the t o t a l customer , r e l a t i o n s h i p . Canadian bank a n a l y s i s procedures are e x t e n s i v e l y o u t l i n e d as, to the best of the w r i t e r ' s knowledge, t h i s is the f i r s t study and documentation of them outside of the Canadian banking system. The procedures are compared to those of the United States banks and the p o s s i b l e reasons f o r the d i f f e r e n c e s are discussed. Strengths and weaknesses of Canadian procedures are o u t l i n e d in. r e l a t i o n to those of the United States banks. The study concludes that the Canadian banks could b e n e f i t from adoption of a t o t a l customer r e l a t i o n s h i p approach to the a n a l y s i s o f t h e i r commercial customers. V TABLE OF CONTENTS CHAPTER Page 1. INTRODUCTION 1 1.1 The Customer R e l a t i o n s h i p in Banking 1 1.2 Customer V a l u a t i o n 1 1.3 Purpose of Thesis 2 1.4 A D e t a i l e d D e s c r i p t i o n of Thesis Format 2 1.5 Assumptions and Exclusions 3 1.5.1 Data Considerations 3 1.5.2 CostlAccounting and Data C o l l e c t i o n 4 1.5-3 Improvement to the P r o f i t a b i l i t y A n a l y s i s Model 4 I I . COMMERCIAL CUSTOMERS, BANK SERVICES, AND THE CONCEPT OF A CUSTOMER RELATIONSHIP 5 2.1 Commercial Customers 5 2.2 Bank Services Provided to Commercial Customers .... 7 2.2.1 Credit P r o v i s ion 7 2.2.1.1 Types of Loans 8 2.2.1.2 Loan Revenues 9 2.2.1.3 Loan Costs 10 2.2.2 The Demand Deposit Account 11 2.2.2.1 Demand Deposit Account Services ... 11 2.2.2.2 Demand Deposit Account Revenues ... 12 2.2.2.3 Demand Deposit Account Costs 13 2.2.3 Other F i n a n c i a l Services 14 2.2.3.1 Time Deposits 14 2.2.3.2 Foreign Exchange 15 2.2.3.3 Sp e c i a l Services 15 2.3 The Customer R e l a t i o n s h i p 16 2.3.1 An A n a l y s i s Approach for Commercial Customers 17 2.3.1.1 Interdependency of the Loan and Demand Deposit Account 17 2.3.1.2 Customer Convenience, Bank A t t i t u d e and S e r v i c e Q u a l i t y 18 2.3.1.3 Customer Negotiation Strategy and Customer Loss 20 2.4 The Form of A n a l y s i s 21 2.5 Hodgman's Customer R e l a t i o n s h i p Model 22 2.5.1 A Summary of the Hodgman Model 25 I I I . PROFITABILITY ANALYSIS: THE CUSTOMER RELATIONSHIP MODEL OF SELECTED UNITED STATES BANKS 27 3.1 P r o f i t a b i 1 i t y A n a l y s i s Model Objectives 28 3.2 P r o f i t a b i 1 i t y A n a l y s i s Model Development 28 v i CHAPTER Page 3.3 The P r o f i t a b i l i t y A n a l y s i s Model of the P h i l a d e l p h i a National Bank 30 3.3.1 Types of Customers 30 3.3.2 The Basic A n a l y s i s Process 31 3.3.2.1 Source and A p p l i c a t i o n of Funds ... 34 3.3.2.2 P r o f i t a b i 1 i t y A n a l y s i s Summary 36 3.3.3 The Non-Borrower and Net Depositor 37 3.3.3.1 The Non-Borrower 38 3.3.3.2 The Net Depositor 38 3.4 S i t u a t i o n a l Usage of the P r o f i t a b i l i t y A n a l y s i s Model 38 3.4.1 Present Customer Usage 39 3.4.2 P o t e n t i a l Customer Usage 40 3.5 Model Strengths and Weaknesses 40 3.5.1 Model Weaknesses 40 3.5.1.1 H i s t o r i c a l Data 41 3.5.1.2 C a p i t a l A l l o c a t i o n as an Approach to R i s k Adjustment 41 3.5.1.3 D u p l i c a t i o n of Income, Expense and C a p i t a l A l l o c a t i o n s 42 3.5.2 Model Strengths 43 3.5.2.1 Consistency and S u b s i d i z a t i o n 43 3.5.2.2 P r e p a r a t i o n f o r Negotiations 44 3.5.2.3 Overly P r o f i t a b l e Customers 46 3.5.2.4 S e l e c t i v e S e l l i n g and Performance Evaluations 47 3.6 Summary of Model Strengths and Weaknesses 47 3.7 Model Costs and Benefi t s 48 3.8 Conclusion 49 IV. THE COMMERCIAL ACCOUNT ANALYSIS PROCEDURES OF THE CANADIAN CHARTERED BANKS 50 4.1 Research Methodology 51 4.1.1 Questionnaire S t r u c t u r e 52 4.1.2 Interviewee Response 53 4.2 The A n a l y s i s Procedures of the Canadian Chartered Banks - General 54 4.3 The A n a l y s i s of the Demand Deposit Account .-. 55 4.3.1 Data Inclusions and the Data C o l l e c t i o n P e r i o d 56 4.3.2 A n a l y s i s Frequency 56 4.3.3 C r i t e r i a f o r S e l e c t i o n of the Demand Deposit Account f o r A n a l y s i s 56 4.3.4 The A n a l y s i s Procedure 58 4.3.4.1 Routine Services 58 4.3.4.2 Balances 62 4.3.4.3 A d d i t i o n a l S e r v i c e Charges or Balances Required 62 v i i CHAPTER Page 4.3.5 M o d i f i c a t i o n o f A n a l y s i s R e s u l t by Ot h e r S e r v i c e A r e a s o f t h e Customer R e l a t i o n s h i p 65 4.4 The C r e d i t A n a l y s i s 67 4.4.1 M o d i f i c a t i o n o f t h e C r e d i t Based I n t e r e s t R ate by Ot h e r S e r v i c e A r e a s o f t h e Customer R e l a t i o n s h i p 68 4.4.2 R i s k A d j u s t m e n t o f t h e I n t e r e s t Rate 69 4.5 O t h e r F i n a n c i a l S e r v i c e s 70 4.5.1 P r i c e M o d i f i c a t i o n s by Ot h e r S e r v i c e A r e a s o f t h e Customer R e l a t i o n s h i p 71 4.6 Trends and Views toward P r o f i t a b i l i t y A n a l y s i s .... 72 4.6.1 Bank I 73 4.6.2 Bank II 74 4.7 Summary ' 75 V. UNITED STATES AND CANADIAN BANKS 1COMMERCIAL ACCOUNT ANALYSIS PROCEDURES: A COMPARISON AND SUMMARY 77 5.1 P r o c e d u r a l D i f f e r e n c e s 77 5.1.1 P h i l o s o p h y 77 5.1.2 A n a l y s e s Conducted 78 5.1.3 A n a l y s e s R e s u l t s 78 5.1.4 S e r v i c e A r e a O v e r l a p s and N e g o t i a t i o n s w i t h Customers 80 5.2 Reasons f o r P r o c e d u r a l D i f f e r e n c e s 81 5.2.1 Compensating Loan B a l a n c e s 81 5.2.2 C o m p u t e r i z a t i o n 82 5.2.3 Banking System D i f f e r e n c e s and t h e C o m p e t i t i v e Environment 83 5.2.4 A New System 84 5.3 Canadian Bank P r o c e d u r e S t r e n g t h s and Weaknesses R e l a t i v e t o t h e P r o f i t a b i l i t y A n a l y s i s Model ... 84 5.3.1 P r o c e d u r e S t r e n g t h s 84 5.3.2 P r o c e d u r e Weaknesses 84 5.4 C o n c l u s i o n s and Recommendations f o r F u t u r e R e s e a r c h 86 SELECTED READINGS AND SOURCES 89 APPENDIX A - INTERVIEW QUESTIONNAIRE 92 LIST OF TABLES TABLE Page I I - l Hodgman's Customer R e l a t i o n s h i p Model 24 l l l - l P r o f i t a b i 1 i t y A n a l y s i s of A.B.C. Company Ltd 32 (Source and A p p l i c a t i o n of Funds) III — II P r o f i t a b i 1 i t y A n a l y s i s of A.B.C. Company Ltd 33 ( P r o f i t a b i 1 i t y A n a l y s i s Summary) IV-I A n a l y s i s of Demand Deposit Account 59 CHAPTER I INTRODUCTION 1.1 The Customer R e l a t i o n s h i p in Banking^ Banks o f f e r a wide range and v a r i e t y of s e r v i c e s to t h e i r 2 commercial customers . These s e r v i c e s may be categorized into three major s e r v i c e areas: (1) c r e d i t p r o v i s i o n - the lending of funds to c r e d i t worthy borrowers; (2) demand deposit (or current) account  management - p r o v i s i o n of the medium f o r the customer to meet a l l of hi s normal payment needs, and (3) what is defined as other f i n a n c i a l  s e r v i c e s - a l l other bank s e r v i c e s that may be u t i l i z e d by commercial customers. These three b a s i c d i v i s i o n s of bank s e r v i c e s o u t l i n e the elements of a customer r e l a t i o n s h i p in banking - the e n t i r e range of s e r v i c e s u t i l i z e d by any one i n d i v i d u a l commercial customer. 1.2 Customer V a l u a t i o n P e r i o d i c a l l y , banks enter into n e g o t i a t i o n s with t h e i r commercial customers. The purpose of these negotiations is determination of the compensation to be received by the bank for s e r v i c e s provided to the customer. A c r u c i a l problem is the approach to customer v a l u a t i o n that should be u t i l i z e d by the bank to determine compensation requirements and to negotiate these with the customer. S p e c i f i c a l l y , there are two, p o s s i b l e , a l t e r n a t i v e approaches: (1) the bank could value a l l s e r v i c e s 'See, for example: D.R. Hodgman, Commercial Bank Loan and  Investment P o l i c y , (Champaign, I l l i n o i s : U n i v e r s i t y of I l l i n o i s , 1963) Chapter 10. ^Those customers of a bank, whether c o r p o r a t i o n s , partnerships or s o l e - p r o p r i e t o r s h i p s , engaged in a business of a commercial or i n d u s t r i a l nature (see p.5). 2 provided to a commercial customer as a composite package - a customer relationship valuation. This implies the negotiation of compensation trade-offs between service areas within the customer relationship to reach an overall revenue goal, as the philosophy is not one of dis-crete services but of a package; (2) alternatively, each service area could be valued, and negotiated upon, separately. Of course, the final choice between these alternative approaches to customer valua-tion depends on whether the customers view themselves as utilizers of a package of bank services or as uti l i z e r s of three distinct and separate services. 1.3 Purpose of Thes is The purpose of this thesis is to determine, assess and com-pare the methods by which selected United States and Canadian banks analyse or value their commercial customers. Since selected United States banks have the more highly formalized model they will be treated f i r s t ; Canadian procedures will be discussed second. 1.k A Detailed Description of Thesis Format Chapter II presents and discusses background information necessary to an understanding of the study. The nature of a commercial customer is f i r s t outlined. This is followed by a description of the services performed by banks for them. Included is a discussion on the associated forms of revenues and costs which will enter the model that is subsequently generated. An argument for valuing a commercial customer under the composite package, or customer relationship approach is next presented. Lastly, the concept of a customer relationship is discussed in r e l a t i o n to the customer r e l a t i o n s h i p model of Hodgman . Chapter 111 traces the development of, and discusses the p r o f i t a b i l i t y a n a l y s i s model of s e l e c t e d United States banks, con-c l u d i n g w i t h a p r e s e n t a t i o n o f the strengths and weaknesses of the 2 model . Chapter IV then o u t l i n e s the commercial account a n a l y s i s procedures of s e l e c t e d Canadian banks. Chapter V compares the commercial account a n a l y s i s procedures of the s e l e c t e d United States and Canadian banks and comments on the reasons for the more s o p h i s t i c a t e d approach in the United S t a t e s . The strengths and weaknesses of Canadian procedures r e l a t i v e to the p r o f i t a b i l i t y a n a l y s i s model are then o u t l i n e d . L a s t l y , study conclusions are presented in conjunction w i t h suggestions f o r f u t u r e research. 1.5 Assumptions and Exclusions 1.5.1 Data Considerations Only bank data p e r t i n e n t to the a n a l y s i s of the customer r e l a t i o n s h i p is considered in t h i s study. That i s , the costs and revenues generated by customer usage of bank s e r v i c e s . Excluded, t h e r e f o r e , is the subject of c r e d i t a n a l y s i s , i . e . the a n a l y s i s of a customer's f i n a n c i a l statements as the basis to determining c r e d i t worthiness and the i n t e r e s t rate on the loan. However, to present a w e l l rounded view of a bank's dealings with i t s commercial customers 'Hodgman, Commercial Bank Loan and Investment P o l i c y . Chapter o Weaknesses are merely i d e n t i f i e d . See, Improvement to the P r o f i t a b i 1 i t y A n a l y s i s Model, p.4. k oand as knowledge of the c r e d i t a n a l y s i s is necessary background i n f o r -mation to the study, t h i s subject is accorded short d i s c u s s i o n . 1.5.2 Cost Accounting and Data C o l l e c t i o n It w i l l be apparent in subsequent d i s c u s s i o n that s o p h i s t i c a t e d cost accounting and data generation systems are r e q u i r e d . This aspect of commercial account a n a l y s i s is not discussed, as focus is on the concepts employed in the a n a l y s i s process i . e . a customer r e l a t i o n s h i p or s e r v i c e area approach, and the b e n e f i t s the procedures y i e l d to the bank, not on cost accounting or data generation techniques. 1.5.3 Improvement to the P r o f i t a b i l i t y A n a l y s i s Model The p r o f i t a b i l i t y a n a l y s i s model of s e l e c t e d United States banks, w h i l e a h i g h l y developed system r e l a t i v e to Canadian procedures, is not without i t s f a u l t s . As study focus is on the b e n e f i t s y i e l d e d by the model, not is shortcomings, no attempt is made to extend or improve model development. However, those areas of the model that warrant a t t e n t i o n are presented in the d i s c u s s i o n in Chapter IV and again in Conclusions and Suggestions f o r Future Research at the end of Chapter V. CHAPTER I I COMMERCIAL CUSTOMERS, BANK SERVICES AND THE CONCEPT OF A CUSTOMER RELATIONSHIP This chapter presents and discusses background information necessary to an understanding of the study. In a d d i t i o n to p r o v i d i n g a d e s c r i p t i o n of commercial customers and the s e r v i c e s performed by banks for them, i t introduces a major study theme - the concept of a  customer r e l a t i o n s h i p . The term commercial customer is f i r s t e xplained. Discussion then turns to i d e n t i f i c a t i o n o f bank s e r v i c e s u t i l i z e d by commercial customers. This includes i s o l a t i o n of the v a r i e d forms of associated revenues and costs which w i l l enter the model that is subsequently generated. However, no attempt i s made to discuss c o s t i n g procedures and p h i l o s o p h i e s , s i n c e such a discourse is not contained w i t h i n the scope of t h i s study. An argument f o r v a l u i n g a commercial customer under the composite package or customer r e l a t i o n s h i p approach is next presented. L a s t l y , the concept of a customer r e l a t i o n s h i p is discussed in conjunction w i t h Hodgman's customer r e l a t i o n s h i p model \ 2.1 Commercial Customers The term commercial customer r e f e r s to the customers of a Hodgman, Commercial Bank Loan and Investment P o l i c y , Chapter 6 bank, whether c o r p o r a t i o n s , p a r t n e r s h i p s or s o l e - p r o p r i e t o r s h i p s , engaged i n a b u s i n e s s o f a commercial o r i n d u s t r i a l n a t u r e . 11 i s w i d e l y d e f i n e d t o i n c l u d e b o t h p r i m a r y and s e c o n d a r y i n d u s t r y , c o n s t r u c t i o n c o n t r a c t o r s , u t i l i t i e s , w h o l e s a l e r s and r e t a i l e r s , and commercial a c t i v i t y i n g e n e r a l . I t does not i n c l u d e f a r m e r s and g r a i n d e a l e r s , i n v e s t m e n t d e a l e r s and s t o c k b r o k e r s , and a l l l e v e l s o f government'. The s p e c i f i c o r s p e c i a l i z e d form o f i n d u s t r y and commerce i s i r r e l e v a n t t o t h e g e n e r a l c o n c e p t . L i m i t e d a g g r e g a t e d a t a i s a v a i l a b l e on t h i s c l a s s o f bank customer i n both t h e U n i t e d S t a t e s and Canada and r e l a t e s o n l y t o loans i n Canada, and loans and demand d e p o s i t s i n t h e U n i t e d S t a t e s . Even w i t h l i m i t e d d a t a , however, t h e i r i mportance i s a p p a r e n t . For example, i n December 1971, loans t o commercial customers a c c o u n t e d f o r a p p r o x i m a t e l y 48 and 37 p e r c e n t o f t h e t o t a l l o a n p o r t f o l i o s o f 2 3 t h e Canadian and U n i t e d S t a t e s b a n k i n g systems-" r e s p e c t i v e l y , w h i l e demand d e p o s i t s o f commercial customers i n t h e U n i t e d S t a t e s a c c o u n t e d f o r a p p r o x i m a t e l y 45 p e r c e n t o f t h e t o t a l o f t h i s d e p o s i t c a t e g o r y ^ . For a c o m p l e t e l i s t i n g o f t h e v a r i o u s forms o f b u s i n e s s i n c l u d e d i n t h e d e f i n i t i o n , see: Bank o f Canada Review ( B u s i n e s s L o a n s ) , and F e d e r a l R e s e r v e B u l l e t i n , F i n a n c i a l and B u s i n e s s S t a t i s t i c s , (Commercial and I n d u s t r i a l L o a n s ) . 2 Bank o f Canada Review, May 1972, pp.S34 and S38. ^ F e d e r a l R e s e r v e B u l l e t i n , F i n a n c i a l and B u s i n e s s S t a t i s t i c s , F e b r u a r y 1972, pp.A26, A28 and A31. S b i d . , June 1971, p.466. 7 2.2 Bank Services Provided to Commercial Customers^ Bank s e r v i c e s provided to commercial customers may be segregated into three major areas: ( l ) c r e d i t p r o v i s ion - the lending of funds to c r e d i t worthy borrowers, (2) demand deposit (or current) account  management which provides the customer with a medium to meet a l l of his normal payment needs, and (3) what w i l l be defined as other  f i n a n c i a l s e r v i c e s - a l l other bank s e r v i c e s that may be u t i l i z e d by the customer e.g. time d e p o s i t s , f o r e i g n remittances and safekeeping of s e c u r i t i e s . Each o f these s e r v i c e areas are discussed in turn below. As p r e v i o u s l y mentioned, the costs and revenues a s s o c i a t e d w i t h each s e r v i c e area are i d e n t i f i e d , but no attempt is made to discuss c o s t i n g procedures or p h i l o s o p h i e s . 2.2.1 Cred i t P rov is ?on Banks make loans on the'basis of the c r e d i t worthiness of borrowers. This is determined, in p a r t , by the character of the borrower and h i s f i n a n c i a l c a p a c i t y to undertake and s e r v i c e the borrowings he has a p p l i e d f o r . The loan w i l l n a t u r a l l y vary in terms and in amounts according to the needs and circumstances of the p a r t i c u l a r borrower. Di s c u s s i o n throughout r e f e r s to both the United States and Canada unless otherwise noted, 'anad Primary Canadian sources were: J.A. G a l b r a i t h , Canadian Banking (Toronto, Ontario: The Ryerson Press, 1970) A.B. Jamieson, Chartered  Banking in Canada (Toronto, Ontario: The Ryerson Press, 1962). Information on the American banking system was p r i m a r i l y obtained from various p e r i o d i c p u b l i c a t i o n s e.g. The Journal of Commercial Bank Lending. 8 2.2.1.1 Types of Loans Two major types of loans are u t i l i z e d by commercial customers - the short-term operating or seasonal loan and the term loan. The operating loan is s e l f - 1 i q u i d a t i n g , in that the assets purchased w i t h the proceeds are expected to generate s u f f i c i e n t cash flows to repay the loan in less than one year, and is made under a 1ine of c r e d i t . T h i s ' l i n e ' i s a statement of w i l l i n g n e s s made by the bank to the customer, a f t e r review and a n a l y s i s of hi s request, to lend up t o a s p e c i f i e d maximum amount f o r s t i p u l a t e d purposes. Under normal circumstances the ' l i n e ' i s extended f o r a p e r i o d of one year and renegotiated annually t h e r e a f t e r . Int e r e s t rates on operating loans are set in r e l a t i o n t o , and vary with changes i n , the prime lending r a t e - the rate a p p l i e d to the best or l e a s t r i s k y loans of the bank. Higher r i s k loans incur a r i s k premium which is added to the prime r a t e , the s i z e of the premium being dependent upon the amount of perceived r i s k . In bank terminology, the loan is p r i c e d at 'prime p l u s ' . Term loans, or more p r e c i s e l y intermediate term loans, r e f e r to a c l a s s of loans made for periods in excess of one year and, normal-l y , less than s i x years. In con t r a s t to operating loans they are not s e l f-iKiqu idat ing as the funds are borrowed for c a p i t a l expenditure purposes and are repaid according to an ins t a l l m e n t schedule over the term of the loan; a l s o , they g e n e r a l l y a t t r a c t a higher i n t e r e s t r a t e than that on a short-term loan to the same borrower. The rate is set in one of two ways; e i t h e r a f i x e d r a t e e f f e c t i v e f o r the l i f e of the loan is e s t a b l i s h e d at the ou t s e t , or a v a r i a b l e r a t e i s set at 'prime 9 p l u s 1 subject to annual review, and adjusted in keeping w i t h changes in the pr ime r a t e . Term loans are u t i l i z e d to a s i g n i f i c a n t l y greater extent in the United States banking system than in Canada'. For the former, term loans accounted f o r 39 per cent of a l l business loans outstanding 2 in November 1971 , w h i l e f o r Canada the equivalent percentage, in •J December 1970, was approximately 13 per cent . 2.2.1.2 Loan Revenues In Canada, the i n t e r e s t rate a p p l i e d on the loan g e n e r a l l y represents the t o t a l e f f e c t i v e cost of the loan to the customer, or revenue to the bank. T h i s , however, is not the case in the United States where widespread use is made of compensating loan balance requirements, i . e . the customer may be quoted a contract rate of i n t e r e s t on a loan, or o f f e r e d the a l t e r n a t i v e of a lower contract rate but with the s t i p u l a t i o n he maintain a s p e c i f i e d l e v e l of balances. For example, a bank may agree to grant a loan f o r $20,000 at a 7 1/2% contract rate of i n t e r e s t . It may a l s o o f f e r the customer the a l t e r n a t i v e of a 6% contract rate but w i t h the s t i p u l a t i o n that $5,000 be maintained on The Canadian banks were r e s t r i c t e d to a 6 per cent i n t e r e s t rate c e i l i n g u n t i l 19&7- Due to t h i s low return they d i d not enter into term lending in any appreciable manner u n t i l a f t e r the c e i l i n g was l i f t e d . (Information obtained w h i l e i n t e r v i e w i n g bank o f f i c i a l s on the account a n a l y s i s methodology of Canadian chartered banks. See Chapter IV) . 