Financial Product Engineering: How Banks Turn Ideas into Cash Flow

As finance professionals, we often focus on numbers, ratios, and forecasts.

However, have we considered the interconnectedness between departments in a bank or financial institution when introducing new products?

In the world of banking and financial services, the creation of a new product is not simply about designing a physical item to be sold. Instead, it's about transforming financial concepts into services that can generate, manage, and redistribute wealth. This process involves more than just numbers—it's about crafting an offer that balances risk, revenue, and customer demand while ensuring the bank’s overall financial health.

Let’s take a deep dive into how financial products are designed, developed, and launched, all while staying grounded in the practical realities of how money flows within the system and the broader economy.

The process begins with a deep understanding of the bank’s capacity to lend or offer services. Unlike a product that requires physical manufacturing, a financial product, such as a loan or an investment product, uses the bank’s existing capital base and customer deposits as the raw materials for creation. The bank must carefully assess how much money it has available to lend or invest, considering its capital reserves and the regulatory requirements set by authorities.

At its core, the bank’s ability to lend is determined by how much liquidity it holds. Liquidity comes from customer deposits, which are the foundation of the funds the bank uses to issue loans, extend lines of credit, or offer other financial services. However, the money is not just coming from a single source; it’s part of a much larger system where each department—sales, operations, marketing, and customer service—plays a crucial role in creating, promoting, and managing these financial offerings.

Role in Financial Services

When the product development team at a bank embarks on creating a new service—be it a personal loan, mortgage, or investment vehicle—the first thing they need to consider is feasibility.

But unlike traditional products, designing a financial service product involves multiple calculations and assumptions about customer behavior, market demand, and the overall financial landscape. The team does not simply decide on an interest rate or fee structure in isolation; they must evaluate the bank’s existing costs, customer needs, and the competitive environment.

For example-

• Imagine a bank wants to introduce a personal loan product that ranges from $5,000 to $50,000.
• Annual Interest Income: If a customer borrows $10,000, interest income for the year is: 10,000 × 5% = 500 .Over the loan's 5-year period, the bank earns: 500 × 5 = 2,500
• The interest rate cannot simply be picked randomly—it needs to cover the bank’s operational costs (e.g., loan processing, underwriting, servicing) and also create room for profitability.
• A 5% interest rate may be set to ensure the bank can cover its costs and earn revenue. However, this figure isn’t just arbitrary; it's the result of a balancing act between customer affordability and the bank's financial sustainability.
• The interest income impacts the Income Statement as part of Revenue.

The product development team must also anticipate the risk of defaults. Since financial products are built around money, and money doesn’t come with guarantees, the risk management team plays a key role.

By assessing the creditworthiness of potential customers and creating systems for automated repayment reminders, they ensure the product is designed with mitigation strategies in place.

A credit score helps in determining who qualifies for the product and at what terms—reducing the likelihood that customers with higher chances of default will be offered larger loan amounts.

How Product Development Works – Designing a Personal Loan ?

When the bank's Product Development team designs a new personal loan, they base the design on several factors that align with market demand and customer preferences. Here’s how they go about it:

Customer Needs and Preferences:

• Process: The product development team studies what customers want, based on the market research and surveys. They design the loan with terms that will attract the largest customer segment.
• Example: If customers are asking for more flexible repayment options, the team may offer loans that can be paid off in 1 to 5 years instead of only 3 years.
• Design Decision: The loan offers a flexible repayment term (1 to 5 years) because customers prefer longer repayment periods to keep monthly payments low.

Competitor Offerings:

• Process: The team checks what competitors are offering to ensure that the new loan is competitive. They might adjust the interest rate, loan amount, or features to make the product stand out.
• Example: If the competitors offer loans at a 7% interest rate, the product development team might offer a loan at 5% to attract customers.
• Design Decision: The loan will have a lower interest rate (5%) than competitors to appeal to cost-conscious customers.

