Profit risk is a risk management tool that focuses on understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective.
Profit risk is a risk measurement methodology most appropriate for the financial services industry, in that it complements other risk management methodologies commonly used in the financial services industry: credit risk management and asset liability management (ALM). Profit risk is the concentration of the structure of a company’s income statement where the income statement lacks income diversification and income variability, so that the income statement’s high concentration in a limited number of customer accounts, products, markets, delivery channels, and salespeople puts the company at risk levels that project the company’s inability to grow earnings with high potential for future earnings losses. Profit risk can exist even when a company is growing in earnings, which can cause earnings growth to decline when levels of concentration become excessive.
When a company’s earnings are derived from a limited number of customer accounts, products, markets, delivery channels (e.g., branches/stores/other delivery points), and/or salespeople, these concentrations result in significant net income risk that can be quantified. A loss of just a handful of customer accounts, a loss of a limited number of products, a loss of a select market, a loss of a small number of delivery channels, and/or a loss of a few salespeople can result in significant net income volatility. At this stage, income loss risk is present and the company has reached a level of profit risk that is unhealthy for sustaining net income. The method for quantifying and assessing this potential income loss risk and the volatility that it creates to the company’s income statement is profit risk measurement and management. For financial institutions, profit risk management is similar to the diversification strategies commonly used for investment asset allocations, real estate diversification, and other portfolio risk management techniques.
The concept of profit risk is loosely akin to the well known “80/20” rule or the Pareto principle, which states that approximately 20% of a company’s customers drive 80% of the business. This rule and principle may be appropriate for some industries, but not for the financial services industry. According to Rich Weissman, it is true that this small group of customers dominate the income statement, but the old “80/20” rule no longer applies. “There are real-life examples where financial institutions have seen profit risk ratios as high as 300 percent. Their top 10 percent of customer/member relationships accounted for three times net earnings – a “300/10″ rule!”
To measure these concentrations and manage profit risk, the most important tools for financial institutions may be their MCIF, CRM, or profitability systems that they use to keep track of their customer/member relationship activities. The data in these systems can be analyzed and grouped to gain insights into profitability contribution of each customer/member, product, market, delivery channels, and salespeople. Reports illustrating the concentrations of net income are used by senior management to show (1) the location of the concentrations in the income statement, (2) the levels of the concentrations, and (3) the predictions for future earning losses to be drawn from the concentrations. Often, these reports examine earnings contributions by deciles (groupings of customers or other units of analysis by 10% increments), illustrating concentrations for each 10% group.
- ^Weissman, Rich “Managing Profit Risk to Avoid a Meltdown”, California Banker Magazine, August 2008 Retrieved 05/06/2010
- ^Weissman, Rich “Profit Risk – The Third Leg of Risk Management”, The Mortgage Press, December 2004 Retrieved 05/06/2010
- ^Weissman, Rich “Bank Marketers Measure Profit Risk in Changing Times Archived2010-06-11 at the Wayback Machine”, Michigan Bankers Magazine, March/April 2009, p 12-14, Retrieved 05/06/2010
- ^Coffey, John and Palm, Gene “Profit Decile Report: An Eye-Opener”, ABA Bank Marketing, Jan-Feb, 2006 Retrieved 05/06/2010
- ^Weissman, Rich “Profit in the Drink”, ABA Bank Marketing, March 2010 Retrieved 05/06/2010
- ^Investopedia, “Diversification Strategies” Retrieved 05/06/2010
- ^Website Magazine, “Pareto Principle and the Infinite Value of CRM” Retrieved 05/06/2010
- ^Wang, Hongjie “For Bank Marketing, Re-Focus the Pareto Principle on Customer Profitability Archived 2010-03-23 at the Wayback Machine”, Bank Systems and Technology, November 2009 Retrieved 05/06/2010
- ^Reprinted with permission from The Mortgage Press; Profit Risk: The third leg of risk management
- ^Totty, Patrick “Pinpointing Preferences with MCIF”, CUNA Operations and Sales/Services Council, August, 2005
- ^Duclaux, Denise “Are You Getting the Most from Your MCIF?”, ABA Banking Journal, June 1995
- ^Retail Profit Management, “Decile Report Archived 2010-03-22 at the Wayback Machine”
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.