2 This a p p l i e s only to the 'large commercial banks'. These banks, however, account for approximately 70 per cent of a l l loans to commercial customers. Federal Reserve B u l l e t i n , F i n a n c i a l and  Business S t a t i s t i c s , December 1971, p -A31 . ^This r e f e r s to term loans authorized in excess of $1 m i l l i o n o nly. Other data is not a v a i l a b l e . Factbook, Chartered Banks of Canada 1971, Canadian Bankers' A s s o c i a t i o n . d e p o s i t . In t h i s case, the customer would borrow $25,000 and leave $5,000 on deposit, which r a i s e s the e f f e c t i v e borrowing ra t e to 7 1/2%. S u b s i d i a r y forms of loan revenues, f o r both United States and Canadian banks, are stand-by and committment fees. In ne i t h e r country, however, does t h e i r usage appear to be frequent. A stand-by fee, f o r making a l i n e of c r e d i t a v a i l a b l e t o a borrower, is l e v i e d as compensation t o the bank f o r holding the funds a v a i l a b l e . Committ-ment fees, on the other hand, are sometimes c o l l e c t e d on term loans i f the t o t a l amount of the loan agreement is not u t i l i z e d at one time and a p r o t r a c t e d drawdown is involved. In both cases, and in both c o u n t r i e s , the charge is t y p i c a l l y one quarter to one h a l f of one per cent on the unused p o r t i o n of the c r e d i t . 2.2.1.3 Loan Costs In s e t t i n g i n t e r e s t rates on advances, banks must provide fo r coverage of a l l lending costs and provide a r i s k adjusted required rate of return on the investment of t h e i r shareholders from t h i s aspect of a bank's business. These costs are b r i e f l y o u t l i n e d below. F i r s t l y , and most importantly, there are the costs of the funds, i . e . the cost of gathering and s e r v i c i n g the deposit l i a b i l i t i e s that permit loans to be made (the f i n a n c i a l intermediation f u n c t i o n of banking). The t o t a l c o s t , in a d d i t i o n to the i n t e r e s t paid on time deposit accounts and the l i k e , includes s a l a r i e s of c l e r i c a l and management s t a f f , equipment r e n t a l s , and rent and d e p r e c i a t i o n on b u i l d i n g space associated w i t h deposit accounts. Secondly, there are the costs d i r e c t l y a s s o c i a t e d w i t h the lending f u n c t i o n eg. s a l a r y 11 costs incurred in determining c r e d i t worthiness, lending the funds, r e c e i v i n g c a p i t a l and i n t e r e s t repayments and, in general, s u p e r v i s i n g the advance. T h i r d l y , and l a s t l y , there are the costs of losses i n the o r d i n a r y course of business; for banking, d e f a u l t on c a p i t a l repayment of the loan. In t h i s regard, we saw on page 8 that banks attempt to make p r o v i s i o n for t h i s cost through a r i s k adjustment of the i n t e r e s t rate on s p e c i f i c advances'. 2.2.2 The Demand Deposit Account^ A demand deposit account is c a r r i e d by a l l forms of commercial customers and i t s primary r o l e in modern cash management is to carry on t r a n s a c t i o n s . It may a l s o serve, to a l i m i t e d extent, as a l i q u i d asset reserve. In both Canada and the United States the account is non-interest bearing. 2.2.2.1 Demand Deposit Account Services The most widely used and recognized s e r v i c e s of the demand deposit account are: ( l ) the chequing s e r v i c e , where the bank w i l l honour a l l cheques issued by the customer up to balance maintained in the account, and (2) the d e p o s i t i n g s e r v i c e , where the bank c o l l e c t s a l l funds owed to the customer on cheques and other items that he d e p o s i t s . However, depending upon the nature of a customer's business other s e r v i c e s may-reach s i g n i f i c a n t volumes e.g. in the case of customers with a branch o f f i c e system the bank may be c a l l e d upon to No attempt has been made to a s c e r t a i n i f the banks are r i s k averse or i f they are merely equating expected r e t u r n s . ^The demand deposit account of commercial customers in Canada is r e f e r r e d to as a Current Account. 12 transmit a large volume of fund t r a n s f e r s , or for a cash business customer, p r o v i s i o n and r e c e i p t of s i g n i f i c a n t volumes of coin and currency. These s e r v i c e s , and others of a minor nature such as 1 ? cheque c e r t i f i c a t i o n and issuance of stop payments , w i l l subsequently be r e f e r r e d to as Routine Services and are c l a s s i f i e d as being p r o p e r l y part of demand deposit s e r v i c e s as d i s t i n g u i s h e d from Other F i n a n c i a l Services (the t h i r d category of commercial customer s e r v i c e s - see page \k). 2.2.2.2 Demand Deposit Account Revenues The bank c o l l e c t s revenues for p r o v i s i o n of the demand deposit account and rout i n e s e r v i c e s to the customer in two ways: ( l ) i n d i r e c t l y , by the investment of funds held on deposit in the loans and investments of the bank - the f i n a n c i a l intermediation f u n c t i o n of banking discussed, in p a r t , in the C r e d i t P r o v i s i o n s e c t i o n (see page 10), (2) the levying of charges, on a per item b a s i s , f o r rou t i n e s e r v i c e s u t i l i z e d by the customer. (In Canada, c u r r e n t l y 20 cents per cheque issued and deposit made.) These rout i n e s e r v i c e revenues may be c o l l e c t e d d i r e c t l y by the bank by means of a monthly charge to the customer's account, or the customer may be o f f e r e d the a 1t e r n a t i v e of maintaining funds on deposit which y i e l d the equivalent of s e r v i c e charges due. (This balance requirement is d i s t i n c t from the compensating balance s t i p u l a t i o n that is employed in c r e d i t p r o v i s i o n - see page 9.) Where the bank guarantees payment of a cheque issued by a customer. 2 Where the customer issues a d i r e c t i v e , to the bank, not to pay a p a r t i c u l a r cheque that he has issued. 2.2.2.3 Demand Deposit Account Costs Banks incur three forms of costs in the operation of a demand deposit account. The f i r s t and most obvious of these is the p h y s i c a l cost of p r o v i d i n g r o u t i n e s e r v i c e s to the customer e.g. processing deposits and c o l l e c t i n g cheques. The other two, however, cash reserves and f l o a t , are associated w i t h the l e v e l of funds held on deposit and take the form of opportunity - v i s - a - v i s out of pocket - c o s t s , as they r e s u l t in a reduction of the funds in the account that the bank can use f o r investment purposes. Secti o n 72 of the Bank Act s t i p u l a t e s that a l l banks in Canada must maintain cash reserves amounting t o 12 per cent of t h e i r Canadian d o l l a r demand deposits in e i t h e r Bank of Canada notes or balances w i t h the Bank of Canada^. Both of these assets are n o n - y i e l d i n g and, t h e r e f o r e , reduce the amount of demand deposit balances that the banks have a v a i l a b l e for investment in earning assets by 12 per cent. 2 S i m i l a r p r o v i s i o n s apply to the United States banks . F l o a t a r i s e s when banks give immediate c r e d i t to customers for cheques and other items deposited to t h e i r demand deposit accounts. ^An Act Respecting Banks and Banking (Ottawa, Ontario: Q.ueen's P r i n t e r , 1967). 2 Cash reserve requirements for United States banks can be considerably more complicated than the simple a p p l i c a t i o n o f f l 2 per cent depending, among other t h i n g s , upon the l e v e l of deposits of a p a r t i c u l a r bank and whether or not i t is a member of the Federal Reserve System. For a concise explanation of cash reserve requirements in the United States see: The Federal Reserve System: Purposes and Functions, (Board of Governors of the Federal Reserve System, 1963). 3 e.g. d r a f t s and money orde r s . The bank, however, then has to col 1ect these deposited funds from the cheque issuers. If the collection period is one day or more, the volume of funds to be collected - float - must be deducted from the customer's account balance to give the actual figure the bank has available for investment purposes. 2.2.3 Other Financial Services The remaining services that may be utilized by commercial customers are briefly discussed below. These are: time deposits, foreign exchange, and special services. 2.2.3.1 Time Deposits This form of deposit, unlike the demand deposit, is not subject to chequing, is interest bearing, and is issued for a fixed term; the term depending upon the amount of funds the customer wishes to invest and his desire as regards term. In addition, time deposits are usually redeemable, normally at a penalty rate, but are non-transferable and non-negotiable. The bank derives revenue from investment of the deposit funds in the loans and investments.of the bank (financial intermediation) with the great majority of costs being incurred through interest payment to the customer. Also, as was the case with demand deposits, cash reserves must be maintained. In Canada this is k% of the amount of the deposits outstanding. Similar provisions apply to United States banks' . As with demand deposits, the cash reserve requirement varies with the level of deposits held and whether the bank is a Federal Reserve member. See footnote 2 page 13. 15 2.2.3.2 Foreign Exchange As was the case with domestic currency, banks o f f e r loans, time deposits and demand deposits in fo r e i g n c u r r e n c i e s . In terms of revenues and costs these f o r e i g n currency deposits and loans req u i r e no a d d i t i o n a l d i s c u s s i o n to what has already been presented f o r domestic deposits and loans . In a d d i t i o n to the above, banks provide the important f u n c t i o n of f i n a n c i n g i n t e r n a t i o n a l trade through the issuance of commercial  l e t t e r s of c r e d i t . For t h i s s e r v i c e a commission is c o l l e c t e d , u s u a l l y on a s l i d i n g percentage s c a l e depending upon the s i z e of the c r e d i t . A l s o , payment instruments in fo r e i g n currencies are a v a i l a b l e to customers, e.g. d r a f t s and money orders. For these s e r v i c e s banks c o l l e c t a s t r a i g h t fee per instrument s o l d in a d d i t i o n to making a small commisssion on the d i f f e r e n c e between the buying and s e l l i n g rates on the fo r e i g n currency. 2.2.3.3 S p e c i a l Services Apart from the p r i n c i p a l s e r v i c e s provided to customers in the way of deposit accounts and the granting of loans, banks a l s o provide a v a r i e t y of s p e c i a l s e r v i c e s some of which are set out below. For such s e r v i c e s the banks u s u a l l y c o l l e c t some form of commission, fee or r e n t a l . These s e r v i c e s are: ( l ) issuance of domestic payment instruments such as d r a f t s and money orders, (2) c o l l e c t i o n of matured bonds and coupons, (3) safekeeping of s e c u r i t i e s and/or p r o v i s i o n of s a f e t y deposit box f a c i l i t i e s , (k) buying and s e l l i n g of stocks and bonds, (5) night In contrast to Canadian d o l l a r deposits there are no lega l cash reserve requirements against f o r e i g n currency l i a b i l i t i e s . Banks, t h e r e f o r e , u t i l i z e t h e i r own judgement in t h i s matter. This i s a l s o t r u e f o r United States banks. S t a r r s , Catherine J . , A Guide to the Bank of Canada's Weekly F i n a n c i a l S t a t i s t i c s , The Canadian Banker, September-October 1968. 16 depository f a c i l i t y , and (6) p a y r o l l p l a n s , whereby the customer gives the bank one cheque to cover the complete p a y r o l l , together wit h a l i s t of employees, and the bank d i s t r i b u t e s the funds. 2.3 The Customer R e l a t i o n s h i p As can be imagined, not a l l customers are eq u a l l y p r o f i t a b l e as each customer u t i l i z e s a d i f f e r e n t package of bank s e r v i c e s , thereby c o n t r i b u t i n g in varying ways and amounts to bank revenues and co s t s . The bank is u s u a l l y in a p o s i t i o n to negotiate, w i t h i n l i m i t s , the con-f i g u r a t i o n of the composite package by varying the methods in which i t can c o l l e c t revenues e.g. compensating loan balances for an i n t e r e s t rate reduction, and equivalent value demand balances in l i e u of s e r v i c e charges for r o u t i n e s e r v i c e s . The varying l e v e l s of customer p r o f i t a b i l i t y and the varying methods by which the bank can negotiate and c o l l e c t revenues r a i s e s the f o l l o w i n g c o n s i d e r a t i o n relevant to a banker entering into p r i c e n e g o t i a t i o n s . What is the proper approach toward v a l u a t i o n of a commercial  customer? i . e . should each s e r v i c e area be considered independently of the others or should a composite p i c t u r e be taken? The composite p i c t u r e p e r t a i n s to the concept of a customer r e l a t i o n s h i p in banking and the f o l l o w i n g d i s c u s s i o n of An A n a l y s i s Approach for Commercial Customers forms the b a s i s , or theme, for the remainder of t h i s study. In p a r t i c u l a r , i t serves as an i n t r o d u c t i o n to subsequent d i s c u s s i o n on Hodgman's customer r e l a t i o n s h i p model^ and to the expansion of t h i s model in Chapter I I I . Hodgman, Commercial Bank Loan and Investment P o l i c y , Chapter 10. 2.3.1 An Analysis Approach for Commercial Customers Banks should analyse their commercial customers on the basis  of the customers' total business with the bank (the total customer  relationship) and not on a separate service area basis. Moreover,  the analysis should provide a composite profit picture of the  customer as its end result. Banking services provided to commercial customers are not totally separated services; rather, they are linked in varying ways: (1) interdependency of the loan and demand deposit account, (2) customer convenience, bank attitude, and service quality, and (3) customer negotiation strategy and customer loss. These factors, which are discussed below, dictate the performance of a total customer relationship analysis rather than separate service area analyses. 2.3.1.1 Interdependency of the Loan and Demand Deposit Account It has already been discussed that loan terms may be negotiated with the requirement of compensating demand deposit account balances'. In such a situation, the demand deposit account and loan are inseparable. However, whether or not compensating loan balances are part of loan terms, the demand deposit account and the loan are strongly linked, as the former is the medium through which the customer receives loan proceeds, spends these proceeds and deposits funds generated by the loan (routine services), and meets his periodic See page 9. 18 c a p i t a l and i n t e r e s t repayments. Thus, the loan and demand deposit account should be viewed as one integrated banking s e r v i c e and analysed as such, rather than as two separate s e r v i c e s . 2.3.1.2 Customer Convenience, Bank A t t i t u d e and Se r v i c e d u a l i t y An i m p l i c i t assumption in the above d i s c u s s i o n , and one that is maintained throughout t h i s study, is that the customer w i l l maintain h i s demand deposit account at the bank where he borrows. In f a c t , i t is assumed that the commercial customer w i l l deal with only one bank f o r a l l o f h i s banking needs. It i s c l e a r l y t r u e that the customer w i l l maintain h i s loan and demand deposit account at the same bank in the s i t u a t i o n of compensating loan balances and h i g h l y probable even i f there are no compensating balance s t i p u l a t i o n s , as the demand deposit account is the medium through which loan proceeds are spent and r e p a i d . (See above d i s c u s s i o n . ) However, i f there is not a strong i n c e n t i v e f o r a customer to deal in t o t a l at one bank, a package a n a l y s i s is not warranted and each s e r v i c e area would most l i k e l y be se p a r a t e l y analysed. In t h i s instance, a customer would u t i l i z e a p a r t i c u l a r bank s e r v i c e o nly i f i t was c o m p e t i t i v e l y p r i c e d . Three f a c t o r s d i c t a t e that customers w i l l normally conduct a l l of t h e i r banking needs at one bank. These are: customer convenience, bank a t t i t u d e , and s e r v i c e q u a l i t y . It is more convenient f o r the customer to s a t i s f y a l l of hi s banking needs at one l o c a t i o n rather than at s e v e r a l . An analogy is the r e l a t i v e convenience aff o r d e d a consumer purchasing a l l of his food s u p p l i e s and sundry housing needs at the l o c a l supermarket, rather than at the butcher, hardware s t o r e , baker, t o b a c c o n i s t , et c e t e r a . It is a l s o more convenient f o r the customer from an accounting standpoint, as was i n f e r r e d before, in that the bank can e f f i c i e n t l y t r a n s a c t the customer's t o t a l banking needs and at the same time save him time and money^. A customer maintaining his business at a number of banks is a l s o l i a b l e to detract from the bank's a t t i t u d e toward him, which may a f f e c t any requests he may have to make of the bank e.g. a p p l i c a t i o n f o r increased borrowing f a c i l i t i e s . Indeed, in the case of a p o t e n t i a l customer applying f or a loan i t is u s u a l l y a requirement of r e c e i v i n g the loan that the t o t a l business be obtained from the customer's present bankers . Viewing t h i s from the opposite viewpoint, a customer who maintains h i s t o t a l business at one bank is more l i k e l y to f i n d his banker accomodating and responsive to his needs than the customer e.g. Upon one d i r e c t i v e , and at no cost, the bank w i l l make p e r i o d i c loan and i n t e r e s t payments f o r the customer, and debit his account for other r e c u r r i n g items e.g. s p e c i a l s e r v i c e fees (see page 15). The a l t e r n a t i v e is f o r the customer to conduct his own accounting system which w i l l involve him in expenditure of time and money e.g. i f the demand deposit account is held at a bank other than the lending bank, the customer would have to take a bank cheque for the loan proceeds and deposit i t at the bank which holds ,his demand deposit account ( f o r which he w i l l be charged). He would a l s o have to make the loan repayments himself, or i n s t r u c t the bank of deposit to do so, for which s e r v i c e he would be charged a fee. 2 Information obtained w h i l e i n t e r v i e w i n g bank o f f i c i a l s on the account a n a l y s i s methodology of Canadian chartered banks. See Chapter IV. 2 0 who does not . In p a r t i c u l a r , by doing so, the banker obtains an intimate knowledge of the customer and his business , which is a factor o f extreme importance in negot ia t ing loan terms (not neces sa r i ly the interes t r a t e ) ' . 2 . 3 . 1 . 3 Customer Negotiat ion Strategy and Customer Loss It has been argued above that there are strong incentives for customers to transact t h e i r t o t a l business at one bank and that bank services are l inked in varying degrees by quant i t a t ive and q u a l i t a t i v e f a c t o r s . As such, i t is a reasonable expectation that negot iat ions on any one serv ice area, based upon an analys i s of that se rv ice area alone ( e . g . rout ine serv ice pr ices based upon an ana lys i s of the demand deposit account o n l y ) , may be countered by customer pressure to consider aspects of the r e l a t i o n s h i p other than that being negotiated upon. Such a p o t e n t i a l s i t u a t i o n warrants that the banker must consider not j u s t the ind iv idua l s e rv ice area in his negot iat ions with the customer, but the t o t a l r e l a t i o n s h i p . Th i s is perhaps best i l l u s t r a t e d by the s i t u a t i o n of the bank refusing to consider aspects o f the r e l a t i o n s h i p other than that being negotiated upon. Such refusal might lead the customer to approach See, for example, Hodgman, Commercial Bank Loan and Investment  Pol i cy , p.97. Hodgman's interviews revealed that important c r i t e r i a in assessing the d e s i r a b i l i t y of meeting a loan request from a p a r t i c u l a r customer included: his deposit record, the existence or prospect of a long term customer r e l a t i o n s h i p , and the existence of various other f i n a n c i a l s e r v i c e s . another bank and the l o s s , f o l l o w i n g from previous argument, would not be that one s e r v i c e but the e n t i r e r e l a t i o n s h i p . 2.k The Form of A n a l y s i s Having argued that the a n a l y s i s of commercial customers should be on a t o t a l r e l a t i o n s h i p b a s i s , the a c t u a l form of a n a l y s i s procedures is the f i n a l question t o be answered. It is the opinion of the w r i t e r that the only manner in which commercial customers should be analysed must be that which provides the banks with knowledg of the t o t a l p r o f i t or loss being generated by any p a r t i c u l a r customer T h i s p a r t i c u l a r viewpoint is held as there are three b a s i c questions that a bank must have answers t o , i f i t is to deal w i t h the customer in an o b j e c t i v e and r a t i o n a l manner. 