Financial Feasibility (Interest Rate, Fees, Loan Amounts):

• Process: The team calculates the financial feasibility of the loan by determining how much money the bank needs to charge to cover costs (e.g., loan servicing, risk of defaults) and still make a profit. This involves setting the interest rate and loan fees.
• Example: If the bank plans to offer loans of $5,000 to $50,000, the interest rate must cover operational costs (such as underwriting and servicing loans) and generate sufficient revenue to make the product worthwhile.
• Design Decision: The team sets the interest rate at 5% per year to balance customer demand with the bank’s profitability. They also add a 2% processing fee to generate additional revenue.

How It Works Practically: When the product development team designs a loan, they need to ensure that the loan is profitable for the bank. This means they need to carefully calculate:

• Operational Costs: These are the costs the bank incurs to process, maintain, and manage loans.
• Underwriting: The process of evaluating the borrower’s creditworthiness (checking credit scores, reviewing financial history, etc.)
• Servicing: The ongoing management of the loan (processing payments, answering customer inquiries, maintaining loan records).
• Default Risk: The risk that some customers will not repay their loans.
• Revenue Generation: The loan also needs to generate enough revenue to cover these costs and give the bank a profit.

Methods and Tools Used for Calculating Feasibility:

Loan Pricing Model:

• Banks use a loan pricing model to set the interest rate and fees. The model takes into account the operational costs and desired profit margin.
• The model may include factors such as: Fixed costs (e.g., costs to process a loan application),Variable costs (e.g., servicing the loan over time),Risk Premium (extra charges to account for the possibility of defaults)
• Formula Example for Interest Rate Calculation: Interest Rate = Cost of Funds + Operational Cost + Risk Premium + Profit Margin
• The interest rate is typically based on the cost of funds (how much it costs the bank to borrow money, like from depositors or other banks), the operational cost, and a profit margin.

Example Calculation:

• Cost of Funds: 2% (how much the bank pays for the money it lends)
• Operational Cost: 1% (for underwriting, servicing, etc.)
• Risk Premium: 1% (extra to cover possible defaults)
• Profit Margin: 1.5% (the bank’s target profit)
• Total Interest Rate: 5.5% (the bank sets the interest rate based on this calculation)

Many banks use tools like Excel or financial software to perform these calculations. In Excel, the team might build models that calculate:

• The total cost to the bank to process a loan
• The potential interest income from different interest rates
• How much revenue can be generated for each loan size

The team could create a spreadsheet with loan amounts in one column (e.g., $5,000, $10,000, $20,000) and calculate the total interest earned based on different interest rates (5%, 5.5%, etc.) and repayment terms (1 year, 3 years, etc.).

Regulatory Compliance:

• Process: The team ensures that the new loan complies with all relevant laws and regulations in the region. This might include interest rate caps, disclosure requirements, and borrower protections.
• Example: If there’s a law that limits how much interest a bank can charge for personal loans, the team will adjust the interest rate to comply with that law.
• Design Decision: The bank ensures that the interest rate and processing fee are within the legal limits set by regulators.

Risk Management (Preventing Defaults):

• Process: The team works closely with the risk management department to understand the potential risks, such as customers defaulting on the loans. They then design features that help mitigate those risks.
• Example: To reduce risk, the team might design a loan with automated repayment reminders or set up a credit scoring system to ensure that only customers with a good credit history can access higher loan amounts.
• Design Decision: The team includes automated reminders and uses credit scoring to minimize the risk of defaults.

How It Works Practically: Risk management is about reducing the chance that customers will fail to repay their loans. Banks use several methods to manage this risk:

Credit Scoring:

• Credit scoring is the most common method to evaluate how risky a borrower is. A credit score is a number that tells the bank how likely a person is to repay the loan. The higher the score, the lower the risk.
• Process: When a customer applies for a loan, the bank checks their credit score (from credit bureaus like Equifax, TransUnion, etc.). If the score is high, the bank feels safer lending money.The bank may set a minimum credit score to approve loans. For example, the bank may decide that only customers with a credit score of 650 or higher can apply for loans over $20,000.If a customer has a lower score, they might be offered a smaller loan or a loan with a higher interest rate to compensate for the increased risk.

Automated Repayment Reminders:

• Banks can use automated systems (like phone calls, emails, or text messages) to remind customers of upcoming payments.
• Process: When a customer misses a payment, the system sends out reminders to encourage repayment. If the customer still doesn’t pay, further actions (like adding fees or reporting to credit bureaus) might be taken.The cost of setting up this system (software and people) is included in the operational cost of the loan.

