Pilgrim Bank (A): Customer Profitability - notes 04/02

Overview of Pilgrim Bank (A): Customer Profitability

Introduction to Case

  • Date: February 2, 2001

  • Alan Green, a new analyst in the online banking group at Pilgrim Bank, reflects on his boss Ravi Raman's words regarding an upcoming meeting to discuss Internet strategy.

  • Two main questions emerge:

    • Should Pilgrim Bank start charging fees for the online banking channel?

    • Should they offer incentives like rebates or lower service charges to encourage the use of this channel?

  • The underlying issue: Understanding if online customers are indeed more profitable compared to traditional customers.

  • Green is tasked with analyzing data, on which he needs to spend the weekend thinking about relevant data from year-end 1999, as 2000 data is yet to be available.

Importance of Customer Profitability Analysis

  • Green acknowledges the importance of understanding retail banking economics before proceeding with the analysis.

  • He seeks assistance from Jane Raines, an experienced analyst.

Meeting with Jane Raines

Discussion Points

  • Green's project objective: Assess whether online customers are better customers and the implications for the online banking product.

Key Insights from Raines

  • Profitability Analysis Over Balances: instead of simply comparing account balances, Raines advises to focus on profit directly since:

    • Balances just represent a part of overall customer value.

    • Profit is calculated with the formula:
      ext{Customer Profitability} = ( ext{Balance in Deposit Accounts}) imes ( ext{Net Interest Spread}) + ( ext{Fees}) + ( ext{Interest from Loans}) - ( ext{Cost to serve})

  • Raines further elaborates that focusing solely on balances neglects important revenue components like fees and interactions with the bank.

Understanding Customer Profitability Components

  • Explanation of the components that determine customer profitability:

    • Revenue: Three types of revenue generation:

    • Investment income: Generated from deposit balances through net-interest margin.

    • Fee income: Important source of revenue, especially after declines in interest rates (e.g., fees for checking accounts, late payments, overdrafts).

    • Loan interest: Principal asset in banks’ portfolios and crucial source of revenue.

  • Cost-to-Serve: Complexity in estimating costs:

    • Includes transaction-related costs and allocated fixed costs.

    • Different transactions have different costs (e.g., teller visits versus ATM use).

    • Fixed costs reflect resource consumption that is not transaction specific and can vary with demand changes.

Surprising Profitability Patterns

  • Raines indicates strong profitability skew in customer bases at many banks:

    • E.g., 10% of customers generate 70% of profits.

  • The challenge is obtaining accurate measures of customer profitability due to varied customer contributions and cross-subsidization.

Transaction Behavior and Costs

  • Bank's history of changing service channels (e.g., introducing ATMs, call centers, online banking) shows lower costs per transaction but can lead to increased overall costs due to higher transaction volumes.

  • Green considers migrating transactions to lower-cost channels to improve profitability an effective strategy.

Data Acquisition from IT Services

Interaction with Erica Dorstamp

  • Green approaches Erica Dorstamp to request access to customer profitability data.

  • Dorstamp offers a random sample of 30,000 customers data that includes:

    • Profitability for year-end 1999

    • Online usage indicator

    • Plus demographic data due to its importance in profitability analysis.

Initial Data Analysis

Profitability Curve Creation

  • Using the sample data, Green replicates a customer profitability curve:

    • Sorts data to demonstrate profitability skew similar to the one he observed previously with Raines.

  • Findings:

    • Over half of the customers are profitable in 1999.

    • A small number of customers generate most of the profits.

Statistical Findings

  • Green calculates average customer profitability for 1999:

    • Overall Average: 111.50

    • Online customers: 116.67

    • Offline customers: 110.79

  • Green is intrigued by the profitability differences but uncertain about causal conclusions regarding online usage.

Exploration of Customer Demographics

Demographic Data Examination

  • Green explores demographic data considerations:

    • Age, income, geographic region, etc.

  • Recognizes potential correlations and patterns that could influence profitability perceptions.

Summary of Insights from Raines' Notes on Customer Profitability

Revenue Components in Detail

  • Investment income, fees, loan interests contribute to customer revenue significantly.

Challenges in Cost-to-Serve Estimation

  • Transaction-related costs differ widely between channels.

  • Fixed costs are indirectly associated with customer service and can drive operational changes as demand shifts.

Managing Customer Profitability Strategies

  • Financial institutions implement tiered service approaches based on profitability

  • Customer migration strategies can be enhanced by adjusting pricing initiatives, enforcing fees, and robust cross-selling practices to shift low-profitability customers to profitable segments.

Branch Consolidation Efforts

  • Many banks sought to encourage customers towards electronic banking to limit costs but found a disconnect in customer preferences for branch interactions and electronic usage.

Anticipating Customer Behavior

  • Challenges emerge due to static measures and the need for dynamic models to predict future profitability linked to customer ties and behavior patterns.