1. Is the r e l a t i o n s h i p p r o f i t a b l e or is i t c o s t i n g the bank money? 2. What is the l e v e l of the r e l a t i o n s h i p ' s p r o f i t c o n t r i b u t i o n or loss? 3. What l e v e l of p r o f i t is deemed acceptable f o r the r e l a t i o n -ship? Given the answers to these questions, the bank is in a p o s i t i o n t o formulate an o b j e c t i v e , f l e x i b l e , p r i c i n g and n e g o t i a t i o n s t r a t e g y f o r the customer; a t o p i c which is expanded upon in the f o l l o w i n g pages, a f t e r d i s c u s s i o n of Hodgman's customer r e l a t i o n s h i p model \ and again in a more d e t a i l e d manner ?n Chapter I I I . Ibid,, Chapter 10. 22 2.5 Hodgman's Customer R e l a t i o n s h i p Model To the best of the w r i t e r ' s knowledge, the f i r s t p ublished reference to a customer r e l a t i o n s h i p was made by Hodgman in 1963. He defined i t as f o l l o w s : "The customer r e l a t i o n s h i p into which a bank enters w i t h a t y p i c a l demand deposit holder, e s p e c i a l l y a business f i r m , has many aspects. Foremost among these are: ( l ) the deposit i t s e l f w i t h attendent costs and b e n e f i t s to the bank, (2) an implied and often e x p l i c i t o b l i g a t i o n by the bank to make loans to the customer on terms and in amounts which vary w i t h p a r t i c u l a r circumstances, and (3) the p r o v i s i o n by the bank of various other f i n a n c i a l s e r v i c e s ." This d e f i n i t i o n does not include the e n t i r e range of bank s e r v i c e s that might be u t i l i z e d by a customer, as discussed on pages 7 to 16, but r e s t r i c t s a t t e n t i o n to the foremost elements of a r e l a t i o n s h i p . T h i s i s not to say that Hodgman overlooked c e r t a i n aspects of a r e l a t i o n s h i p that might e x i s t i . e . time deposits and f o r e i g n currency loans and d e p o s i t s . Rather, the d e f i n i t i o n excluded such items f o r purposes of s i m p l i c i t y in the c o n s t r u c t i o n of h i s customer r e l a t i o n s h i p model. For the purposes o f t h i s study, the term customer r e l a t i o n s h i p r e f e r s to the e n t i r e range of bank  s e r v i c e s u t i l i z e d by any one i n d i v i d u a l customer. The model, which is presented in Table I i - l , was constructed under very s i m p l i f y i n g assumptions; however, the conclusions reached make worthwhile c o n t r i b u t i o n s to t h i s study and provide a strong foundation f o r the p r e s e n t a t i o n and d i s c u s s i o n of the p r o f i t a b i 1 i t y  a n a l y s i s models of s e l e c t e d United States banks in Chapter I I I . Under Hodgman's assumptions, the customer analysis takes place under static certainty: (l) the bank is in f u l l and certain possession of the relevant information required to assess the balance of costs and benefits associated with a particular customer account, and (2) present and future are identical. The end result of the model is the derivation of the net revenue obtained from the ith customer, Pi (see definitions Table I l - l ) . Hodgman's basic conclusion was that banks will have a strong incentive to compete among themselves for customers showing a rate of return per loan dollar invested, i.e. Pi/|_ij> L U denoting the jth size loan to the ith customer, in excess of the market interest rate r available on loans to non-depositors or on open market securities. The channels for inter-bank competition, according to Hodgman, rest in those variables of the net earnings equation that banks have some degree of discretion or control over and include: the contract rate of interest eij pertaining to the jth size loan to the ith customer, and the charges made for routine and special services S i ( d i ) . For example, a bank may compete with any or a l l of the following: reduction of the contract rate of interest; provision of additional routine and special services at zero or reduced cost, and elimination or reduction of charges on routine and special services presently provided. Hodgman is implicity saying, therefore, that banks have prices pertaining to each service they offer, but in competitive situations for high return customers these prices can be utilized as negotiation variables to obtain or retain a customer Ik TABLE I I-I HODGMAN'S CUSTOMER RELATIONSHIP MODEL P i = rd | (1-R) + c i j L i j + | s i(di) - Fi(di)] - p d i , where P i = net earnings on the customer r e l a t i o n s h i p . d i = demand deposit on the i th customer, net of loan proceeds. R = lega l cash reserves on demand d e p o s i t s . ( l - R ) = p r o p o r t i o n of demand deposits which can be used to acquire earn ing assets 1. r = market rate of i n t e r e s t on loans and investments which do not involve a deposit r e l a t i o n s h i p . This rate is net of loan and investment costs and is r i s k a djusted. L i j = j t h s i z e loan to the i th customer. c i j = contract r a t e of i n t e r e s t charged on the j th s i z e loan to the i t h customer, net of a l l loan c o s t s ^ . S i ( d i ) = charges to the customer f o r s e r v i c e s , r o u t i n e and s p e c i a l 3 , under the assumption that these are equal to some f u n c t i o n of balance s i z e . F i ( d i ) = cost to the bank f o r s e r v i c e s , r o u t i n e and s p e c i a l 3 , again under the assumption that t h i s is equal to some f u n c t i o n of balance s i z e . p" = rate of i n t e r e s t on demand d e p o s i t s ^ . i = s u b s c r i p t denoting the i th customer. j = s u b s c r i p t denoting the s i z e of the loan to the i th customer, ^Hodgman makes no p r o v i s i o n f o r " f l o a t " , t h e r e f o r e the i n v e s t i b l e balance d i ( l - R ) is o v e r s t a t e d . (See page 13). ^Hodgman s t a t e s " — net of costs of loan a d m i n i s t r a t i o n " . It i s assumed he means a l l c o s t s , i n c l u d i n g the cost of funds. ^See pages 12 and 15 where these terms are explained. ^Subsequently dropped from c o n s i d e r a t i o n as demand deposits a r e n o n - i n t e r e s t b e a r i n g . and, hence, to maximize bank profits per loan dollar invested. That is, failure to obtain or retain a high profit customer by not offering price concessions can lead to a decline in bank profits. Hodgman's approach and conclusions, however, need not be restricted to identification of, and negotiations with, high profit customers, as these can be expanded to include a l l commercial customers e.g. identification of low profit customers with negotiations being directed to attainment of an acceptable or normal profit level'. The expansion of Hodgman's model to a formal, workable technique along these lines will be fully taken up in Chapter Mi - The Customer Relationship Model of Selected United States Banks. To conclude the present chapter, Hodgman's approach to commercial account analysis, together with its strengths and weaknesses, is summarized below. 2.5.1 A Summary of the Hodgman Model Hodgman agrees with the total valuation approach to commercial account analysis - a customer relationship analysis -wiiifch' prices for each service, e.g. the loan rate, not necessarily being independently set, but intimately related to the value of the total relationship to the bank. This provides the bank with the following benefits:-1. Knowledge of the total profit or loss level on any commercial customer. See page 26, where the weaknesses of the Hodgman model are discussed. 2. Knowledge of why the account is in a particular profit or loss situation e.g. in the case of a low profit account the reason might be: a loan paying too low a rate; a troublesome loan which involves a greater than normal expenditure of management time and effort; special services for which the bank is not being adequately compensated, or some combination of these and other factors . 3. Knowledge of the profit or loss, plus the reasons for the situation, provides the bank with the data to formulate an appropriate, flexible, negotiation strategy e.g. for the low profit account discussed in 2 above this might be: an increased loan rate; additional demand or time balances; increased special service fees, or some combination of these to move the account to an "acceptable" profit level. The approach also has some weaknesses:-1. What is a 'high' or 'low1 profit customer? This must be identified relative to an "acceptable or normal" profit level - a profit level that covers all costs including a return on equity capital. Hodgman's model does not cover this important point. 2. The model was constructed under a very simplifying assumption - static certainty. Can the dynamics of the customer relationship be captured? 3. Lastly, and most importantly, can the model be operationalized? And, if it can, what are the costs of operationalization vis-a-vis benefits? i.e. the model is only of use if the costs of its introduction and usage are exceeded by the returns and benefits it generates . It is obvious that the Hodgman approach to commercial account analysis could be applied to al1 commercial customers. It is just as obvious that the technique would afford no net benefit to the bank for "small" commercial customers e.g. the corner grocery store. Concern will therefore reside with'"larger" commercial customers, where the opportunity may exist for the bank to receive a net benefit. CHAPTER I I I PROFITABILITY ANALYSIS THE CUSTOMER RELATIONSHIP MODEL OF SELECTED UNITED STATES BANKS Chapter II introduced the concept of a customer r e l a t i o n s h i p . This was i l l u s t r a t e d by means of the Hodgman model and a b r i e f d i s c u s s i o n presented the strengths and weaknesses of that model. The most ser i o u s weaknesses were the s t a t i c c e r t a i n t y assumption and the underlying question of whether or not the model could be operationa1ized. The purpose of t h i s chapter is to t r a c e the development of the customer r e l a t i o n s h i p a n a l y s i s of Hodgman into the o p e r a t i o n a l p r o f i t a b i l i t y a n a l y s i s model of s e l e c t e d United States banks. These banks, to the best of the w r i t e r ' s knowledge, were the innovators of t h i s approach to commercial account a n a l y s i s . The chapter commences with a statement of model o b j e c t i v e s . A b r i e f d i s c u s s i o n is then presented on the growing importance of t h i s approach to commercial account a n a l y s i s in United States banking. Basic model s t r u c t u r e is next o u t l i n e d . This includes an i l l u s t r a t i o n of the model's f i n a l output, as u t i l i z e d by account managers' in determining p r i c i n g and n e g o t i a t i o n s t r a t e g i e s . The chapter concludes with a d i s c u s s i o n on the strengths and weaknesses of the model. No attempt is made, however, to extend or improve model development The bank o f f i c e r who has r e s p o n s i b i l i t y for the e n t i r e r e l a t i o n s h i p i . e . a d m i n i s t r a t i o n , p r i c e s e t t i n g , and n e g o t i a t i o n s . inasmuch as t h i s would be out of the scope of the study . It w i l l be apparent in subsequent d i s c u s s i o n that a s o p h i s t i c a t e d cost accounting and data generation system is necessary t o provide the inputs and c a l c u l a t i o n s as required by the model. This aspect of p r o f i t a b i l i t y a n a l y s i s is not discussed as focus is on the model and the b e n e f i t s i t y i e l d s to the bank, not on the generation of inputs. 3 .1 P r o f i t a b i 1 i t y A n a l y s i s Model Objectives The p r o f i t a b i l i t y a n a l y s i s model has two bas i c o b j e c t i v e s : (1) measurement of the p r o f i t ( l o s s ) earned by the bank over the e n t i r e r e l a t i o n s h i p w i t h a commercial customer for some h i s t o r i c a 1 time p e r i o d , (e.g. three or s i x months), and (2) determination of 2 the p r o f i t that should be earned on the r e l a t i o n s h i p . This w i l l subsequently be r e f e r r e d to as the p r o f i t g o a l . The model then r e l a t e s r e l a t i o n s h i p p r o f i t to the p r o f i t g o a l , from which appropriate n e g o t i a t i o n and p r i c i n g s t r a t e g i e s are formulated. 3.2 P r o f i t a b i l i t y A n a l y s i s Model Development The p r o f i t a b i l i t y a n a l y s i s approach to the a n a l y s i s of commercial customers, which commenced with Hodgman's t h e o r e t i c a l customer 'Model weaknesses are, however, accorded a short d i s c u s s i o n and are f u r t h e r i d e n t i f i e d as p o s s i b l e t o p i c s f or future research in Chapter V. ^ h ereby meeting a c r i t i c i s m of the Hodgman model - the need f o r an acceptable or normal p r o f i t l e v e l . r e l a t i o n s h i p in 1963, appears to have received wide r e c o g n i t i o n and gained a strong f o o t h o l d in United States banking. To the best of the w r i t e r ' s knowledge, the f i r s t o p e r a t i o n a l p r o f i t a b i l i t y a n a l y s i s model was introduced by the P h i l a d e l p h i a National Bank (P.N.B.) in I 9 6 5 ' . This apparently represented the f i r s t formalized attempt by a bank to determine the p r o f i t ( l o s s ) earned on a t o t a l customer r e l a t i o n s h i p . Previous methods apparently never completely integrated returns and costs in separate s e r v i c e areas and, t h e r e f o r e , d i d not y i e l d a t o t a l p r o f i t p i c t u r e as the f i n a l a n a l y s i s r e s u l t : "The p r o f i t a b i l i t y a n a l y s i s system ... is a new method [[for a n a l y s i n g commercial customers]]. T r a d i t i o n a l systems of analyses are concerned p r i m a r i l y with the deposit r e l a t i o n s h i p ... A l s o , these systems sometimes use p r i c e s for s e r v i c e s which vary from a c t u a l c o s t . " ^ Since the P.N.B.'s i n t r o d u c t i o n of the p r o f i t a b i l i t y a n a l y s i s model in 1965, i t would appear that the worth of t h i s approach to commercial account a n a l y s i s has been w e l l recognized by the banking commun i t y : "In the w r i t e r ' s o p i n i o n , there are p o s s i b l y f i f t y banks in the country £United S t a t e s J which are now using or working on p r o f i t a b i l i t y a n a l y s i s and p o s s i b l y the same number s e r i o u s l y c o n s i d e r i n g the technique."^ Vhe P h i l a d e l p h i a National Bank, P r o f i t a b i l i t y A n a l y s i s of Commercial Customers (unpublished manuscript, J u l y 1965). I b i d . , Page 5. This quote depicts the current s i t u a t i o n of commercial account a n a l y s i s in Canada. See Chapter IV. •3 John F. Falkenberg " P r o f i t a b i l i t y A n a l y s i s : A Marketing Tool - Part 1", The Journal of Commercial Bank Lending. February 1970, page 7. In p a r t i c u l a r , the P.N.B. p r o f i t a b i l i t y a n a l y s i s procedures were followed by the F i r s t National C i t y Bank and the S e a t t l e F i r s t N a tional Bank in 1967 1. While the methodology and procedures o f a l l banks u t i l i z i n g the p r o f i t a b i l i t y a n a l y s i s model are broadly s i m i l a r , the P.N.B. system is described in t h i s chapter inasmuch as more d e t a i l e d information is a v a i l a b l e on i t s c o n f i g u r a t i o n . 3.3 The P r o f i t a b i l i t y A n a l y s i s Model  of the P h i l a d e l p h i a National Bank 3.3.1 Types of Customers In the context of loan and deposit balances, there are three basic types of commercial customers: ( l ) the non-borrower - a pure deposit r e l a t i o n s h i p ; (2) the net borrower - a borrowing customer whose loan balance exceeds that of hi s deposit balance, and (3) the net depositor - a borrowing customer whose deposit balance exceeds that of h i s loan balance. As the focus and major use of the p r o f i t a b i l i t y a n a l y s i s model is on the borrowing customer, the f o l l o w i n g d i s c u s s i o n assumes a net borrower throughout. Procedural m o d i f i c a t i o n s f o r the non-borrower and net depositor are s m a l l . These are o u t l i n e d at the conclusion of d i s c u s s i o n on the net borrower. Frank R. Dyer J r . and John W. Heil s h o r n " P r o f i t A n a l y s i s for Loans: A Panel D i s c u s s i o n " , The Journal of Commercial Bank Lending, November 19^7, pp.40-52. Richard C. MacDonald, "A Do-It-Yourself Formula f o r Loan P r o f i t a b i l i t y A n a l y s i s " , The Journal of Commercial  Bank Lending, June 19&7, pp.20-27. 31 3.3.2 The B a s i c A n a l y s i s P r o c e s s The p r o f i t a b i l i t y a n a l y s i s p r o c e s s i s s e p a r a t e d i n t o two s t e p s : (1) a s o u r c e and a p p l i c a t i o n o f f u n d s , and (2) a p r o f i t ( l o s s ) c a l c u l a t i o n . The s o u r c e and a p p l i c a t i o n o f funds d e t e r m i n e s t h e s o u r c e s o f f i n a n c i n g f o r t h e customer's loa n - t h e customer's own net d e p o s i t b a l a n c e s ^ , p o o l f u n d s ^ , and bank e q u i t y c a p i t a l - and t h e r e f o r e t h e raw d a t a f o r c o m p u t a t i o n o f t h e c o s t o f f u n d s ; a needed i n p u t t o t h e second s t e p . P r o f i t o r l o s s i s next c a l c u l a t e d - t h e revenues and expenses a s s o c i a t e d w i t h t h e e n t i r e r e l a t i o n s h i p , i n c l u d i n g t h e c o s t o f funds r e q u i r e d f o r l o a n f i n a n c e . The c o s t o f bank e q u i t y c a p i t a l i s t h e p r o f i t g o a l f o r t h e a c c o u n t . (See page 37.) The f o l l o w i n g i l l u s t r a t i v e a n a l y s i s , w h i c h w i l l be used t h r o u g h o u t , d e s c r i b e s t h e p r o f i t a b i l i t y a n a l y s i s p r o c e d u r e f o r t h e A.B.C. Company L t d . , (a net b o r r o w e r ) , s u p p o r t e d by t h e p r e s e n t a t i o n in T a b l e s l l l - l and 111-11 o v e r l e a f . These t a b l e s i l l u s t r a t e t h e f i n a l o u t p u t o f a p r o f i t a b i l i t y a n a l y s i s i n t h e form t h a t would be s u p p l i e d t o an a c c o u n t manager and from w h i c h he would d e t e r m i n e a p p r o p r i a t e n e g o t i a t i o n and p r i c i n g s t r a t e g i e s ^ . Customer d e p o s i t b a l a n c e s minus cash r e s e r v e s and f l o a t . See page 1,3 f o r an e x p l a n a t i o n o f t h e s e t e r m s ; a l s o , why t h e y must be d e d u c t e d from t h e customer's d e p o s i t b a l a n c e . ^Net d e p o s i t o r c u s t o m e r s ' d e p o s i t b a l a n c e s i n excess o f t h e i r l o a ns a r e assumed t o f l o w i n t o a p o o l o f funds w h i c h i s a v a i l a b l e f o r l o a n s u p p o r t o r f i n a n c e f o r net b o r r o w e r s . 3 A l s o s u p p l i e d t o a c c o u n t managers a r e s u p p o r t s c h e d u l e s w h i c h d e t a ?1 t h e volume, revenue, and c o s t c o m p o s i t i o n o f r o u t i n e and s p e c i a l s e r v i c e s by i n d i v i d u a l s e r v i c e e.g. cheques i s s u e d . 32 TABLE I I I - l PROFITABILITY ANALYSIS OF A . B . C . COMPANY LTD. JANUARY 1, 1972 to DECEMBER 31, 1972 SOURCE AND APPLICATION OF FUNDS A p p l i c a t i o n of Funds Average loan $ 1,000,000 Source of Funds T o t a l app1icat ion $ 1,000,000 Equity Capi ta l Customer Deposits(debt) $ 150,000 $ 750,000 Average 1edger ba1ance Less: F loat $ 195,000 Cash Reserves 55,000 250,000 Average i n v e s t i b l e balance Def ic iency from pool funds T o t a l sources $ 500,000 $ 650,000 350,000 $ 1,000,000 1 Commentary on th i s table may be found on pages 3^ to 36. 33 TABLE I I 1-1 I PROFITABILITY ANALYSIS OF A.B.C. COMPANY LTD. JANUARY 1, 1972 to DECEMBER 31, 1972 PROFITABILITY ANALYSIS SUMMARY I income: Loan i n t e r e s t ($1,000,000 (?) 5 1/2%) Routine s e r v i c e charges Sp e c i a l s e r v i c e charges $ 55,000 5,000 2,000 $.'62,000 Expense: Loan cost Routine s e r v i c e s Pool funds ($350,000 <® 5%) S p e c i a l s e r v i c e s Desired p r o f i t on equity c a p i t a l ($150,000 <S> 20%) D e f i c i e n c y $ 10,000 15,000 17,500 3,750 30,000 (14,250) $ 62,000 Commentary on t h i s t a b l e may be found on pages 36 to 37. The P.N.B. do not present t h e i r p r o f i t a b i l i t y a n a l y s i s summary as i l l u s t r a t e d above. They c a l c u l a t e a c t u a l p r o f i t ($15,750), r e l a t e t h i s to the desired p r o f i t l e v e l ($30,000), then compute a p r o f i t a b i l i t y index:-P r o f i t a b i 1 i t y Index == Actual P r o f i t = 15,750 x 100 = 52.5 Des ired P r o f i t 30,000 The p r o f i t goal is that which w i l l y i e l d an index of 100 i . e . $14,250 in a d d i t i o n a l revenues. As des i r e d p r o f i t corresponds to the shareholders' d e s i r e d rate of r e t u r n , (see page 37) i t should more properly be included as a charge against revenues, as i n d i c a t e d , rather than as u t i l i z e d by the P.N.B. 3.3.2.1 Source and A p p l i c a t i o n of Funds The a n a l y s i s p e r i o d having been s e l e c t e d by the bank, the commencement p o i n t is c a l c u l a t i o n of the customer's average loan balance f o r that p e r i o d . In the case of the A.B.C. Company L t d . , t h i s is one m i l l i o n d o l l a r s . The loan is then assumed to be financed by: ( l ) bank equity c a p i t a l , (2) the average i n v e s t i b l e deposit balances of the customer being analyzed, and (3) pool funds, i f requ i red. Equity c a p i t a l is a l l o c a t e d to the loan under the assumption that i t s purpose is to p r o t e c t depositors against any r i s k of loss a r i s i n g from the loan and investment p o r t f o l i o . It is a l l o c a t e d at a percentage ra t e which depends upon the r i s k c l a s s of the loan i . e . the higher the r i s k in the loan the greater w i l l be the c a p i t a l a l l o c a t e d per loan d o l l a r ^ . In the case of the A.B.C. Company, the a l l o c a t i o n r a t e is assumed to be f i f t e e n cents per loan d o l l a r . The a l l o c a t i o n procedure u t i l i z e d by the P.N.B. i s as fo11ows:-1. D i v i d e the loan and investment p o r t f o l i o into broadly defined r i s k c a t e g o r i e s , e.g. short term U.S. Government s e c u r i t i e s , long term U.S. Government s e c u r i t i e s , commercial loans, personal i n s t a l l m e n t loans, f e d e r a l l y guaranteed mortgage loans, et c e t e r a . This technique i s d i r e c t l y comparable to c a p i t a l s t r u c t u r e theory i . e . the greater the business r i s k faced by a c o r p o r a t i o n , the greater i t s investments w i l l be financed by equity and the less by debt. Debt, as i t p e r t a i n s to banking, r e f e r s to customer d e p o s i t s . 