Loan Covenants or Collateral:

• Some loans are backed by collateral (e.g., car loans, home loans). If the borrower doesn’t repay, the bank can take the collateral to recover the money.
• For unsecured loans (e.g., personal loans), the bank may require a guarantor (a person who promises to repay the loan if the borrower can’t).

Methods to Calculate Risk:

Credit Risk Models: Banks often use credit risk models to predict the likelihood of defaults based on data. These models can calculate the risk by considering:

• Credit score
• Debt-to-income ratio (how much debt the borrower already has compared to their income)
• Employment status and income
• Previous loan performance (how well the customer repaid previous loans)

Stress Testing:Banks also perform stress testing to see how the loan portfolio would behave under extreme conditions, like a recession or a significant rise in unemployment. This helps ensure the bank can handle potential loan defaults.

Note:

• Financial Feasibility calculations are typically done using financial models, Excel spreadsheets, and loan pricing formulas to ensure the loan is profitable for the bank. Banks analyze their costs, set appropriate interest rates, and calculate potential revenues.
• Risk Management involves evaluating customer risk using credit scores, setting up automated reminders, and using credit risk models to predict defaults. Risk management is largely automated using software, but the team monitors and adjusts the strategies based on real-world data and customer behavior.

By using these methods and tools, banks ensure that they can offer loans that meet customer demand while protecting themselves from financial losses.

Putting It All Together:

In order to calculate the total operational cost and revenue from a loan, the bank will:

1. Estimate the underwriting costs, servicing costs, and default risk.
2. Add those costs together to determine the total operational cost.
3. Set a price (interest rate) for the loan to generate enough revenue to cover costs and provide a profit margin.
4. Ensure that the loan revenue (from interest and fees) is higher than the operational costs.

Example Summary:

Let’s consider a $10,000 personal loan:

• Underwriting Cost: $50
• Servicing Cost: $20
• Default Risk (Risk Premium): $500
• Total Operational Cost: $570 (sum of the costs above)
• Revenue from Interest: $600 (6% interest on the loan)
• Processing Fee Income: $200 (2% fee)
• Total Revenue: $800

Since the total revenue of $800 is greater than the operational cost of $570, the loan is profitable for the bank. The profit in this case would be: Profit=800?570=230.

This process ensures the bank can cover its costs and generate a profit, while also considering the risks involved in lending.

It might be wondering how these will be computed before a loan is introduced to customers......

While it is not directly tied to a specific customer at the product development stage,even before specific customers are identified, the bank estimates the default risk based on historical data and industry trends. The risk is then factored into the pricing model of the product, like setting a higher interest rate or adding risk premiums.

Based on this, the bank will add a risk premium (additional charges) or set a higher interest rate to account for these defaults, even though no customer has yet applied for the loan.

Credit scoring doesn’t apply directly to a specific customer at the product development stage. However, the bank still designs the product with certain credit score requirements in mind.When designing a new product, the bank sets criteria (e.g., minimum credit score) based on historical patterns of how borrowers with certain credit scores tend to perform. These criteria help the bank anticipate how risky the loan product will be.before it is introduced to individual customers.

How Much Money Can the Bank Loan (Lending Capacity)?

A bank’s lending capacity depends on a variety of factors, including its capital, reserves, and regulatory requirements. Let’s break it down step-by-step:

Capital Reserves (Equity Capital)

• Banks need to have sufficient capital reserves to cover the loans they issue. Capital reserves are the money the bank holds in reserve to absorb losses in case some loans go bad (i.e., defaults).
• The capital comes from shareholders' equity and retained earnings (profits that the bank reinvests).
• Regulatory Requirements: Governments and regulators (such as the Central Bank) set rules on how much capital a bank must hold relative to its total assets. This is known as the capital adequacy ratio (CAR). For example, a bank might be required to hold a minimum of 8% of its loans and other assets in reserves to ensure that it can cover potential losses.

Example:

• Let’s say the bank has $10 million in capital reserves.
• If the regulatory capital adequacy ratio is 8%, the bank can lend out up to $125 million (since 8% of $125 million is $10 million).