35 2. Assign a ba s i c value of one ( l ) to the category of loan or investment with the lowest r i s k , e.g. short term U.S. Government s e c u r i t i e s . Every other category would then be assigned a r i s k f a c t o r r e l a t i v e to t h i s base, e.g. commercial loans may be rated three (3) i . e . three times the r i s k of short-term U.S. Government s e c u r i t i e s ; personal installment loans, four (4), et c e t e r a . Then equity c a p i t a l , less a 100% a l l o c a t i o n to f i x e d assets such as b u i l d i n g s and equipment, is ap p l i e d or a l l o c a t e d on a weighted average basis as f o l l o w s : -Let X% = Equity C a p i t a l x 100 ( l x U.S. Gov. secs.)+(3x comm.loans)+(4x p e r s o n a l l o a n s ) The percentage a l l o c a t i o n of c a p i t a l to commercial loans would then be 3x%!. 3. A f t e r having obtained the general a l l o c a t i o n of c a p i t a l t o the commercial loan category, t h i s a l l o c a t i o n is r e f i n e d by c l a s s i f y i n g the d i f f e r e n t degrees of r i s k w i t h i n the commercial loan p o r t f o l i o i t s e l f , e.g. unsecured and secured loans under a ' l i n e of c r e d i t ' ; two, three and four year term loans, et c e t e r a . The second source of finance resides in the average depos i t  balances of the customer being analysed, under the assumption that the customer's deposit balances should o f f s e t his loan^. However, cash reserves and f l o a t must f i r s t be deducted from the average balance to a r r i v e at the actu a l balance that the bank has a v a i l a b l e f or loan support or finance - the i n v e s t i b l e balance^. The th i rd and f i n a l source of finance is pool funds. With regard to the A.B.C. Company L t d . , as equity c a p i t a l plus average A second approach, which is a l s o u t i l i z e d by the P.N.B., involves merely saying, f o r instance, that 5% of equity c a p i t a l w i l l cover the market r i s k in U.S. s e c u r i t i e s , 15% the c r e d i t r i s k in commercial loans, 20% the c r e d i t r i s k in personal loans, et c e t e r a . T h e o r e t i c a l l y , then, the customer's deposit balances flow into the pool and are immediately withdrawn. However, the cost attached to these deposits is c o r r e c t l y set at the actual cost incurred by the bank with respect to that p a r t i c u l a r customer, not the pool funds c o s t . See page 36 - Cost of Funds . ^See page 13 where the reasons f o r cash reserve and f l o a t deduction are explained. i n v e s t i b l e customer deposits f a l l s short of the loan amount by $350,000, t h i s d e f i c i e n c y is drawn from pool funds. 3.3.2.2 P r o f i t a b i l i t y A n a l y s i s Summary1 The p r o f i t a b i l i t y a n a l y s i s summary is simply an h i s t o r i c a l statement of earnings and expenses f o r an i n d i v i d u a l customer r e l a t i o n s h i p . The customer is f i r s t allowed c r e d i t f o r a 11 income generated f o r the bank in the a n a l y s i s p e r i o d . As i l l u s t r a t e d , the 2 A.B.C. Company L t d . is allowed c r e d i t f o r loan i n t e r e s t and s e r v i c e charges p a i d ^ . The customer is then charged with al1 costs incurred by the bank on his behalf. For the A.B.C. Company L t d . these were: (1) Loan cost - the costs a s s o c i a t e d w i t h the a n a l y s i s of the loan request ( c r e d i t a n a l y s i s ) , r e c e i v i n g c a p i t a l and i n t e r e s t repayments and, in general, s u p e r v i s i n g the loan account; (2) S p e c i a l s e r v i c e s -the cost a s s o c i a t e d w i t h the i s s u i n g of d r a f t s , money orders, et c e t e r a , and (3) Cost of funds - the costs associated w i t h the f i n a n c i n g of the customer's loan. This is comprised of three separate c o s t s . F i r s t l y , there are the costs of the customer's own deposit balances. In the See pages 9 to 16, where d i s c u s s i o n on the revenues and costs associated w i t h s e r v i c e p r o v i s i o n to commercial customers is presented. 2 Loan i n t e r e s t is the r e a l i z e d , not the expected r e t u r n . ^Had the A.B.C. Company L t d . been a net depositor (see page 30) c r e d i t would have been allowed f or revenues emanating from investment of deposit funds s u p p l i e d to the p o o l , less investment and s e r v i c i n g c o s t s . case of the A.B.C. Company Ltd., this was the cost of providing routine services to the customer'. Secondly, there is the cost of pool funds supplied and, lastly, the cost of bank equity capital allocated to the loan. This latter cost is calculated by applying the bank's desired rate of return on total bank equity capital, at book value, to the portion of equity capital allocated to the loan - in financial theory terms, the shareholders' desired rate of return-^. As equity capital is allocated according to the risk in a particular loan (see page 34) and as the same desired rate of return is required on a l l allocated capital, the effect is to add extra costs to the more risky loans. With the A.B.C. Company Ltd., the desired rate of return on allocated equity capital was assumed to be 20 per cent on $150,000, or $30,000. This resulted in a deficiency of $14,250 or a pr o f i t a b i l i t y index of 52.5^. 3.3.3 The Non-Borrower and Net Borrower The procedures outlined in the preceeding pages for analysis ' i t should be noted that banks also collect service charges for providing routine services (see page 12). This is illustrated in Table I l l - l I. A more correct procedure would be to net these costs and service charges to give the "true" cost of customer deposit balances. 2 The cost of maintaining the deposit pool pro-rated to the amount of pool funds supplied. Pool fundi-cost is comprised mainly of interest and administrative expenses. In Table I 11-I I this was assumed to be 5 per cent. 3 It should be noted that the P.N.B. computes the desired rate of return on the book value of the equity and not on the market value, as is common usage. See, for example, J.C. Van-Horne, Financial Management  and Pol icy (Englewood C l i f f s , New Jersey: Prentice-Hall Inc., 1971)• % e e Table I I I-I I and footnote. 38 of the net borrowing customer are u t i l i z e d , with minor a d d i t i o n , f or a n a l y s i s of the non-borrower and net d e p o s i t o r . These minor a d d i t i o n s are described below. 3.3.3.1 The Non-Borrower In the Source and A p p l i c a t i o n of Funds statement, equity c a p i t a l is a l l o c a t e d to the customer's i n v e s t i b l e deposit balance at that r a t e which corresponds to the average r i s k of the bank's t o t a l loan and investment p o r t f o l i o ^ . In the P r o f i t a b i l i t y A n a l y s i s Summary the customer is allowed c r e d i t f o r his i n v e s t i b l e deposit balance plus a l l o c a t e d c a p i t a l at the bank's average gross earnings r a t e on loans and investments, and is charged with the cost of lending and in v e s t i n g h i s funds. 3.3.3.2 The Net Depos i t o r This type of customer represents an amalgamation of the procedures already o u t l i n e d f o r the net borrower and non-borrower, in that he has both a loan, plus "excess" deposit balances which are su p p l i e d to the p o o l . Equity c a p i t a l is f i r s t a l l o c a t e d to the loan as described for the A.B.C. Company L t d . e a r l i e r in the chapter; however, as the customer has deposit balances in excess of that required to finance the remainder of his loan, these are s u p p l i e d to the pool and the process described above f o r the non-borrower is a p p l i e d to these "excess" funds. 3 A S i t u a t i o n a l Usage of the P r o f i t a b i l i t y A n a l y s i s Model A p r o f i t a b i l i t y a n a l y s i s , as presented on the preceeding 'This customer's t o t a l i n v e s t i b l e balance flows into the deposit p o o l , from where i t is drawn to finance the loans of net borrowing customers and bank investments. pages, is prepared f o r account managers in three major s i t u a t i o n s which lead, or could lead, to p r i c e n e g o t i a t i o n s with a customer on any or a l l aspects of h i s business t r a n s a c t i o n s with the bank. Two of these s i t u a t i o n s r e l a t e to present customers of a bank and one to p o t e n t i a l , as o u t l i n e d below. Discuss i o n on the merits and weaknesses of p r o f i t -a b i l i t y a n a l y s i s f o l l o w s . 3.4.1 Present Customer Usage A p r o f i t a b i l i t y a n a l y s i s is prepared f o r the account manager at the time of the annual c r e d i t review, i . e . l i n e of c r e d i t , e t c e t e r a , whether t h i s is a renewal, or a p p l i c a t i o n f o r new or increased f a c i l i t i e s . In t h i s s i t u a t i o n , i t is u t i l i z e d f o r the a s s i s t a n c e i t provides the account manager in n e g o t i a t i n g c r e d i t and other terms with the customer, e.g. the customer may be p r e s s i n g f o r a 'prime r a t e ' on h i s loan, but the p r o f i t a b i l i t y a n a l y s i s shows that a rat e of prime plus one per cent would be necessary to meet the p r o f i t g o a l . An h i s t o r i c a l p r o f i t a b i l i t y a n a l y s i s is a l s o p e r i o d i c a l l y prepared at the request of the account manager f o r the purpose of ensuring that the account is performing in a s a t i s f a c t o r y manner, i . e . a monitoring procedure to ensure p r o f i t goals are being met. Based upon the r e s u l t s , the account manager would decide whether and what a c t i o n was necessary. It is i n t e r e s t i n g to note in t h i s regard that the F i r s t National C i t y Bank, whose a n a l y s i s procedure i s t o t a l l y computerized, provides i t s account managers with a p r o f i t a b i l i t y a n a l y s i s 'The bank o f f i c e r who has r e s p o n s i b i l i t y f o r the e n t i r e r e l a t i o n s h i p i . e . a d m i n i s t r a t i o n , p r i c e s e t t i n g and n e g o t i a t i o n s . of a l l r e l a t i o n s h i p s they manage on a q u a r t e r l y b a s i s ' . 3.4.2 P o t e n t i a l Customer Usage L i t t l e information on t h i s t o p i c was contained in the l i t e r a t u r e , as the major usage of the model is an h i s t o r i c a l a n a l y s i s of present customers. Only one reference to the a n a l y s i s of p o t e n t i a l customers was noted: "With advance knowledge of the e s s e n t i a l ingredients of a p r o s p e c t i v e d e a l , we are able t o develop a p r o j e c t e d index 2 which sets f o r t h the p r o f i t p o t e n t i a l of a proposed r e l a t i o n s h i p . The index, t h e r e f o r e , can serve as a guide in determining how a g g r e s s i v e l y we seek a piece of new bus i n e s s " . ^ 3.5 Model Strengths and Weaknesses Having o u t l i n e d the model and s t a t e d the s i t u a t i o n s in which i t is u t i l i z e d , i t is now appropriate to present the strengths and weaknesses of t h i s approach to commercial account a n a l y s i s . The d i s c u s s i o n w i l l serve as an input f o r comparing United States bank procedures to those of Canadian banks in Chapters IV and V. P o s s i b l e , major, model weaknesses w i l l be t r e a t e d f i r s t . 3.5.1 Model Weaknesses Three, p o s s i b l e , major, model weaknesses e x i s t . These are: 'W.'l. Else, "Account P r o f i t a b i l i t y ' , , F i r s t National C i t y Bank, Bank Management Seminar - December 14-15, 1970 (unpublished speech). 2See Table 11 I - l I. ^Dyer and H e i l s h o r n , P r o f i t A n a l y s i s for Loans, p.45 ( P h i l a d e l p h i a N a t i o n a l Bank). (1) the usage of h i s t o r i c a l rather than pro j e c t e d customer r e l a t i o n s h i p data; (2) c a p i t a l a l l o c a t i o n as an approach to r i s k adjustment, and (3) d u p l i c a t i o n of income, expense and c a p i t a l a l l o c a t i o n s . 3.5.1.1 H i s t o r i c a l Data P r o j e c t e d , not h i s t o r i c a l data should be employed si n c e p r i c e n e g o t i a t i o n s are t a k i n g place f o r a future time p e r i o d . The a b i l i t y to for e c a s t the v a r i a b l e s is p o t e n t i a l l y very d i f f i c u l t . It should be r e a l i z e d , however, that both the p r o f i t a b i l i t y a n a l y s i s model and the computer are r e l a t i v e l y recent i n t r o d u c t i o n s to banking; the l a t t e r being a p r a c t i c a l n e c e s s i t y for p r o j e c t i o n s and u n t i l r e c e n t l y was being p r i m a r i l y u t i l i z e d for a d m i n i s t r a t i v e rather than research and a n a l y s i s purposes. As banks turn more towards the l a t t e r use of computers, we may expect, in the w r i t e r ' s o p i n i o n , to see such p r o j e c t i o n s take p l a c e . Indeed steps are already being made in t h i s d i r e c t i o n . "A system l i k e C.I.S. 1 can a l s o be h e l p f u l in determining the opportunity value of keeping a customer r e l a t i o n s h i p during the foreseeable f u t u r e . This can be accomplished simply by using a forecasted long-term cost of pool funds together w i t h p r o j e c t e d l e v e l s of business f o r the customer and then c a l c u l a t i n g the pre-tax earnings in future years. We have performed t h i s operation several times by l e t t i n g the computer do the work f o r us. In t h i s way, C.I.S. has become a t a c t i c a l planning t o o l for the account manager."^ 3.5.1.2 C a p i t a l A l l o c a t i o n as an Approach to Ris k Adjustment In Chapter I I , adjustment of the i n t e r e s t rate to account f or r i s k d i f f e r e n t i a l s between loans was b r i e f l y discussed i . e . the higher the r i s k the greater would be the i n t e r e s t r a t e . In t h i s chapter, the process of goal s e t t i n g based upon a r i s k a l l o c a t i o n of equity c a p i t a l ^Customer Information Systems. The name of the computerized p r o f i t a b i l i t y a n a l y s i s system of the F i r s t National C i t y Bank. 2 E l s e , Account P r o f i t a b i l i t y , p.8. ( F i r s t N a t i o n a l C i t y Bank) hi was discussed i . e . the greater the r i s k in any p a r t i c u l a r c l a s s of advance, the greater w i l l be the c a p i t a l a l l o c a t e d and, hence, the greater the p r o f i t g o a l . If i n t e r e s t rates are being r i s k adjusted in a con s i s t e n t manner and c a p i t a l is being a l l o c a t e d on a r i s k c l a s s b a s i s , i t seems to the w r i t e r that a d u p l i c a t i o n is ta k i n g p l a c e . This matter, however, is not c l e a r cut and the s o l u t i o n would appear to r e s i d e in r i s k adjustment of rates in a c o n s i s t e n t manner, as evidenced in the f o l l o w i n g quote: "Most of us say we adjust i n t e r e s t rates according to r i s k , but c o n s i d e r i n g the wide q u a l i t y range of customers borrowing at prime, there is ser i o u s doubt that we are paid for many of the r i s k s we are assuming."' 3.5.1.3 D u p l i c a t i o n of Income, Expense and C a p i t a l A l l o c a t i o n s 2 In p r o f i t a b i l i t y a n a l y s i s , income is a l l o c a t e d both to borrowers and to d e p o s i t o r s . Hence, except to the extent that a borrower's own deposit balance is used to finance his own loan, income is a l l o c a t e d t w i c e . The same is tru e of expenses e.g. in the case of a pure depo s i t o r , the cost of maintaining these deposit balances is charged f i r s t to the depositor then to the borrower who uses them (cost o f pool funds). C a p i t a l is a l s o a l l o c a t e d twice in that t o t a l e q uity c a p i t a l is f i r s t consumed by the loans and investments of the bank, then i t is " a l l o c a t e d " to deposit balances (see page 38). A p o t e n t i a l weakness of p r o f i t a b i l i t y a n a l y s i s then, is that the sum of a l l income, expense and p r o f i t s of commercial customers, as ^Dyer and H e i l s h o r n , P r o f i t Analys i s , p. hi ( F i r s t National C i t y Bank). It is not c l e a r , nor has any attempt been made to a s c e r t a i n , i f the r i s k adjustment merely equates expected returns or i f a r i s k premium has been b u i l t i n . 2See P h i l a d e l p h i a National Bank, P r o f i t a b i l i t y A n a l y s i s , Chapter XII where the P.N.B. attempt to defend t h i s d u p l i c a t i o n o f income, expense and c a p i t a l a l l o c a t i o n s . hi w e l l as t h e sum o f c a p i t a l a l l o c a t i o n s , w i l l be more t h a n t h a t f o r t h e bank as a wh o l e ' . 3.5.2 Model S t r e n g t h s The major s t r e n g t h o f t h e p r o f i t a b i l i t y a n a l y s i s a p p roach i s t h a t i t a c c o u n t s f o r t h e t o t a l r e l a t i o n s h i p i n a s y s t e m a t i c  manner and one w h i c h y i e l d s r e s u l t s i n a d i r e c t l y u s a b l e form. Based upon t h i s n o t i o n , t h e d i s c u s s i o n t h a t f o l l o w s has i t s o r i g i n i n comments and i n f e r e n c e s made by v a r i o u s bank o f f i c e r s when o u t l i n i n g t h e p r o f i t a b i l i t y a n a l y s i s p r o c e d u r e s o f t h e i r companies. 3.5.2.1 C o n s i s t e n c y and S u b s i d i z a t i o n P r o f i t a b i l i t y a n a l y s i s i s a t e c h n i q u e t h a t p r o v i d e s f o r a l l commercial customers b e i n g a n a l y s e d i n t h e same manner and by t h e c o n s i s t e n t a p p l i c a t i o n o f t h e same s e t o f r u l e s . T h i s r e d u c e s , t h e r e f o r e , t h e n o n - o b j e c t i v e d e c i s i o n s t h a t might o t h e r w i s e be made and a c c o r d s t h e customer a f a i r , o b j e c t i v e a n a l y s i s o f h i s b u s i n e s s . The r e s u l t s o f t h e a n a l y s i s p r o v i d e t h e b a s i s f o r each r e l a t i o n s h i p " p a y i n g i t s own way" o r " p u l l i n g i t s own w e i g h t " , w h i c h reduces t h e p o s s i b i l i t y t h a t p r o f i t a b l e r e l a t i o n s h i p s may be s u b s i d i z i n g low p r o f i t o r l o s s r e l a t i o n s h i p s . In t h i s s e n s e , i t i s f a i r t o a l l c u s t o m e r s . The word red u c e was u n d e r l i n e d as i t has been s u g g e s t e d t h a t banks f r e q u e n t l y s e e k l a r g e p r e s t i g e c u s t o m e r s , a t t h e expense o f p r o f i t , assuming t h a t growth i n s i z e e q u a l s growth i n p r o f i t a b i l i t y 2 . T h i s i s b e s t i l l u s t r a t e d i f i t i s assumed t h a t a bank o n l y has commercial c u s t o m e r s . 2 S e e , f o r example, P a u l S. N a d l e r , "Three P r o f i t A r e a s You Can E x p l o r e " , B a n k i n g , A p r i l 1970, p.77. This f a c t is w e l l recognized, however, should a b a n k have such sub-goals, p r o f i t a b i l i t y a n a l y s i s provides an unambiguous measurement of the opportunity cost of pursuing these, which cost might not have p r e v i o u s l y been f u l l y r e a l i z e d . The f o l l o w i n g quote i l l u s t r a t e s both the s u b s i d i z a t i o n argument and the banks' p o s s i b l e lack of awareness of the costs of pursuing s i z e or p r e s t i g e customers. "When the p r o f i t formula £profitabi1ity a n a l y s i s ] is a p p l i e d to the commercial loans J V e l a t i o n s h i p s ] in a bank, i t produces s u r p r i s i n g r e s u l t s . Many customers formerly thought to be h i g h l y p r o f i t a b l e w i l l show d i s a p p o i n t i n g index figures£ p r o f i t s ] w h i l e many other customers formerly thought to be marginal producers w i l l show very good r e s u l t s . 3 . 5 . 2 . 2 P r e p a r a t i o n f o r Negotiations P r o f i t a b i l i t y a n a l y s i s prepares the account manager for n e g o t i a t i o n s with h i s customers, in both the general and s p e c i f i c sense. F i r s t , and in the general, the procedure brings together a l l f a cets of the r e l a t i o n s h i p in a l o g i c a l and d e t a i l e d manner. This provides a v a l u a b l e c o n t r i b u t i o n to the account manager's understanding of h i s customer - a necessary input to n e g o t i a t i o n s and of p a r t i c u l a r importance in a complex s i t u a t i o n . In the s p e c i f i c sense, the procedure answers two very b a s i c questions - what were earnings and how much d o w e wish to earn? Thus, i n a d d i t i o n t o knowledge of the absolute p o s i t i o n of the account, the P h i l a d e l p h i a National Bank, P r o f i t a b i l i t y A n a l y s i s , p.32. account manager is provided with overall direction for his negotiations. This, when coupled with the detailed composition of the account profit (loss)', places the account manager in a position to recognize sources of weakness and to prepare rational or objective courses of action. Sources of weaknesses could be, for example, unusual activity or high float in relation to deposit balances, non-deposit services for which the bank is not being compensated, or a loan paying too low a rate. Appropriate courses of action might be: a request for additional deposit balances or fees, a higher interest rate, or possibly some combination thereof. Undoubtedly, the bank will wish to improve relationship performance through the delinquent area(s); however, with the knowledge that p r o f i t a b i l i t y analysis supplies, the bank is in a position to provide the customer with alternatives should he desire this, or if he is known to be particularly averse to certain forms of compensation. To illustrate the above, reference is made to the analysis of the A.B.C. Company Ltd. (Tables I l l - l and I II-l I) which showed a profit deficiency of $14,250. An obvious source of weakness is that the customer is not paying his way in the Routine and Special Services area - a combined deficiency of $11,750 . A second source of weakness is the large amount of float being generated - $195,000 - which has See footnote 3, page 3 1 . Assuming that the bank at least wishes to cover costs. s e v e r e l y eroded the customer's d e p o s i t . A l s o , cost of funds plus loan cost exceeds loan i n t e r e s t received by $17,500, i n d i c a t i n g that the current i n t e r e s t rate should be adjusted upwards'. The bank has a number of a l t e r n a t i v e s to r a i s e the required $14,250 and meet i t s p r o f i t goal for the A.B.C. Company Lt d . : 1. A d d i t i o n a l fees of $11,750 plus a 1/4% adjustment of the i n t e r e s t r a t e . 2. An i n t e r e s t rate adjustment only - 1 1/2%. 3. A d d i t i o n a l f r e e deposit balances of $285,OOO2. 4. Some combination of fees, i n t e r e s t rate and deposit balances . 3.5.2.3 Overly P r o f i t a b l e Customers The above d i s c u s s i o n concerned i t s e l f mainly w i t h recognizing p r o f i t goal d e f i c i t accounts and improving t h e i r performance; however, the m a j o r i t y of comments made r e f e r to a l l customers, whether p r o f i t d e f i c i e n t or o v e r l y p r o f i t a b l e . (This l a t t e r type of customer was p a r t i a l l y discussed in Chapter II (pages 23 to 25).) With o v e r l y p r o f i t a b l e customers, the account manager is in a p o s i t i o n to strengthen bank/customer a s s o c i a t i o n by one of three methods: p r i c e reduction on present s e r v i c e s accorded the customer, expenditure of a d d i t i o n a l time and e f f o r t in s e r v i c i n g the account, or a combination of both. As regards the second a l t e r n a t i v e , t h i s could include making the customer aware of a d d i t i o n a l s e r v i c e s he might be able to use and 'Loan i n t e r e s t received during the year t o t a l l e d $55,000 w h i l e cost of funds ( r o u t i n e s e r v i c e s , pool funds, and desired p r o f i t ) plus loan cost t o t a l l e d $72,500. 2Avoidance of pool fund::costs of $14,250:- $285,000(5) 5%. extending these at zero or reduced cost. In any event, irrespective of which course of action is taken, it can only serve to strengthen the bank/customer relationship and can only be undertaken in an objective manner if the profit level and profit goal are first known. 3.5.2.4 Selective Selling and Performance Evaluation The uses of the profitability analysis model extend beyond the analysing of individual customer relationships into the areas of selective selling and account manager performance evaluations; the latter is accomplished by periodically measuring how well the account manager is performing relative to improving the position of his deficit customers. The use of the model in selective selling, or concentration of marketing efforts on high profit level prospects, is evidenced in the following quote:-"C.I.S.' has become a strategic tool too. By consolidating future years' [[forecasted] pre-tax earnings for corporate account analyses into industry groupings, it is possible to assess the opportunity value of maintaining a strong share of market in each industry."2 3.6 Summary of Model Strengths and Weaknesses The strengths of the profitability analysis model, in terms of both the account manager and the bank, may be summarized as follows (1) provision of an intimate knowledge of the account, (2) knowledge of both absolute profit and a profit goal, (3) knowledge of all areas ^Customer Information System - the computerized profitabilit analysis system of the First National City Bank. 2Else, Account Profitability, p.9. that r e q u i r e c o r r e c t i v e a c t i o n , (k) knowledge of those customers who are o v e r l y p r o f i t a b l e and who should be accorded a d d i t i o n a l s e r v i c e , (5) f l e x i b i l i t y in c o r r e c t i v e a c t i o n , (6) account manager performance e v a l u a t i o n , and (7) s e l e c t i v e s e l l i n g . The weaknesses of the model may be summarized as f o l l o w s : -( l ) p r o j e c t e d not h i s t o r i c a l data should be u t i l i z e d ; however, i t was noted that research is being undertaken in t h i s area, (2) the c a p i t a l a l l o c a t i o n procedure may p o s s i b l y be a d u p l i c a t i o n of r i s k adjustment, (3) d u p l i c a t i o n of income, expense and c a p i t a l a l l o c a t i o n s , and (k) the procedure w i l l be expensive to i n s t a l l and u t i l i z e ; t h e r e f o r e , the costs and b e n e f i t s i t incurs and provides should be c l o s e l y evaluated. This t o p i c is discussed below. 3.7 Model Costs and Benefi t s The question of the d o l l a r costs of performing p r o f i t -a b i l i t y analyses or i n s t a l l i n g such a system, r e l a t i v e to the returns received, must be answered. Concern here is not with i n t a n g i b l e b e n e f i t s such as a greater understanding of customers or knowing t h e i r p r o f i t l e v e l r e l a t i v e to a g o a l , but t r a n s l a t i n g these into t a n g i b l e d o l l a r income. From the two quotes presented below, p a r t i c u l a r l y the l a t t e r , i t would appear that the returns g r e a t l y exceed the costs of t h e i r generation. "The value of a p r o f i t a b i l i t y a n a l y s i s system to a bank is the opportunity cost of the low p r o f i t loans £ r e l a t ionsh ips]|. It is the w r i t e r ' s opinion that the cost of a p r o f i t a b i l i t y a n a l y s i s system w i l l be much less f o r most banks than the opportunity cost of i t s low pr o f i t loans £relationships] Falkenberg, P r o f i t a b i l i t y A n a l y s i s , Part I I , p.23. " T h e Customer I n f o r m a t i o n S y s t e m w h i c h p r o d u c e s o u r a c c o u n t p r o f i t a b i l i t y r e p o r t s , is one o f t h e few f u 1 l y a u t o m a t e d s y s t e m s o f i t s t y p e in t h e U n i t e d S t a t e s and i t has t h e h i g h l y u n u s u a l d i s t i n c t i o n o f h a v i n g p a i d f o r i t s e l f w i t h i n t h e f i r s t y e a r o f o p e r a t i o n . In f a c t , we t h i n k t h e r e t u r n on o u r i n v e s t m e n t w i t h i n t h e p a s t y e a r has been a p p r o x i m a t e l y d o u b l e o u r d e v e l o p m e n t c o s t s ! " ' a n a l y s i s m o d e l . W h i l e t h e model i s o b v i o u s l y o f g r e a t a s s i s t a n c e t o banks i n t h e a n a l y s i s o f t h e i r c o m m e r c i a l c u s t o m e r s and i n s u b s e q u e n t n e g o t i a t i o n s , i t i s n o t a p a n a c e a . It m e r e l y i d e n t i f i e s what t h e p r o f i t is on an a c c o u n t , and what c o u r s e s o f a c t i o n m i g h t be open t o a b a n k . A t t a i n m e n t o f t h e o b j e c t i v e s s e t o u t by t h e model a r e n o t met by t h e m o d e l , but by t h e s k i l l and j u d g e m e n t o f t h e b a n k ' s n e g o t i a t o r . T h i s i s a p t l y i l l u s t r a t e d i n t h e f o l l o w i n g : -" S o u n d p r i c i n g d e c i s i o n s a r e b a s e d n o t o n l y on p r o f i t a b i l i t y a n a l y s i s but on a number o f f a c t o r s w h i c h we may n e v e r be a b l e t o q u a n t i f y - c o m p e t i t i o n , v a l u e t o t h e c u s t o m e r , p o t e n t i a l p r o f i t a b i l i t y l e v e l s , p a s t p r o f i t a b i l i t y l e v e l s , and s h o r t and l o n g t e r m a c c o u n t r e l a t i o n s h i p c o n s i d e r a t i o n s , t o name a few. In o t h e r w o r d s , r e g a r d l e s s o f t h e d e g r e e o f s t a t i s t i c a l s o p h i s t i c a t i o n , j u d g e m e n t must p r e v a i l . A p r o f i t a b i l i t y a n a l y s i s s y s t e m , a t b e s t , is j u s t E l s e , A c c o u n t P r o f i t a b i l i t y , p . l . ( F i r s t N a t i o n a l C i t y Bank) ^Dyer and H e i l s h o r n , P r o f i t A n a l y s i s f o r L o a n s , p.52 ( F i r s t N a t i o n a l C i t y B a n k ) . 3.8 C o n c l u s ion Many b e n e f i t s have been c i t e d f o r t h e p r o f i t a b i l i t y one CHAPTER IV THE COMMERCIAL ACCOUNT ANALYSIS PROCEDURES OF THE CANADIAN CHARTERED BANKS In contrast to the commercial account a n a l y s i s procedures of s e l e c t e d United States banks, information p e r t a i n i n g to those of the Canadian chartered banks is g e n e r a l l y u n a v a i l a b l e in the l i t e r a t u r e ' . As a r e s u l t , the major o b j e c t i v e of the research was  to determine the procedures by which s e l e c t e d Canadian chartered  banks handle t h e i r customer r e l a t i o n s h i p s . The p a r t i c u l a r o b j e c t i v e s were to determine whether the banks: ( l ) u t i l i z e d a formal t o t a l r e l a t i o n s h i p a n a l y s i s , such as that discussed f o r the United States banks in Chapter I I I , or (2) approached the a n a l y s i s by viewing the customer r e l a t i o n s h i p as three separate s e r v i c e areas, p o s s i b l y w i t h weak overlaps or linkages o c c u r r i n g between the three areas that might a f f e c t the n e g o t i a t i o n approach or p r i c i n g d e c i s i o n s . The chapter commences by o u t l i n i n g the r a t i o n a l e f or the research procedure and approach. A d e t a i l e d d e s c r i p t i o n of the a n a l y s i s procedures u t i l i s e d by the Canadian banks is presented next; included is a d i s c u s s i o n on the extent to which the chartered banks Of course, information on the m a j o r i t y of United States banks i . e . those which do not u t i l i z e a formal p r o f i t a b i l i t y a n a l y s i s model, is eq u a l l y as sparse; t h e r e f o r e , the research methodology developed herein for determining Canadian banks' a n a l y s i s procedures is relevant f o r studying the bulk of the United States banking system. capture the essence of a customer r e l a t i o n s h i p in t h e i r n e g o t i a t i o n approach and p r i c i n g d e c i s i o n s . L a s t l y , current trends in Canadian bank a n a l y s i s procedures are b r i e f l y o u t l i n e d . It w i l l be noted in subsequent d i s c u s s i o n that a s i g n i f i c a n t p o r t i o n of t h i s chapter is devoted to demand deposit account a n a l y s i s . There are two reasons f o r t h i s emphasis: (1) i t is the method of commercial account a n a l y s i s for Canadian banks (excepting c r e d i t a n a l y s i s which is not a concern of t h i s study - see page 3 ) and i t has not, to the best of the w r i t e r ' s knowledge, been p r e v i o u s l y s t u d i e d o utside of the Canadian banking system, (2) the data c o l l e c t i o n needs f o r performance of a p r o f i t a b i l i t y a n a l y s i s are very l a r g e l y demand deposit account based'. k.1 Research Methodology With the exception of c r e d i t a n a l y s i s procedures, apparently only three minor sources e x i s t on the commercial account a n a l y s i s 2 procedures of Canadian chartered banks . Based upon t h i s l i m i t e d m a t e r i a l , plus p r e l i m i n a r y interviews w i t h s e n i o r o f f i c i a l s at the 3 corporate o f f i c e s of two banks in Montreal , a formal q u e s t i o n n a i r e 1 e.g. the m a j o r i t y of a c t i v i t y volumes emanate from the demand deposit account ( r o u t i n e s e r v i c e s ) . There is a l s o : ( l ) f l o a t to be measured, (2) balance l e v e l s to be c a l c u l a t e d and valued, and (3) cash reserves to be c a l c u l a t e d . From a data c o l l e c t i o n standpoint then, i t could be s a i d that the demand deposit account is the heart of a p r o f i t -a b i l i t y a n a l y s i s system. 2 G a l b r a i t h , Canadian Banking, pp.101-102; Jamieson, Chartered  Banking; p.202; The Canadian Bankers' A s s o c i a t i o n , Submiss ion to the  Royal Commission on Banking and Finance (Supplement to the Canadian Banker, Spring 1963) p.4-5. For the reader i n t e r e s t e d in c r e d i t a n a l y s i s , see G a l b r a i t h Part IV and Jamieson Chapters XIV to X V I I I . 'Anonymity was requested. was constructed . This q u e s t i o n n a i r e was designed for use in subsequent d e t a i l e d interviews with the bulk of Canadian banks. These l a t t e r interviews were conducted between March 16 and 23, 1972 w i t h s e n i o r bank o f f i c i a l s at the banks' western region or corporate head o f f i c e s . A t o t a l of s i x banks p a r t i c i p a t e d . With the exception of the Bank of Montreal and the Bank of Nova S c o t i a , anonymity was requested. The q u e s t i o n n a i r e was not given to the respondent banks fo r completion; instead, i t was designed to be retained and u t i l i z e d by the interviewer to ensure that a predetermined sequence of questions was maintained and that no questions were omitted. Major points were recorded during the i n t e r v i e w . These formed the basis for a w r i t t e n p o s t - i n t e r v i e w e l a b o r a t i o n on the t o p i c s discussed. 4.1.1 Questionnaire S t r u c t u r e The l i m i t e d l i t e r a t u r e a v a i l a b l e on account a n a l y s i s procedures, plus the p r e l i m i n a r y interviews conducted in Montreal, provided a strong i n d i c a t i o n of the a n a l y s i s approach u t i l i z e d - three  separate s e r v i c e areas with weak overlaps that might a f f e c t n e g o t i a t i o n  or p r i c i n g d e c i s i o n s . This information provided the base from which to construct the q u e s t i o n n a i r e . It comprises three major sect i o n s :(see Append ix A ) . S e c t i o n I S e c t i o n I was designed to provide the interviewer with a broad overview of a n a l y s i s procedures employed by the s p e c i f i c bank under study and the basis upon which to proceed to the s p e c i f i c See Append ix A. questions that followed. Sect ion II This section was divided into three sub-sections, each of which corresponded to one of the three service areas of banking i.e. the credit, the demand deposit account and other financial services. Each sub-section was designed to f i r s t ascertain the actual analysis procedures employed in that area, then to probe whether or not areas other than the particular one being discussed affected pricing decisions or the negotiation approach, e.g. do demand deposit account balances affect the interest rate on the loan? Sect ion 1 I I Lastly, Section III was designed to obtain bank opinions on the analysis procedures employed by the United States banks as discussed in Chapter III. 4.1.2 Interviewee Response Although varying degrees of co-operation and assistance were provided, each bank was generally helpful and answered a l l questions in as reasonable a manner as could be expected. The written post-interview elaboration of the topics discussed' revealed a number of points that required c l a r i f i c a t i o n . These points were discussed with the banks in follow-up interviews conducted during the weeks of June 5 and 12, 1972. See page 52. k.2 The Analysis Procedures of the Canadian  Chartered Banks - General The Canadian chartered banks do not perform a formal total relationship analysis; rather, they conduct!separate analysis and negotiations on the demand deposit and loan accounts.. The other financial services area is not analysed'. In no instance do the banks  know the profit, on individual customers, either by service area or  over the total relationship. Rather, their procedures provide for the calculation of gross revenues in the credit and other financial service areas of the relationship, while for the demand deposit account analysis revenue surplus or deficit, with respect to the revenues that should have been collected, is calculated. Thus, two major differences exist between the profitab?1ity analysis model of selected United States banks and the Canadian bank procedures described in this chapter: (l) the United States banks compute the costs of providing services to commercial customers, the Canadian banks do not, and (2) the United States banks perform a total relationship analysis of their commercial customers while the Canadian banks utilize a service area approach. This segmented rather than total customer analysis approach reflects the stated opinion of all bankers interviewed - each service area is separate and distinct from the other service areas and negotiation 'Excepting credit analysis on foreign currency loans. See page 70. 55 and p r i c i n g d e c i s i o n s in each area should be made on that b a s i s . Such a philosophy, w i t h minor exception, s t r i c t l y holds t r u e for ne g o t i a t i o n s on the loan i n t e r e s t r a t e ; however, the exi s t e n c e of an elementary customer r e l a t i o n s h i p a n a l y s i s is c l e a r l y evident (under c e r t a i n circumstances) in p r i c i n g n e g o t i a t i o n s on the demand deposit account and other f i n a n c i a l s e r v i c e s ' . By v i r t u e of the s e r v i c e area approach to commercial account a n a l y s i s by the Canadian banks, the d e s c r i p t i o n of t h e i r a n a l y s i s procedures is separated i n t o : ( l ) the a n a l y s i s of the demand deposit  account; (2) the cred i t analys i s , and (3) other f i n a n c i a l s e r v i c e s . 4.3 The A n a l y s i s of the Demand Deposit Account The d e s c r i p t i o n commences with an overview of the a n a l y s i s approach. It then turns to an in-depth p r e s e n t a t i o n of the a n a l y s i s process. T h i s includes a r e p r e s e n t a t i v e sample of the form u t i l i z e d f o r data c o l l e c t i o n and a n a l y s i s and the p r e s e n t a t i o n of a hy p o t h e t i c a l demand deposit account a n a l y s i s . The d e s c r i p t i o n concludes w i t h a d i s c u s s i o n on how the r e s u l t s of the demand deposit account a n a l y s i s may be modified during n e g o t i a t i o n s by v i r t u e of the value of the t o t a l r e l a t i o n s h i p . L i k e the United States banks discussed in Chapter I I I , one person only has r e s p o n s i b i l i t y f or the e n t i r e customer - the branch manager, or in a large branch or head o f f i c e an account manager. However, u n l i k e the United States banks who analyse and negotiate on a l l aspects of the r e l a t i o n s h i p at one time, the Canadian banks analyse and negotiate each s e r v i c e area s e p a r a t e l y , as s t a t e d above. 56 4.3.1 Data Inclusions and the Data C o l l e c t i o n P e r i o d ' The a n a l y s i s includes only data which a r i s e from and are d i r e c t l y r e l a t e d to the operation of a demand deposit account i . e . the demand deposit balance i t s e l f , f l o a t , and routine s e r v i c e s . Data  emanating from the loan and other f i n a n c i a l s e r v i c e s areas of the  r e l a t i o n s h i p are excluded. An a n a l y s i s , or data c o l l e c t i o n p e r i o d o f one month is considered as being r e p r e s e n t a t i v e of normal a c t i v i t y and balances . 4.3.2 A n a l y s i s Frequency The frequency w i t h which the demand deposit account is analysed v a r i e s between banks. Three banks analyse a l l demand deposit accounts meeting c e r t a i n c r i t e r i a once per year; another performs the a n a l y s i s every second year provided that an annual a n a l y s i s does not appear warranted, and the remaining two banks perform " p e r i o d i c analyses"^. 4.3.3 C r i t e r i a f or S e l e c t i o n of the Demand Deposit Account f o r A n a l y s i s The c r i t e r i a u t i l i z e d by the banks to determine whether or The f i n a l t a b u l a t i o n and a n a l y s i s of data is manual, but f o r those banks with computer i n s t a l l a t i o n s in the metropolitan areas the m a j o r i t y of raw data inputs are obtained from computer p r i n t o u t s . 