Deposits (Customer Accounts)

Banks primarily use the money deposited by customers (checking accounts, savings accounts, and fixed deposits) as a source of funds for lending.

• When customers deposit money in their accounts, the bank can lend out a large portion of it, but it must maintain a portion as reserves (this is known as the reserve requirement).
• The reserve requirement is the percentage of customer deposits that the bank must keep on hand and cannot lend out. This is set by the Central Bank.

Example:

• Suppose the bank has $50 million in customer deposits.
• If the reserve requirement is 10%, the bank must keep $5 million in reserves and can lend out the remaining $45 million.

Interbank Loans (Borrowing from Other Banks)

In addition to deposits, banks can borrow money from other banks in the interbank market. If a bank needs more funds to lend, it can borrow money from other banks that have excess reserves.

• Banks also have access to overnight borrowing facilities from the Central Bank in case they need quick liquidity.

Securitization and Bond Issuance

Banks can also raise money by selling securities or issuing bonds. These funds can then be used for lending. When the bank issues a bond, it’s essentially borrowing money from investors, promising to pay them back with interest over time.

• Securitization involves bundling loans together (like mortgages or auto loans) and selling them as securities to investors. This allows the bank to raise money upfront, which it can use to issue new loans.

Sources of Funds for Lending:

Now, let's address the specific question of where the money comes from for loans. There are several sources:

a) Customer Deposits

The most common source of funds for a bank is customer deposits. For example, when you deposit money in a savings account, the bank can use a portion of that deposit to lend money to others (subject to the reserve requirements).

b) Capital Reserves

Banks also rely on their own equity capital (shareholders’ investment and retained earnings). This capital acts as a cushion for the bank in case of loan defaults or other financial risks.

c) Borrowing from Other Financial Institutions

Banks can also borrow money from other banks, especially in the short-term interbank lending market. This is a common practice for managing liquidity and ensuring that the bank has enough money to cover its loans.

d) Issuing Bonds and Securitization

Banks can also issue bonds to raise funds. Investors buy the bonds, providing the bank with funds that it can then use for lending purposes. Similarly, banks can bundle loans into securities and sell them to investors, allowing the bank to free up capital and lend again.

How Much Money a Bank Can Loan:

• The total amount a bank can lend depends on how much money it has in deposits, its capital reserves, and how much liquidity it can borrow from other sources.
• The bank must ensure it doesn’t lend out too much, which could jeopardize its ability to meet withdrawal requests from depositors or cover loan defaults.
• The bank must also follow regulatory capital adequacy ratios, which set limits on how much risk it can take on in relation to its capital.

Example of Lending Capacity Calculation:

Let’s assume a simple scenario where the bank has:

• $50 million in customer deposits
• A reserve requirement of 10%
• $10 million in capital reserves
• A capital adequacy ratio of 8%

Here’s how we calculate the lending capacity:

Deposits Available for Lending:

• The bank has $50 million in customer deposits.
• The reserve requirement is 10%, so the bank must keep 10% of $50 million = $5 million as reserves.
• This means the bank can lend out $45 million ($50 million – $5 million).

Capital Adequacy:

• The bank has $10 million in capital reserves.
• The required capital adequacy ratio is 8%, meaning the bank needs to hold 8% of its lending amount in reserves.
• The bank’s total lending capacity can be calculated as: Total?Lending?Capacity=Capital?Reserves/Capital?Adequacy?Ratio=10?million/0.08=125?million

Thus, the bank’s total lending capacity is $125 million, which includes customer deposits, capital reserves, and any borrowing the bank can access to support its lending.

Banks calculate how much money they can safely lend by ensuring they maintain the required capital reserves and meet regulatory requirements to prevent too much risk exposure.

By balancing these factors, a bank can ensure that it has enough money to lend out while still being able to cover its costs, manage risks, and remain financially stable.

Note:

• Revenue Management involves understanding market demand through surveys, competitor analysis, historical trends, and customer segmentation. By gathering and analyzing this information, the bank can predict how much money it will earn from interest and fees.
• Product Development involves designing the product based on customer preferences, market conditions, competitor analysis, financial feasibility, and regulatory compliance. The goal is to create a product that meets customer needs while also being profitable and manageable for the bank.