2The account manager examines the account f o r the a n a l y s i s month and s u b j e c t i v e l y decides whether or not a c t i v i t y volumes and balances are reasonably r e p r e s e n t a t i v e . If he decides they are not, data would be c o l l e c t e d over a longer p e r i o d , say three months, and averaged. Two banks average the deposit balance over a one year p e r i o d . ^ C l a r i f i c a t i o n of the word " p e r i o d i c " was pursued w i t h no d e f i n i t i v e r e s u l t . It is t h e r e f o r e i n t e r p r e t e d as meaning i r r e g u l a r , as s u b j e c t i v e c r i t e r i a are the determing analyses f a c t o r s (see page 57). not demand deposit accounts require analysis also varies. For those four banks that have a set annual frequency, two tie their analyses to the credit review date; one analyzes the account if the average ledger balance exceeds a certain level and another does so if the monthly dollar throughput' exceeds a certain level. With the majority of credit reviews occurring annually and as the average balance and throughput levels are "relatively low", it can be expected that all of the accounts with which this study is concerned will be analysed or reviewed annually. Each of these four banks also utilize secondary selection criteria and reviews will also occur if the account: (1) is not paying standard service charges ; (2) involves greater than normal supervision^, or (3) has "high" activity^1-. For the remaining two banks, where an irregular analysis or review is conducted, there is only one set down account selection criterion. This is: all accounts not paying standard service charges. Subjective selection criteria were the major determinants. These are: (l) a "high" level of dollar throughput; (2) "high" average balances or activity levels, and.(3) accounts involving greater than normal supervis ion. 'The total dollar value of cheques debited, or deposits credited, to the account. 220 cents per cheque issued and deposit made. ^e.g. an account that is frequently overdrawn and, therefore, demanding upon management time. ^a "large" volume of cheques issued on, or deposited to, the account. 4.3.4 The A n a l y s i s Procedure There are two d i s t i n c t steps to the a n a l y s i s of the demand deposit account: ( l ) Routine Services - computation of the extent to which revenues exceed or f a l l short of what the customer should have paid the bank for r o u t i n e s e r v i c e s provided during the a n a l y s i s p e r i o d ; (2) Balances - computation and v a l u a t i o n of the demand deposit account balance. The r e s u l t s of these two a n a l y s i s steps lead to the c a l c u l a t i o n of a d d i t i o n a l s e r v i c e charges or balances required for the account to operate in a s a t i s f a c t o r y manner (or computation of the excess revenues received or balances h e l d ) . The a n a l y s i s procedure is discussed below in r e l a t i o n to a r e p r e s e n t a t i v e sample of the form u t i l i z e d by the banks for data c o l l e c t i o n and a n a l y s i s purposes (Table I V - l ) . 4.3.4.1 Routine Services This aspect of the a n a l y s i s determines the extent to which the customer has over or under paid the bank f o r r o u t i n e s e r v i c e s provided. This is depicted on Line 14 of the a n a l y s i s form - Revenue Surplus or D e f i c i t (not p r o f i t or loss - costs do not enter into the c a l c u l a t i o n ) . C a l c u l a t i o n of the revenue surplus or d e f i c i t is comprised of two steps; the revenues due f o r the period (Lines 1-9) and the revenues a c t u a l l y received (Lines 10-14). The volumes of a l l major r o u t i n e s e r v i c e s are c a l c u l a t e d and m u l t i p l i e d by the p r i c e s ' at which they are s o l d to the customer; P r i c e s appear to be uniform f o r a l l banks and are set accordi t o a long standing p r i c e agreement between a l l chartered banks (see page 70). The i n d i v i d u a l s interviewed d i d not know whether a p r o f i t mark-up was included in the p r i c e but suggested the p r i c e was probably below " c o s t " . P r i c e concessions may be granted f o r large volume accounts. This was a n e g o t i a t i o n item in three cases and an automatic a p p l i c a t i o n i n the other t h r e e . TABLE IV-I ANALYSIS OF DEMAND DEPOSIT ACCOUNT A.B.C. COMPANY LTD. Month of February 1973 WORK DONE Amount Charged 1 1. Deposits received and c r e d i t e d to the account $ No. at 20t each 2. Items deposited c l e a r e d to other banks or other branches ;.No. at 06<j each 3. Currency deposited $ at 95£ per $M k. Coin deposited $ at $1.80 per $C 5. Cheques issued and debited to the account No. at 20<2 each 6. 7. 8. T o t a l charge f o r work done $ Z. REVENUES COLLECTED Amount Due 2 10. S e r v i c e charges c o l l e c t e d $ 11 . 12. 13. T o t a l Revenue C o l l e c t e d j> 14. Revenue Surplus or D e f i c i t j i 'The Amount Charged is revenue due f o r work done in the p e r i o d , i . e . charges for the s e r v i c e s l i s t e d on l i n e s 1-5 are at the p r i c e charged  to the customer, not bank c o s t . Lines 6 , ,1,and 8 include other r o u t i n e s e r v i c e s of s u b s t a n t i a l volume, again at p r i c e not cost, e.g. stop payments t e l e g r a p h i c t r a n s f e r s . These l i n e s may a l s o include non-priced s e r v i c e s , e.g. d a i l y balance advice to the customer, which are charged at d i r e c t cost plus mark-up. 2The act u a l revenues c o l l e c t e d by the bank from p r o v i d i n g the se r v i c e s l i s t e d on l i n e s 1-8; thus l i n e \k depicts not p r o f i t or l o s s , but as s t a t e d - Revenue Surplus or D e f i c i t . TABLE IV-I (Cont'd)  AVERAGE DAILY AMOUNT IN FLOAT 15. T o t a l value of cheques debited' 16. T o t a l value of t r a n s f e r of customer funds 2 (remittances received from other branches) 17- Net value of items in f l o a t ( l i n e 15 minus 1ine 16) 18. Average d a i l y amount in f l o a t ^ ADDITIONAL BALANCES REQUIRED 19. Average d a i l y c r e d i t balance 20. Net average d a i l y balance a f t e r a l l o w i n g for average d a i l y amount in f l o a t ( l i n e 19 minus 1ine 18) 21. Average d a i l y balance in l i e u of revenue surplus or d e f i c i t from l i n e 14 22. A d d i t i o n a l average d a i l y c r e d i t balance required (or surplus) ADDITIONAL SERVICE CHARGES REQUIRED 23. Revenue surplus or d e f i c i t from l i n e 14 24. Value of net average d a i l y balance^ 25. A d d i t i o n a l monthly s e r v i c e charge required 'Debit f l o a t . 2 C r e d i t f l o a t . ^Reduction of the t o t a l monthly f l o a t ( l i n e 17) t o a d a i l y b a s i s . The f a c t o r was not provided. \ h e average d a i l y balance (debit or c r e d i t ) that y i e l d s the equivalent of the revenue surplus or d e f i c i t on l i n e 14 (see page 64). ^Value to the bank, in revenues, of the net average d a i l y balance on l i n e 20. (See page 63) 61 y i e l d i n g the revenues that should have been c o l l e c t e d by the bank during the a n a l y s i s month. This is i 1 l u s t r a t e d on l i n e s 1 - 5; the s e r v i c e s d e t a i l e d t h e r e i n are standard i n c l u s i o n s f o r a l l banks'. Lines 6, 7 and 8 are u t i l i z e d in the same manner as l i n e s 1 - 5 and include other r o u t i n e s e r v i c e s that reach " s u b s t a n t i a l volume". Services that may be included are u s u a l l y mail and t e l e g r a p h i c t r a n s f e r s , coin and currency s u p p l i e d , stop payments and c e r t i f i e d cheques 2. In a d d i t i o n to the p r i c e d s e r v i c e s included in l i n e s 6, 7 and 8, a d d i t i o n a l non-priced s e r v i c e i n c l u s i o n s may be made^. In these instances, p r i c e takes the form of d i r e c t cost plus mark-up " i f the account is demanding upon management time by way of requests, d i s c u s s i o n s and s p e c i a l s e r v i c e s Inclusions of t h i s nature are t o t a l l y s u b j e c t i v e and are included by means of a process With two exceptions, a l l banks provide f o r r o u t i n e s e r v i c e i n c l u s i o n s as i l l u s t r a t e d in Table IV-1. The exceptions are the o m i t t i n g of Deposits Received and Credited (Line 1) and Items Cleared (Line 2). The r a t i o n a l e provided f o r t h i s divergence from the norm was that d e p o s i t i n g costs should not be f o r the account of the depositor as they are a cost of gathering and maintaining deposit balances. They should, t h e r e f o r e , be a l l o c a t e d to that area - a cost of funds. One of the two banks that u t i l i z e s t h i s procedure is in the process of changing i t s philosophy and w i l l be i n c l u d i n g the two items mentioned above in i t s a n a l y s i s . 2 Two banks make e x p l i c i t p r o v i s i o n f o r these items; the other four include them on a s u b j e c t i v e basis only i . e . i f the account manager was of the opinion that the volume was s u b s t a n t i a l l y greater than would normally be expected f o r that type of account. ^e.g. d a i l y advice to the customer of his account balance. G a l b r a i t h , Canadian Banking, p.101. This was a l s o v e r i f i e d in i n terview d i s c u s s i o n s . i d e n t i c a l to that o u t l i n e d f o r p r i c e d s e r v i c e s of s u b s t a n t i a l volume (see page 61). The act u a l revenues received by the bank f o r the s e r v i c e s discussed above, are entered in l i n e s 10 - 13. These are r e l a t e d to the revenues due (Line 9) and revenue surplus or d e f i c i t is computed on l i n e 14. The usage of t h i s f i g u r e in computing the a c c e p t a b i l i t y , or otherwise, of the demand deposit account is discussed below a f t e r the a n a l y s i s of demand deposit balances is completed. 4.3.4.2 Balances Lines 15 - 18 compute the average d a i l y amount of f l o a t ' generated by the customer. The f l o a t f i g u r e is then subtracted from (added to) the average d a i l y c r e d i t balance in the account (Line 19) which r e s u l t s in the i n v e s t i b l e balance a v a i l a b l e to the bank 2. This is i n d i c a t e d on l i n e 20. 4.3.4.3 A d d i t i o n a l S e r v i c e Charges or Balances Required The banks c a l c u l a t e the a d d i t i o n a l remuneration due from the customer by two equivalent methods - a d d i t i o n a l s e r v i c e charges or  demand deposit balances required. The customer is given the a l t e r n a t i v e See page 13 where t h i s term is explained. A l l s i x banks u t i l i z e an average f l o a t f a c t o r f o r the m a j o r i t y of t h e i r commercial accounts. For high volume accounts, where the bank has reason to b e l i e v e the average f a c t o r to be inaccurate or where the bank is encountering n e g o t i a t i o n d i f f i c u l t i e s w i t h a customer, a f l o a t c o s t i n g study may be undertaken. One bank a u t o m a t i c a l l y conducts a f l o a t study i f the monthly d o l l a r throughput exceeds $1,000,000. Reserves are not provided f o r as a balance deduction; t h e r e f o r e , the i n v e s t i b l e balance is o v e r s t a t e d . See page 13 and footnote ] page 63. of paying the s e r v i c e charge requirement or d e p o s i t i n g a d d i t i o n a l demand balances. The s e r v i c e charge requirements f o r operating the account are computed as f o l l o w s : ( l ) the " i n v e s t i b l e " balance on l i n e 20 of the a n a l y s i s form is converted to i t s revenue equivalent to the bank (Line 2k). If the i n v e s t i b l e balance is c r e d i t , i t is converted at a ra t e based upon or r e l a t e d to the cost of short term funds'; i f d e b i t , i t is converted at the customer's borrowing rate , (2) t h i s revenue equivalent is then added t o , or subtracted from the revenue surplus or d e f i c i t (Lines ]k and 2 3 ) . The r e s u l t of t h i s process is the a d d i t i o n a l s e r v i c e charges required by the bank from the customer to operate the account, or the surplus revenues received (Line 2 5 ) . To i l l u s t r a t e the foregoing d i s c u s s i o n , the f o l l o w i n g s i t u a t i o n is assumed: ( l ) an i n v e s t i b l e balance of $1,000 (2) a revenue d e f i c i t of $4-5 per month and (3) a conversion rate of 3 per cent per A l l s i x banks i n d i c a t e d they u t i l i z e conversion rates below the i n t e r e s t cost of o b t a i n i n g short term funds. The conversion rates were not provided. The lower than market p r i c e v a l u a t i o n of the demand balances is a long standing p r a c t i c e , the reason f o r which is not c l e a r l y understood by the bankers. One apparent reason, however, is to provide f o r the reserve deduction to the " i n v e s t i b l e " balance on l i n e 20 i . e . the " i n v e s t i b l e " balance is not i n v e s t i b l e in that a deduction f o r cash reserves is not made, so the conversion rate is adjusted downwards to c o r r e c t l y r e f l e c t the value of the funds to the bank. Four banks change t h e i r rates " i n f r e q u e n t l y " i . e . rates do not change with market changes in the p r i c e of short term money. For the remaining two banks, one t i e d the conversion rate to the prime lending rate ( l e s s x%) w h i l e the other t i e d i t to a bank deposit instrument ( l e s s x % ) . 2 T h i s is a v a r i a b l e rate which changes as the customers borrowing rate changes e.g. the prime lending r a t e . annum. The corresponding l i n e s of the a n a l y s i s form are in d i c a t e d in parenthes i s . Revenue d e f i c i t (Line 23) $(45.00) per month Value of net balance a v a i l a b l e to bank (Line 24) 2.50 per month A d d i t i o n a l monthly s e r v i c e charge required (Line 25) $(42.50) per month The banks n e g o t i a t i o n g o a l , in t h i s case, would be to obtain an a d d i t i o n a l $42.50 per month from the customer. The equivalent demand deposit balance requirement is c a l c u l a t e d in a s i m i l a r manner. The revenue surplus or d e f i c i t on l i n e 14 of the a n a l y s i s form is converted to i t s demand balance e q u i v a l e n t 2 (Line 21) i . e . what balance is required to y i e l d the r e s u l t i n d i c a t e d on l i n e 14. This equivalent balance is then added t o , or subtracted from, the i n v e s t i b l e balance (Line 20) r e s u l t i n g in the a d d i t i o n a l d a i l y c r e d i t balance to be maintained by the customer, or the surplus (Line 22). U t i l i z i n g the data provided above, c a l c u l a t i o n of a d d i t i o n a l demand deposit balance requirements would be made as f o l l o w s : -Net balance a v a i l a b l e to bank $ 1,000 (Line 20) Average d a i l y balance in l i e u of revenue d e f i c i t ( L ine 21) ( l 8 , 0 0 0 ) 3 A d d i t i o n a l average d a i l y c r e d i t balance required (Line 22) $(17,000) '$1,000 at 3 per cent per annum is equivalent to $2.50 per month. 2 Four banks convert revenue surplussesrand^'deficits to equivalent demand deposit balances at the short term cost of money rate discussed above. The remaining two banks convert revenue surplusses at that r a t e , but convert revenue d e f i c i t s at the customers borrowing r a t e . ^$18,000 at 3 per cent is equivalent to $45 per month in revenues. The banks negotiation goal, in this case would be the deposit of an additional $17,000; the equivalent of, and alternative to, the additional service charge goal of $42.50 per month. 4.3-5 Modification of Analysis Result by Other Service Areas of the Customer Relationship' With one exception, specific instructions to account managers regarding the data that should be collected from other areas of the 2 customer relationship do not exist . The remaining banks, however, have an unwritten practice as follows: the greater the volume of business in the other areas of the relationship and/or the greater the possibility of encountering negotiation d i f f i c u l t i e s , the greater the data detail that will be collected. In the extreme case - a large volume of other business and negotiation problems are expected - the data to be collected would take the following form: (l) deposit balances at interest as at the date of completion of the demand deposit analysis; (2) loan revenues for the past month or year and (3) brief comments on other financial services. These comments may range from an indication of 3 volumes to detailing revenues received over the past month or year . The situation of a service charge or balance deficit is assumed. In the case of a customer that has an analysis result of zero to a "small" excess, the bank will do nothing as it is satisfied with account performance. At some subjective level this "small" excess becomes "large", at which point the bank might approach the customer with a view to reducing service charges or suggesting that some portion of the balance be transferred to time deposits. 9 The instructions for this one exception are the same as for the unwritten practice discussed above. ^All data are gross i.e. in no case are both costs and revenues obtained to ascertain net income. This data does not a l t e r the banks o b j e c t i v e f o r the demand deposit account i . e . in the h y p o t h e t i c a l a n a l y s i s o u t l i n e d on pp. 63-65, the o b j e c t i v e was e i t h e r $42.50 per month in a d d i t i o n a l revenues or $17,000 in a d d i t i o n a l demand balances. I r r e s p e c t i v e of the v a l u e 1  of other business t h i s o b j e c t i v e does not change. The n e g o t i a t i o n approach, however, may be modified in keeping with the "value" of other business as customers are prone to b r i n g t h i s into demand deposit  account n e g o t i a t i o n s ; hence, the reason f o r the banks c o l l e c t i n g the data i n d i c a t e d above. The customer w i t h very l i t t l e other business presents no problem f o r the bank - the a n a l y s i s o b j e c t i v e must be met w i t h i n a reasonable p e r i o d of time ( u s u a l l y one year) otherwise the bank no longer wishes the account. The customer with a great deal of other business, which has "high v a l u e " to the bank, presents an e n t i r e l y d i f f e r e n t s i t u a t i o n . This is a s i t u a t i o n where the bank, i f i t t o t a l l y adhered to i t s s e r v i c e area philosophy, could lose not the demand deposit account but the t o t a l customer r e l a t i o n s h i p 2 . In such s i t u a t i o n s the banks negotiate c a u t i o u s l y and i f there is l i t t l e customer r e s i s t a n c e they w i l l push for the a n a l y s i s o b j e c t i v e being met w i t h i n the year; however, i f customer pressure is strong, the banks are prepared to negotiate over a p e r i o d of years, or even to a f i g u r e less than that i n d i c a t e d by the a n a l y s i s . A bank term f o r a subject ive e v a l u a t i o n of the p r o f i t a b i l i t y of other areas of the r e l a t i o n s h i p . 2See page 20. What is v i v i d l y i l l u s t r a t e d in the above is the banks' acute awareness of a t o t a l customer r e l a t i o n s h i p and the performance of a crude and elementary defensive t o t a l customer r e l a t i o n s h i p a n a l y s i s . This is i l l u s t r a t e d in both cases - a strong n e g o t i a t i o n approach on the customer w i t h very l i t t l e other business, as the bank knows i t can only lose l i t t l e more than the demand deposit account, and a weak approach on the " v a l u a b l e " customer as the bank knows i t may lose much more than the demand deposit account. A very serious weakness in the foregoing is the manner in which the banks c a l c u l a t e "value". T h e i r v a l u a t i o n concept equates customer s i z e ' w i t h his p r o f i t a b i l i t y . This is a dangerous assumption, as opinions on customer p r o f i t a b i l i t y are an e n t i r e l y unsound basis upon which to base p r i c i n g and n e g o t i a t i o n d e c i s i o n s - as the P h i l a d e l p h i a National Bank discovered:-"When the p r o f i t formula f j p r o f i t a b i 1 i t y a n a l y s i s ] ] is a p p l i e d to the commercial loans [[relationships]] in a bank, i t provides s u r p r i s i n g r e s u l t s . Many customers formerly thought (my underline) to be h i g h l y p r o f i t a b l e w i l l show d i s a p p o i n t i n g index f i g u r e s £ pr o f its]] while many other customers thought to be marginal producers w i l l show very good r e s u l t s . " 2 k.k The Credit Analys is The c r e d i t a n a l y s i s , part and p a r c e l of the lending f u n c t i o n , Data c o l l e c t e d from other s e r v i c e areas to supplement the demand deposit a n a l y s i s i n d i c a t e s volume, ba1ances and revenues i . e . i t is gross not net data. As such i t i n d i c a t e s the s i z e of the customer. P h i l a d e l p h i a National Bank, P r o f i t a b i l i t y A n a l y s i s , page 3 2 . 