In both cases, the ultimate aim is to launch a product that attracts customers, generates revenue for the bank, and balances the bank’s financial system by managing risks effectively.

Risk Assessment and Loan Loss Provisions:

To account for the possibility of defaults, banks must calculate the Expected Credit Loss (ECL), which affects financial products like loans.

Example Calculation for ECL: The ECL is a way to estimate the amount a bank could lose from loan defaults over time. It's a forward-looking measure that ensures banks account for potential losses on their loan books.

• Probability of Default (PD): 2% (for a loan book)-This is the likelihood that a borrower will default on the loan.
• Loss Given Default (LGD): 50% (what the bank loses in the event of default)-This is the percentage of the loan the bank expects to lose if the borrower defaults.
• Exposure at Default (EAD): $10,000 (the loan amount)-This is the amount of loan that the bank is exposed to at the time of default.

The ECL can be calculated as:

ECL = EAD × PD × LGD

ECL =10,000 × 0.02 × 0.50 =100

So, the bank expects to lose $100 due to loan defaults.

The provision for loan losses of $100 impacts the Balance Sheet as an increase in Allowance for Loan Losses under Assets and reduces the Net Income in the Income Statement.

Impact on Financial Statements:

• Income Statement: Increases revenue (from interest income), decreases net income (due to provisions for loan losses).
• Balance Sheet: Increase in assets (loans) and liabilities (loan loss provisions).

Accounting Entry:

• Debit: Provision for Loan Losses (Expense) $100
• Credit: Allowance for Loan Losses (Liability/Contra Asset) $100

Research and Development (R&D):

During this phase, banks conduct market research and assess customer needs to refine the product's features (e.g., loan tenure, flexibility in repayments). If the product is complex (such as structured finance products, mortgages, or investment vehicles), R&D expenses may be incurred.

These costs would be capitalized or expensed depending on the accounting standards used. Under IFRS, certain development costs could be capitalized if they meet specific criteria.

Impact on Financial Statements:

• Income Statement: R&D costs, if expensed, will reduce the operating income.
• Balance Sheet: If capitalized, R&D will appear as an intangible asset.

Creating a Sustainable Financial Offering

But designing the product is only part of the equation. The sales, marketing, and customer service teams are equally important in ensuring the financial product reaches the right audience and performs as expected in the market.

Once the product is designed, the sales team kicks into action. Their role is to ensure that the right customers are targeted—those who need the product the most and have the ability to repay. With loans, for instance, the bank might focus on individuals with stable incomes or a good credit history, ensuring that the risk of defaults is minimized. The sales team also helps customers understand the terms—how much they will pay in interest, the fees involved, and the loan tenure. Clear communication here is critical to maintaining trust and minimizing confusion or frustration.

Meanwhile, the marketing team works on positioning the product in a way that appeals to customers. A 5% interest rate might sound like a great offer to potential borrowers, but the marketing team needs to frame this offering in a way that highlights its advantages over other products in the market. The promotional messaging emphasizes the simplicity of the loan application process, quick disbursement, and easy repayment structure. Cross-selling other bank products, like credit cards or insurance, also becomes an essential part of the overall marketing strategy. By integrating these additional services, the bank can drive higher customer lifetime value and increase overall profitability.

Launching and Marketing Financial Products

The product launch involves sales, marketing, and customer acquisition costs.

If the product is a personal loan, and the marketing campaign drives 500 new loan applications, of which 400 are approved, the bank incurs costs in acquiring customers.

Impact on Financial Statements:

• Income Statement: The marketing expenses are recognized as part of operating expenses and reduce Net Income.
• Balance Sheet: There is no immediate impact, but customer acquisition may lead to an increase in loans (asset increase).

The Interplay Between Operations and Risk Management

As the financial product hits the market, the operations team ensures the product runs smoothly in day-to-day banking. Unlike physical products, a financial service involves constant transactional flows, such as loan repayments, interest accrual, and customer inquiries. To ensure everything runs seamlessly, the operations team oversees systems integration—updating customer records, monitoring repayments, and handling exceptions like delayed payments or missed deadlines.