68 c o n s i s t s of an a n a l y s i s of the customer's f i n a n c i a l statements to determine the f i n a n c i a l adequacy of that customer to undertake and s e r v i c e the borrowings he has a p p l i e d f o r . It a l s o includes c o n s i d e r a t i o n of other f a c t o r s such as: ( l ) the adequacy of c o l l a t e r a l provided; (2) the character of the borrower; (3) "loose or t i g h t " money c o n d i t i o n s ; (k) the purpose of the loan and the industry in which the customer is involved, and (5) competitive f a c t o r s . Consideration and a n a l y s i s of these and other f a c t o r s determine whether or not the bank w i l l agree to the customers request; plus the i n t e r e s t rate to be negotiated upon. This i n t e r e s t r a t e , as was f u l l y discussed on page 8, w i l l normally be set in r e l a t i o n to the prime lending r a t e ; i t s l e v e l being dependent upon the amount of perceived r i s k in the advance. As has already been i n d i c a t e d , the d e t a i l s of the c r e d i t a n a l y s i s are not a s p e c i f i c c o n s i d e r a t i o n of the study; what is important, however, is the i n t e r r e l a t i o n s h i p of other s e r v i c e areas in the customer r e l a t i o n s h i p w i t h the c r e d i t based i n t e r e s t r a t e . k.h.] M o d i f i c a t i o n of the C r e d i t Based Interest Rate by Other S e r v i c e Areas of the Customer R e l a t i o n s h i p The c r e d i t a n a l y s i s is supplemented in a manner s i m i l a r to that of the demand deposit a n a l y s i s . Supplements are: ( l ) a recent demand deposit a n a l y s i s ; (2) time deposit balances, i f of importance, and (3) gross revenues or volume d e t a i l s on other f i n a n c i a l s e r v i c e s , again, i f of importance. This information is not normally u t i l i z e d 69 to modify the c r e d i t based i n t e r e s t r a t e , but merely to gain a broader view of the account. Interest rate m o d i f i c a t i o n may occur only: ( l ) under extreme customer pressure to consider other areas of h i s r e l a t i o n s h i p and only i f these other areas are "extremely p r o f i t a b l e " ' to the bank, or (2) i f the customer is not "paying his way" in the rest of the r e l a t i o n s h i p and attempts by the bank to remedy the s i t u a t i o n have not been s u c c e s s f u l . A l l of the banks interviewed s t a t e d t h a t , w i t h minor exception: ( l ) the customer does not bring into c r e d i t n e g o t i a t i o n s other aspects of the r e l a t i o n s h i p , and (2) i n t e r e s t r a t e m o d i f i c a t i o n s are a very infrequent occurrence. Thus, for p r i c i n g and n e g o t i a t i o n decisions in the lending area of Canadian banking c o n s i d e r a t i o n of the t o t a l r e l a t i o n s h i p is almost non-existent . k.k.2 R i s k Adjustment of the Interest Rate A l l Canadian bankers that were interviewed s t r o n g l y s t a t e d that they could p r o p e r l y evaluate r i s k on any p a r t i c u l a r loan and 3 make an appropriate r i s k . adjustment to the prime lending rate . However, a prominent United States bank has s t a t e d : -"Most of us say we adjust i n t e r e s t rates according to r i s k , but cons i d e r i n g the wide q u a l i t y range of customers borrowing at prime, there i s serious doubt we are being p a i d for many of the r i s k s we are assuming."^ See pages 66-67. 2 A p o s s i b l e reason f o r the sharp separation of the loan account from the t o t a l r e l a t i o n s h i p is o u t l i n e d in Chapter V (see pp.81-82). 3 As p r e v i o u s l y s t a t e d , no attempt was made to determine i f the Canadian banks are r i s k averse or merely equate expected r e t u r n s . ^Dyer and H e i l s h o r n , P r o f i t Analys i s , page k7 ( F i r s t National C i t y Bank) . This statement i n f e r s to the w r i t e r t h a t , contrary to the remarks made by Canadian bankers, the Canadian banks may not have the e x p e r t i s e they thought they possessed. If so, the r i s k adjusted c a p i t a l a l l o c a t i o n process discussed in Chapter III may merit t h e i r study. k.S Other F i n a n c i a l Services As i l l u s t r a t e d on pages \h to 16 t h i s area of a customer r e l a t i o n s h i p c o n s i s t s of: ( l ) Canadian d o l l a r time d e p o s i t s ; (2) f o r e i g n currency loans and d e p o s i t s ; (3) other f o r e i g n exchange business of an a c t i v i t y nature e.g. d r a f t s , money orders, and cheques and deposits a s s o c i a t e d w i t h a f o r e i g n currency demand account, and (4) s p e c i a l s e r v i c e s e.g. d r a f t s , safekeeping and night depository f a c i 1 i t i e s . With the exception of the c r e d i t a n a l y s i s on f o r e i g n currency loans, analyses of t h i s area of a customer r e l a t i o n s h i p are not performed. Categories three and four, however - Other Foreign Exchange Business and S p e c i a l Services - present an i n t e r e s t i n g s i t u a t i o n as there has been a long standing p r i c e agreement between a l l chartered banks on the minimum charges that w i l l be a p p l i e d in compensation f o r these s e r v i c e s ' . The agreement appears to cover a l l a c t i v i t y areas of a customer r e l a t i o n s h i p ( i n c l u d i n g r o u t i n e s e r v i c e s ) w i t h the exception of s e r v i c e s p e c u l i a r to any one i n d i v i d u a l bank e.g. computerized corporate s e r v i c e s . 'The banks are not covered by the Combines I n v e s t i g a t i o n Act and p r i c e agreements are p r o h i b i t e d only on the rate of i n t e r e s t on advances or d e p o s i t s . This was introduced into the Bank Act of 1967; s e c t i o n I38. 71 . 4.5.1 P r i c e M o d i f i c a t i o n s by Other S e r v i c e Areas of the Customer R e l a t i o n s h i p For categories one and two - time deposits and f o r e i g n currency loans - the m o d i f i c a t i o n l i n k was extremely weak and q u i t e d e f i n i t e l y less so than that discussed in the c r e d i t s e c t i o n on page 68. Rates are set by the i n t e r p l a y of market forces and only in very rare circumstances', p a r t i c u l a r l y in i n t e r n a t i o n a l business, would c o n s i d e r a t i o n be given to paying a m a r g i n a l l y s u p e r i o r deposit rate or charging a m a r g i n a l l y lower lending r a t e . Foreign exchange a c t i v i t y business and s p e c i a l s e r v i c e s , however, present an e n t i r e l y d i f f e r e n t case. It has already been pointed out that there is a long standing p r i c e agreement between banks on t h i s aspect of t h e i r business. The research conducted f o r t h i s study i n d i c a t e s t h a t , u n t i l r e c e n t l y , agreement p r i c e s were being charged and s t r i c t l y adhered t o . However, i t would appear that the agreement is in the process of breaking down in the area of inter-bank competition f o r large " p r o f i t a b l e " customers, as agreement p r i c e s are being shaded or dropped in order to a t t r a c t or r e t a i n the t o t a l business of these customers^. T h i s is a f u r t h e r i n d i c a t i o n of the e x i s t e n c e of a crude and elementary customer r e l a t i o n s h i p in Canadian bank account a n a l y s i s procedures. What the banks are doing, in e f f e c t , is s u b j e c t i v e l y v a l u i n g the t o t a l r e l a t i o n s h i p and based Ci t e d were very large and prestigous customers. 2Three banks i n d i c a t e d that they are prepared to shade or drop agreement p r i c e s in the circumstances o u t l i n e d ; while the remaining three s t a t e d that the p r i c e s were s t r i c t l y adhered to in a l l circumstances. upon that valuation are prepared to lose revenues in one service area in order to make an overall gain i.e. gain a customer from a competitor or retain a customer who has been approached by a competitor. Again, valuation or profit as used here is the banks' subjective interpretation of what is a profitable customer!. 4.6 Trends and Views toward Pr o f i t a b i l i t y Analysis The interviews conducted for this study indicated that customer pressure on banks to consider other aspects of the customer relationship while negotiating on the demand deposit account is strong and increasing 2. Furthermore, a l l banks agreed that the data collected on the total relationship for demand deposit account negotiations was insufficient upon which to base a sound decision, especially when negotiating with a "high value" customer. The banks also agreed that the manner in which they based decisions to shade or drop special service prices was entirely subjective and required substantial improvement. Given the analysis procedures of the Canadian banks and the problems that they are currently experiencing, each bank was asked their opinion of the p r o f i t a b i l i t y analysis model. In concept, a l l banks were receptive to the p r o f i t a b i l i t y analysis approach in that The subjectivity of this valuation process was criticized on page 67 for the demand deposit account. The statements made there apply equally as well here. ^There is no indication of like trends in loan interest rate negotiations. As was stated on page 69, "... for pricing and negotiating decisions in the lending area of Canadian banking consideration of the total relationship is almost non-existent." i t would s u b s t a n t i a l l y improve t h e i r knowledge of customers in both p h y s i c a l 1 and p r o f i t ( l o s s ) terms and, thus, the o b j e c t i v i t y of t h e i r 2 d e c i s i o n making . In p a r t i c u l a r , they were of the op i n i o n i t would s o l v e t h e i r current problems. While agreeing in concept and looking to development of t h e i r commercial account a n a l y s i s procedures in the d i r e c t i o n of the p r o f i t a b i l i t y a n a l y s i s model, they d i d not foresee any s i g n i f i c a n t advances in t h i s d i r e c t i o n u n t i l a higher degree of computerization was achieved i . e . data c o l l e c t i o n was the major problem and f u r t h e r development of t h e i r computer f a c i l i t i e s would be required to e f f e c t i v e l y and e f f i c i e n t l y perform a p r o f i t a b i l i a n a l y s i s 3 . Nevertheless, two banks have r e c e n t l y taken steps of an experimental nature to improve t h e i r a n a l y s i s and n e g o t i a t i o n procedures. The l a t t e r is a d i s t i n c t step towards the performance of a p r o f i t a b i l i t y a n a l y s i s . 4.6.1. B a n k ] This bank u t i l i z e s a standard a n a l y s i s format which d i f f e r s very l i t t l e from an amalgamation of the demand deposit account a n a l y s i and the information that is appended on other aspects of the customer e.g. volume and range of s e r v i c e s u t i l i z e d . 2 T h i s a p p l i e s only to the demand deposit account and other f i n a n c i a l s e r v i c e s . No a t t r i b u t e was accorded the model for improving loan p r i c i n g . 3The reasons why the p r o f i t a b i l i t y a n a l y s i s system developed in the United S t a t e s , rather than Canada, are explained in Chapter V. relationship. It consists of the following:-1. A demand deposit analysis, as previously described, but including a float costing study rather than the application of a standard float factor. 2. A detailed analysis of all fund, transfers' . 3. Special service revenues for the past year or month, if. A list of all services utilized. As can be seen, the procedure introduces no new concepts or ideas to the analysis process, apart from a formalization of the collection of certain data which was before appended to the demand deposit analysis plus a float costing study. if.6.2 Bank 22 In contrast to Bank 1, the approach of this bank to account analysis does introduce new concepts and procedures to Canadian account analysis procedures and is akin to the profitability analysis models of the United States banks. It was introduced only "very recently" due to "the incomplete knowledge of the total relationship  in both physical and profit and loss terms" and "the inadequate  preparation for negotiations with the customer supplied by the  conventional methods of analysis". The procedure is "very limited in operation and utilized where the need presents itself for a more detailed understanding of the account and only on the largest customers of the bank". It is "very crude and unsophisticated" and in this To assist the customer in his money management. 2Q.uotes are statements made by the bank officers interviewed. As previously stated (see page 52) anonymity is preserved. context c o n s i s t s of the gathering of a l l costs and revenues from the e n t i r e r e l a t i o n s h i p , i n c l u d i n g loan revenues and c o s t s ; however, is u t i l i z e d f o r p r i c i n g and n e g o t i a t i n g on non-loan s e r v i c e s o n l y . Bank 2 would not discuss t h e i r methodology f u r t h e r than what has been o u t l i n e d above. They d i d add, however, that the procedure has s u b s t a n t i a l l y improved the o b j e c t i v i t y of t h e i r d e c i s i o n making and that they were looking to f u r t h e r development of the system in the d i r e c t i o n of the p r o f i t a b i l i t y a n a l y s i s models of the United States banks. 4.7 Summary This chapter presented the commercial account a n a l y s i s procedures of the Canadian chartered banks. The major features are summarized below:-1. The Canadian banks e s s e n t i a l l y view t h e i r customers as c o n s i s t i n g of three separate s e r v i c e areas i . e . the loan, the demand deposit account and other f i n a n c i a l s e r v i c e s . 2. In no instance do the banks know the p r o f i t on i n d i v i d u a l customers, e i t h e r by s e r v i c e area or over the t o t a l r e l a t ionship. 3- The loan is analysed in i s o l a t i o n of the remainder of the customer r e l a t i o n s h i p and the i n t e r e s t rate is set on that b a s i s . It is an infrequent occurrence f o r a customer to bring other aspects of h i s r e l a t i o n s h i p with the bank into n e g o t i a t i o n s on the i n t e r e s t r a t e ' . The reason f o r t h i s c l e a r separation of the c r e d i t from the customer r e l a t i o n s h i p is explored on page 81 "Compensating Loan Balances". The banks would l i k e to f o l l o w a s i m i l a r i s o l a t i o n procedure f o r the demand deposit account; however, t h i s approach is not always accepted by customers who fr e q u e n t l y and s u c c e s s f u l l y bring other aspects of the customer r e l a t i o n s h i p i n t o demand deposit account n e g o t i a t i o n s . It was noted that the banks perform an elementary defensive t o t a l customer r e l a t i o n s h i p a n a l y s i s f o r demand deposit account n e g o t i a t i o n s . C r i t i c i s m was d i r e c t e d towards the s u b j e c t i v i t y of t o t a l r e l a t i o n s h i p v a l u a t i o n in demand deposit n e g o t i a t i o n s and in shading and dropping p r i c e s on other f i n a n c i a l s e r v i c e s . A l l banks agreed that d e c i s i o n s were s u b j e c t i v e l y based and that improvement was req u i r e d . To t h i s end two banks have r e c e n t l y introduced new procedures on an experimental b a s i s , one of which is a c l e a r movement in the d i r e c t i o n of a p r o f i t a b i l i t y a n a l y s i s . A l l banks agreed in concept with the p r o f i t a b i l i t y a n a l y s i s model and were of the opinion i t would improve the o b j e c t i v i t y of t h e i r d e c i s i o n making (except loan p r i c i n g - see page 73); however, they d i d not foresee any s i g n i f i c a n t advances in t h i s area u n t i l a higher degree of computerization was achieved. CHAPTER V UNITED STATES AND CANADIAN BANKS' COMMERCIAL ACCOUNT ANALYSIS PROCEDURES A COMPARISON AND SUMMARY Chapters III and IV o u t l i n e d the commercial account a n a l y s i s procedures of s e l e c t e d United States and Canadian banks r e s p e c t i v e l y . With regard to the former, the advantages of a t o t a l customer r e l a t i o n s h i p a n a l y s i s ( p r o f i t a b i l i t y a n a l y s i s ) were discussed in some depth. This chapter commences by summarizing the e s s e n t i a l d i f f e r e n c e s between the two sets of procedures with d i s c u s s i o n subsequently t u r n i n g to the reasons why these d i f f e r e n c e s may e x i s t . The l i m i t a t i o n s of Canadian procedures, with regard to the strengths of the p r o f i t a b i l i t y a n a l y s i s model, are then presented. The chapter closes w i t h study conclusions and suggestions for future research. 5.1 Procedural Dif f e r e n c e s The major d i f f e r e n c e s between the United States and Canadian banks' commercial account a n a l y s i s procedures may be summarized as f o l l o w s : - 1 5.1.1 Philosophy The Canadian banks view t h e i r customers as e s s e n t i a l l y The r e c e n t l y introduced procedures of the two banks discussed on pages 73 to 75 are not included here as they are of an experimental nature and t h e r e f o r e do not represent the normal analyses procedures of Canadian banks. 78 consisting of three separate service areas, i.e. the lending function, the demand deposit account, and other financial services. The selected United States banks', on the other hand, view their customers not as utilizers of three separate services but as utilizers of a package of bank services made up of the loan, the demand deposit account and other financial services - the customer relationship . 5.1.2 Analyses Conducted Following from their basic philosophies on customers, the United States banks systematically account for all aspects of the customer relationship in one analysis. The Canadian banks conduct separate credit and demand deposit account analyses, while the other financial services area is not analysed^. 5.1.3 Analyses Results The procedures employed by the United States banks result in the profit generated by a customer relationship and the profit a bank wishes to earn on that relationship. For the Canadian banks, neither profit nor a profit goal is known either by service area or over the total relationship. Indeed, an amalgamation of the data It should be kept in mind that comments on the commercial account analysis procedures of United States banks are not generalizations, but specific references to selected banks. As argued in Chapter II, the "correct" method of approaching the analysis of a commercial customer is on a total relationship basis, not by separate service areas. ^See footnote 2 above. generated by the Canadian banks from the three s e r v i c e areas does not even approach a p r o f i t p i c t u r e f o r the i n d i v i d u a l customer: ( l ) f or the loan account, gross revenues only are known. No attempt is made to a s c e r t a i n the cost of the i n d i v i d u a l l o a n 1 ; (2) for the demand  depos i t account, r o u t i n e s e r v i c e p r i c e s are u t i l i z e d rather than c o s t s , cash reserve deductions are not made from account balances and balances are undervalued 2; (3) f o r other f i n a n c i a l s e r v i c e s , again there is no cost data and gross revenues on s p e c i a l s e r v i c e s and f o r e i g n currency loans may be computed. In a d d i t i o n , deposit account balances, ( i f held) are not v a l u e d 3 . In short there are con s i d e r a b l e d i f f e r e n c e s between an amalgamation of the loan, demand deposit account and other f i n a n c i a l s e r v i c e s , and a p r o f i t a b i l i t y a n a l y s i s . However, there are a l s o s i m i l a r i t i e s . From a pure data c o l l e c t i o n standpoint, the demand deposit a n a l y s i s is the heart of a p r o f i t a b i l i t y a n a l y s i s (see page 51). Further, i t would be but a small step f o r the Canadian banks in t h e i r demand deposit account a n a l y s i s t o : ( l ) f a c t o r in rou t i n e s e r v i c e costs in pla c e of p r i c e s ; (2) include cash reserves as a deduction from account balances, and (3) change t h e i r balance v a l u a t i procedure. By doing t h i s they would achieve, w i t h small e f f o r t , a large step in the d i r e c t i o n of performing a p r o f i t a b i l i t y a n a l y s i s . Thus, the d i f f e r e n c e s discussed above are not as great as they f i r s t seemed. See page 65. See pp. 58, 62 (footnote 2 ) , and 63 (footnote 1). 3See page 65. 5.1.4 Service Area Overlaps and Negotiations with Customers For the United States banks' procedures, a l l service areas overlap in the sense that a l l are included in the profit computation. In negotiations, it cannot be said that the bank is indifferent to the manner of compensation as it will centre its attention on revenue delinquent or overly profitable service areas. However, the banks can and do provide customers with revenue alternatives should they or the bank desire this, or if customers are known to be averse to certain forms of compensation'. For Canadian bank procedures, each service area is analysed in isolation and there are no overlaps. In negotiations, the interest rate on the loan is normally negotiated on the basis of the credit analysis alone. While the bank wishes to u t i l i z e the same procedure for the demand deposit account it was noted, in the event that other service areas of the relationship are brought to bear by the customer, the bank does consider the total relationship in negotiations. It was also noted that the other financial services area might have prices shaded or dropped by the bank by virtue of the "value" of other bus i ness. See page 4-5. 5.2 Reasons f o r Procedural D i f f e r e n c e s Four p o s s i b l e reasons can be combined to e x p l a i n the d i f f e r e n t approaches to the a n a l y s i s of commercial customers by United States and Canadian banks. These are: ( l ) extensive use of compensating loan balance requirements in the United S t a t e s ; (2) a higher degree of computerization in the United S t a t e s ; (3) d i f f e r e n t banking system s t r u c t u r e s , and (k) the r e l a t i v e l y recent innovation of p r o f i t a b i l i t y a n a l y s i s . 5.2.1 Compensating Loan Balances' The use of compensating loan balances creates a d i r e c t l i n k between the c r e d i t and other s e r v i c e areas in a customer r e l a t i o n s h i p . T h i s , in i t s e l f , may n e c e s s i t a t e the performance of a t o t a l r e l a t i o n s h i p a n a l y s i s rather than separate s e r v i c e area analyses. For instance, in n e g o t i a t i n g a loan the bank may request compensating demand deposit balances; thus, the loan is l i n k e d to the demand deposit account. In t u r n , the c r e a t i o n of, or increase in the demand deposit account balance implies the issuance of cheques and the d e p o s i t i n g of funds, i . e . the normal a c t i v i t i e s a s s o c i a t e d w i t h a demand deposit account. Thus, demand deposit account a c t i v i t y is l i n k e d to the loan. A s i t u a t i o n such as t h i s implies an a n a l y s i s that includes at le a s t the loan and the demand deposit account with i t s a s s o c i a t e d a c t i v i t i e s . See page 9, where t h i s term is f u l l y e xplained. 82 It was seen in the analysis procedures of the Canadian chartered banks that loan terms were negotiated in almost total isolation of the remainder of the customer relationship, while in the United States the loan analysis was an integral part of the total customer analysis. As compensating loan balances are, for all practical purposes, almost non-existent in Canada while extensive use is made of the technique in the United States', it is entirely possible that this is the major reason for the procedural differences between the two banking systems. 5.2.2 Computerization Due to the amount of data to be collected for the performance of a profitability analysis, a computerized system is preferable to a manual system from both a time and cost standpoint. The United States banks, by and large, computerized their operations at an earlier date than their Canadian counterparts and at the present time a number have achieved computerization of all bank services 2. No bank in Canada has achieved such a level of computerization and most are basically restricted to a computerized demand deposit accounting system. As total computerization allows the rapid performance of a customer relationship analysis, while a manual preparation is relatively costly and time consuming, this may well be one further reason why See page 9. 2See, for example: Else, Account Profitability (First National City Bank) . p r o f i t a b i l i t y a n a l y s i s has not, as yet, been adopted by Canadian banks'. 5.2.3 Banking System D i f f e r e n c e s and The Competitive Environment Canada and the United States possess two r e l a t i v e l y d i f f e r e n t banking systems - branch banking in Canada and u n i t banking in the United States . The u n i t banking system of the United States w i l l be one reason why computerization developed e a r l i e r and f a s t e r than in Canada - the complexity and cost of converting a u n i t bank, or one with a few branches r e l a t i v e to a Canadian bank, w i l l be l e s s . However, the major p o i n t to be made is that the United States system, by v i r t u e of i t s overwhelmingly greater number of banks (see footnote 2 below), is r e l a t i v e l y more competitive than Canada's. Simply s t a t e d , the e x i s t e n c e of a more competitive banking system is more l i k e l y to f o s t e r innovation than a less competitive banking system. It is in t h i s statement that another reason f o r the account a n a l y s i s procedure To f u r t h e r s u b s t a n t i a t e t h i s p o i n t , i t was st a t e d on page 72 that the Canadian banks were s e l f - c r i t i c a l of the manner in which they based d e c i s i o n s on the "value" of a customer. It was a l s o s t a t e d by the banks that a s u b s t a n t i a l improvement in data c o l l e c t i o n was necessary to improve the o b j e c t i v i t y of t h e i r d e c i s i o n making, but a l i m i t i n g f a c t o r was the current l e v e l of t h e i r computerization. 2 The s i t u a t i o n i s r e l a t i v e , not absolute. While there are many banks in the United States without branches there are a l s o many banks with branches, e.g. the P.N.B. and F i r s t National C i t y Bank have been discussed in t h i s study; the former has 15 branches and the l a t t e r 204, World Bank D i r e c t o r y ( N a s h v i l l e , Tennessee: R.L. P o l k and Co.; March, 1972). There are, however, only ten banks in Canada, w h i l e there are in excess of t h i r t e e n thousand in the United S t a t e s . differences may be found. 5.2.4 A New System The profitability analysis system is a relatively recent innovation of the United States banking system (P.N.B. 19&5). As such, sufficient t.ime.has not lapsed for the procedure to be widely utilized by United States banks, far less adopted by the Canadian banking system. 5-3. Canadian Bank Procedure Strengths and Weaknesses Relat ive to the  Profitability Analysis Model 5.3.1 Procedure Strengths The profitability analysis model involves the collection and compilation of a considerable volume of data, with the resultant necessity for a sophisticated cost accounting and data generation system. Canadian procedures, on the other hand, involve the collection of relatively 1 ittle data due to the simplicity of their account analysis procedures. Ease of performance, therefore, is a "strength", and the only strength, accorded the commercial account analysis procedures of the Canadian chartered banks. 5.3-2 Procedure Weaknesses It was argued in Chapter II, and illustrated in that Chapter and Chapter III, that the "correct" manner of commercial account analysis is profit computation over the total relationship. The major reasons presented f o r t h i s stance were: 1. The three s e r v i c e areas of banking are not separated but are l i n k e d in varying degrees by q u a n t i t a t i v e and q u a l i t a t i v e f a c t o r s . 2. P r o f i t or loss knowledge over the t o t a l r e l a t i o n s h i p is a necessary basis to o b j e c t i v e p r i c i n g and n e g o t i a t i o n dec is ions. 3. For a l l commercial customers, p r o f i t or loss knowledge provides v a l u a b l e information to the bank for marketing d i r e c t i o n , based on the r e l a t i v e p r o f i t a b i l i t y of various classes of customers. A t o t a l r e l a t i o n s h i p a n a l y s i s and p r o f i t knowledge are not features of Canadian procedures, thus, f o l l o w i n g from the above, these  are the major c r i t i c i s m s r a i s e d on the commercial account a n a l y s i s  procedures of Canadian chartered banks'. The reasons f o r the Canadian banks non-usage of a p r o f i t a b i l i t y a n a l y s i s system were explored e a r l i e r in t h i s chapter. Thus, the remaining question must be whether or not they could now adopt and reap the b e n e f i t s from the procedure at i t s present stage of development. Many i n d i v i d u a l and s p e c i f i c c r i t i c i s m s could be r a i s e d , but each is r e l a t e d t o , or included in the lack of p r o f i t knowledge c r i t i c i s m , e.g. ( l ) the t o t a l r e l a t i o n s h i p should be analysed and negotiated upon at one time and not in a segmented manner by s e r v i c e area (see page 54); (2) ro u t i n e s e r v i c e s should be costed into the demand deposit a n a l y s i s at cost, not p r i c e (see page 58); (3) cash reserves should be deducted from the demand deposit account balance p r i o r to i t s v a l u a t i o n (see page 62); (4) "proper" v a l u a t i o n rates should be a p p l i e d to the demand deposit account balance (see page 63); (5) loan costs should be known (see page 65); (6) other f i n a n c i a l s e r v i c e s costs and revenues should be known (see page 65). 5.4 Conclusions and Suggestions f o r Future Research 86 Given the b e n e f i t s accorded by the p r o f i t a b i l i t y a n a l y s i s model' and, more s p e c i f i c a l l y , the current s u b j e c t i v e v a l u a t i o n d e c i s i o n s that the Canadian banks are making in the demand deposit account and other f i n a n c i a l s e r v i c e s areas, i t is concluded that they could b e n e f i t from adoption of a p r o f i t a b i l i t y a n a l y s i s system in p l a c e of t h e i r current procedures. The b e n e f i t s accorded would be f u r t h e r enhanced i f research were conducted into the p o t e n t i a l problem areas of the p r o f i t a b i l i t y a n a l y s i s model o u t l i n e d in Chapter I I I 2 . Acceptance and implementation of a p r o f i t a b i l i t y a n a l y s i s system are not considered to be major o b s t a c l e s ^ , as: (1) from a See Chapter III pp.43-4-7 where an extended d i s c u s s i o n is presented on the strengths of the p r o f i t a b i l i t y a n a l y s i s model. 2 See Chapter I I I , pp.40-43. As regards c a p i t a l a l l o c a t i o n p o s s i b l y being a d u p l i c a t i o n of r i s k adjustment, i t is pointed out that major United States banks have used the c a p i t a l a l l o c a t i o n technique for a number of years, e.g. P h i l a d e l p h i a National Bank, Bank of America, F i r s t National C i t y Bank and S e a t t l e F i r s t National Bank. A t t e n t i o n is a l s o drawn to pp.69-70 - R i s k Adjustment of the Interest Rate. A p o s s i b l e a l t e r n a t i v e to c a p i t a l a l l o c a t i o n , which is a l s o used in p r a c t i c e , is i n c l u s i o n of c r e d i t r i s k as an expense. See, Falkenberg: P r o f i t a b i l i t y A n a l y s i s , Parts I and I I . This a r t i c l e a l s o presents arguments against the c a p i t a l a l l o c a t i o n process. As regards d u p l i c a t i o n of income, expense and c a p i t a l a l l o c a t i o n s see, P h i l a d e l p h i a National Bank, P r o f i t a b i l i t y A n a l y s i s , Chapter X I I , where the P h i l a d e l p h i a National Bank defend t h i s d u p l i c a t i o n . J\t is assumed that the Canadian banks possess a cost accounting system capable of supporting p r o f i t a b i l i t y a n a l y s i s . As one bank is performing p r o f i t a b i l i t y a n a l y s i s on an experimental basis (see page 74), i t would appear that the e x p e r t i s e e x i s t s . Cost accounting was not discussed in the t h e s i s (see page 4 ) . It is obvious, however, that a s o p h i s t i c a t e d system i s r e q u i r e d . conceptua1 viewpoint the procedure is already p a r t i a l l y accepted , and (2) from a data c o l l e c t ion standpoint, the procedure is w e l l under way as the demand deposit account a n a l y s i s provides a large p o r t i o n of the required data . While the p r o f i t a b i l i t y a n a l y s i s procedure can be performed manually (see page 74), a needed basis to e f f i c i e n t performance is a higher degree of computerization than that c u r r e n t l y possessed by the Canadian banks. As t h i s aspect of Canadian banking operations is f a s t p r o gressing, the e f f i c i e n t performance of p r o f i t a b i l i t y a n a l y s i s should s h o r t l y be p r o c e d u r a l l y p o s s i b l e . Should the Canadian banks decide to move f u r t h e r in the d i r e c t i o n of p r o f i t a b i l i t y a n a l y s i s , there is no reason to b e l i e v e that t h e i r experience w i l l be any d i f f e r e n t from that of the United States banks. To the extent that the a n a l y s i s is l o g i c a l and complete, greater customer knowledge, improved n e g o t i a t i o n s t r e n g t h , greater o b j e c t i v i t y and f l e x i b i l i t y of p r i c i n g d e c i s i o n s and improved marketing knowledge w i l l r e s u l t . Each of these w i l l c o n t r i b u t e to improved bank p r o f i t s . "The value of a p r o f i t a b i l i t y a n a l y s i s system to a bank is the opportunity cost of the low p r o f i t loans { ^ r e l a t i o n s h i p s ] . It is the w r i t e r ' s opinion that the cost of a p r o f i t a b i l i t y a n a l y s i s system w i l l be much less for most banks than the opportunity cost of i t s low p r o f i t loans [ r e l a t i o n s h i p s ] . 3 See pp.72-73. The c r e d i t area of Canadian banking di d not accord any b e n e f i t to p r o f i t a b i l i t y a n a l y s i s . See, however, pp.69-70 - r R i s k Adjustment of the Interest Rate. See pp .51' ;and 79. 3 F a l k e n b e r g , P r o f i t a b i l i t y A n a l y s i s , Part I I , p.23. 88 'The Customer Information System which produces our account p r o f i t a b i l i t y r e p o r t s , is one of the few f u l l y automated systems of i t s type in the United States and i t has the h i g h l y unusual d i s t i n c t i o n of having paid f o r i t s e l f w i t h i n the f i r s t year of operation. In f a c t , we t h i n k the return on our investment w i t h i n the past year has been approximately double our development c o s t s , " 1 E l s e , Account P r o f i t a b i l i t y , page 1. ( F i r s t National C i t y Bank) SELECTED READINGS AND SOURCES Books and Pamphlets Binhammer, H.H., Money, Banking and the Canadian F i a n c i a l System, Toronto, Metheun P u b l i c a t i o n s , 1968. The Canadian Bankers' A s s o c i a t i o n , A B i b l i o g r a p h y of Canadian Banking, 1970. The Canadian Bankers' A s s o c i a t i o n , Wh i t e Bu1 l e t i n , now the C.B.A.  Bu11et i n , assorted issues. The Canadian Bankers' A s s o c i a t i o n , Factbook, 1970 - 1972. G a l b r a i t h , J.A., Canadian Banking, Toronto, The Ryerson Press, 1970. Hodgman, D.R., Commercial Bank Loan and Investment P o l i c y , I l l i n o i s , Un ivers i t y of 111inois, 1963. Jamieson, A.B., Chartered Banking in Canada, Revised E d i t i o n , Toronto, The Ryerson Press, 1962. Nadler, P.S., Commercial Banking in the Economy, New York, Random House, 1968. Art i c l e s , Journal of Commercial Bank Lending, many issues. Conover, C , "The Case of the Co s t l y C r e d i t Agreement", Finaneia1  Execut ive, September 1971, pp.40-48. Dyer, F. and H e i l s h o r n , J . , " P r o f i t A n a l y s i s f o r Loans: A Panel D i s c u s s i o n " , Journal of Commercial Bank Lending, November 1967, pp.40-52. Falkenberg, J . , " P r o f i t a b i l i t y A n a l y s i s : A Marketing T o o l " , Journa1  of Commercial Bank Lending, February and March 1970. F u r n i s s , J . and Nadler, P., "Should Banks Reprice Corporate S e r v i c e s " , Harvard Business Review, May - June 1966, pp.95-105-Grimes, R., " P r o f i t a b i l i t y A n a l y s i s : Some A d d i t i o n a l Thoughts", Journal  of Commercial Bank Lending, October 1970, pp.38-49. Hock, R., et a l , "Loan Management and P r o f i t a b i l i t y : A Panel D i s c u s s i o n " Robert Morse Associates B u l l e t i n , March 1966, pp.361-38I. Hoskin, G., et a l , " I n c r e a s i n g the P r o f i t a b i l i t y and Improving the Q u a l i t y of the Loan P o r t f o l i o : A Panel D i s c u s s i o n " , Robert Morse  Associates B u l l e t i n , August I965, pp.575-585. McDonald, R., "A D o - i t - Y o u r s e l f Formula for Loan P r o f i t a b i 1 i t y A n a l y s i s " Robert Morse Associates B u l l e t i n , June 1967, pp.20-27 Scheuing, R., " P r i c i n g the Loan - The Lender's Dilemma", Journal of  Commercial Bank Lending, August 1971, pp.43-53-Stud ies , Bank Costs, The A s s o c i a t i o n for Bank A u d i t , Control and Operation, Park Ridge, I l l i n o i s , 1962. Thes is Murphy, N., A Study of Wholesale Banking Behaviour, Ph.D d i s s e r t a t i o n , U n i v e r s i t y of I l l i n o i s , 1968. O f f i c i a l P u b l i c a t i o n s , An Act Respecting Banks and Banking, (The Bank A c t ) , Ottawa, Queen's P r i n t e r , 1967. , Report of the Royal Commission on Banking and Finance, (The P o r t e r Report), Ottawa, Queem's P r i n t e r , 1964. , Bank of Canada Review, assorted issues. , The Federal Reserve System: Purposes and Functions, Board of Governors of the Federal Reserve System, 1963. , Federal Reserve B u l l e t i n , F i n a n c i a l and Business S t a t i s t i c s , assorted issues. Unpublished Speeches E l s e , W., Account P r o f i t a b i l i t y , F i r s t National C i t y Bank, Bank Management Seminar, December 14-15, 1970. 91 Unpublished Reports P h i l a d e l p h i a National Bank, P r o f i t a b ? 1 i t y A n a l y s i s of  Customers, P h i l a d e l p h i a National Bank,1965. Commerc ia1 92 APPENDIX A INTERVIEW QUESTIONNAIRE Study of Canadian Bank Commercial Account A n a l y s i s Procedures Bank and Interviewee Date I . An Overview 1 . A n a l y s i s Performed a) The c r e d i t ? b) The demand deposit account? c) Other f i n a n c i a l s e r v i c e s ? 2 . Other F i n a n c i a l Services a) Fixed p r i c e s f o r a l l customers f o r a l l s e r v i c e s and not subject to negotiation? b) 'Fixed' but subject to m o d i f i c a t i o n w i t h i n d i v i d u a l customers in ne g o t i a t i o n s ? c) F r e e l y negotiable w i t h each customer? 3. Comb ined a) Are the c r e d i t and current account analyses performed at the same t ime? b) Do you negotiate on a l l customer business at one time? k. P r o f i t a b i 1 i t y Analys is a) Are you aware of the research that is being conducted in t h i s area, and the systems that are being used, by major U.S. banks? b) Are you researching t h i s area yourselves? c) Where or what are you aiming f o r in account a n a l y s i s ? d) Do you t h i n k the p r o f i t a b i l i t y a n a l y s i s model is pract i c a l ? 93 I I . S e r v i c e A r e a A n a l y s i s A. C r e d i t A n a l y s i s 1. Assume a customer w i t h o n l y a l o a n , no o t h e r s e r v i c e s . How i s t h e i n t e r e s t r a t e s e t ? 2. Now assume a ' n o r m a l 1 customer w i t h a m u l t i t u d e o f s e r v i c e s e.g. demand d e p o s i t and r e l a t e d s e r v i c e s , t i m e d e p o s i t s , o t h e r s e r v i c e s . How do you s e t t h e i n t e r e s t r a t e now? 3. Does you r customer v i e w t h e manner i n wh i c h you s e t t h e i n t e r e s t r a t e i n t h e same way? k. O n l y been t a l k i n g about t h e i n t e r e s t r a t e . Is t h i s t h e o n l y way i n w h i c h you r e c e i v e compensation? 5. Do you p r e f e r t h e i n t e r e s t r a t e o n l y ? Why? 6. For what f u t u r e p e r i o d do you n e g o t i a t e ? 7. What a r e t h e most c o n t e n t i o u s i s s u e s r a i s e d by your customers in n e g o t i a t i o n s ? 8. What do you t h i n k a r e t h e s t r e n g t h s and weaknesses o f you r c r e d i t a n a l y s i s s y s t e m and where would you l i k e t o see i t improved? B. Demand D e p o s i t A n a l y s i s 1. A c c o u n t S e l e c t i o n , A n a l y s i s T i m i n g and A n a l y s i s P e r i o d a) Bases f o r ac c o u n t s e l e c t i o n f o r a n a l y s i s ? b) P e r i o d o f d a t a c o l l e c t i o n ( a n a l y s i s p e r i o d ) ? c) Do r e s u l t s o f a n a l y s i s d e t e r m i n e when ac c o u n t w i l l be a n a l y s e d i n t h e f u t u r e ? Is t h i s a l s o t h e p e r i o d f o r w h i c h you n e g o t i a t e p r i c e s ? B a l a n c e s - D e d u c t i o n s , V a l u a t i o n and F l o a t a) What d a t a i s c o l l e c t e d ? b) How a r e b a l a n c e s v a l u e d ? c) How i s f l o a t measured? A c t i v i t y a) What a c t i v i t i e s a r e i n c l u d e d ? b) What a c t i v i t i e s a r e not i n c l u d e d ? 2. 3-3. Act iv i ty (cont'd) c) Are costs or prices used as costs? d) Do you allow volume discounts? e) Does the analysis provide for conversion of fees to balances and vice-versa? k. Goals a) Does the analysis give you a profit/loss on the demand deposit function? b) Do you have a profit goal for demand deposit analysis? c) What do you do i f a substantial surplus is indicated? 5. Negot ?at ions a) Do you negotiate solely (in isolation) on the basis of the results of the demand deposit analysis? b) What are the most contentious issues or points raised by customers during negotiations on the demand deposit analys is? c) What do you think are the strengths and weaknesses of the demand deposit analysis system and where would you like to see it improved? Other Financial Services 1. Are prices non-negotiable and subject solely to a fixed price schedule? a) Pricing bas is? b) What detail is carried to the credit and demand deposit analyses? c) What effect does this have on negotiations and price setting in these areas? 2. Do you have a fixed price schedule for a l l other services  but subject to modification with individual customers in  negot iat ions? a) What negotiations? b) What are the factors that determine price modifications? 95 3. A r e p r i c e s f r e e l y n e g o t i a b l e w i t h e a c h c u s t o m e r ? a) When a r e t h e y n e g o t i a t e d ? b) What a r e t h e f a c t o r s t h a t d e t e r m i n e p r i c e ? III. T h e P r o f i t a b i l i t y A n a l y s i s Model 1. What is y o u r o p i n i o n o f t h e p r o f i t a b i l i t y a n a l y s i s m o d e l , i n c l u d i n g i t s s t r e n g t h s and w e a k n e s s e s and where i t c o u l d h e l p you i n y o u r j o b o f a n a l y s i n g and n e g o t i a t i n g w i t h c o m m e r c i a l c u s t o m e r s ? 

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