This operational management has direct implications for financial forecasting. For example, how many customers are expected to repay their loans on time? What happens if there’s an increase in default rates? By continuously tracking these metrics, the bank can adjust its risk premiums or modify the loan offer to ensure that it continues to be profitable.

On the risk management side, understanding default risk isn’t just about assessing customers at the point of sale; it’s a continuous process. Banks use automated tools and algorithms to monitor the performance of the loan book in real-time, flagging potential issues early on. The risk management team may adjust interest rates or even introduce loan modification programs if they see trends that indicate a higher likelihood of defaults.

This dynamic interplay between operations and risk management ensures that the financial services product adapts to market conditions, remains financially viable, and continues to drive the bank’s revenue growth.

Execution and Consumer Use of Product

Once the product is launched and available to consumers, the bank will begin to incur costs related to servicing the financial product (e.g., loan servicing, account maintenance, processing payments) and monitoring risks (e.g., defaults, customer complaints).

Costs Involved:

• Operational Costs: Ongoing costs to maintain and service the financial product (e.g., loan servicing costs, customer support).
• Interest Expense: For products like loans, banks may incur interest expenses to fund the loans they’ve provided.
• Risk Management Costs: These include credit scoring, loan collection efforts, and mitigation strategies for defaults.

Example:

• Loan Disbursement: The bank disburses a $10,000 loan at 5% annual interest.
• Processing Fees: 2% fee on loan amount, i.e., $200.
• Total loan amount disbursed: $10,000. Processing fee revenue: $200.

Impact on Financial Statements:

• Income Statement: The processing fee of $200 is recognized as Revenue, while the loan interest accrues as interest income.
• Balance Sheet: The disbursed loan ($10,000) is added to assets as a loan receivable.

Over time, the loan interest of 5% (annual) will be recognized in the Income Statement as revenue:

Interest?Income?(Year?1) =10,000 × 5% = 500

• Cash Flow Statement: The initial loan disbursement reduces the cash flow from operating activities, while repayments increase the cash flow from financing activities.

Risk Management During Loan Lifecycle:

As the loan life cycle progresses, the bank needs to continually assess the credit risk and adjust provisions if the likelihood of default changes.

If the Probability of Default (PD) increases, the bank needs to increase its ECL provision.

Example Change in Default Risk:

If the PD increases from 2% to 5%, the ECL calculation changes.

• New PD: 5% (0.05)
• EAD: $10,000 (unchanged)
• LGD: 50% (unchanged)

Using the same ECL formula the ECL would adjust:

ECL = 10,000 × 0.05 × 0.50 = 250

Now, the bank expects to lose $250 instead of $100.

Impact on Financial Statements:

• Balance Sheet: The bank will increase the Allowance for Loan Losses to reflect the higher expected loss, which will reduce the net value of loans on the balance sheet. The Allowance for Loan Losses is increased by $150 (from $100 to $250).
• Income Statement:An additional provision expense of $150 will be recognized in the Income Statement to adjust the provision from $100 to $250.

Accounting Entry:

• Debit: Provision for Loan Losses (Expense) $150 (the increase in provision)
• Credit: Allowance for Loan Losses (Liability/Contra Asset) $150

Note:

1. Provision for Loan Losses impacts the Income Statement as an expense, reducing Net Income.
2. Allowance for Loan Losses is recorded on the Balance Sheet as a contra asset to reduce the carrying value of the loan book, showing that the bank anticipates potential losses.
3. If defaults increase and ECL provisions need to be adjusted (as in the second example), the Allowance for Loan Losses is increased, and the corresponding provision expense is reflected in the Income Statement.

Key Accounting Entries for Each Scenario:

• Initial Provision (2% PD):

Debit: Provision for Loan Losses (Expense) $100

Credit: Allowance for Loan Losses $100

• Revised Provision (5% PD):

Debit: Provision for Loan Losses (Expense) $150

Credit: Allowance for Loan Losses $150

Revenue Management: – Analyzing Market Demand

In financial services, revenue management is about ensuring that the products bring in enough to cover costs, manage risks, and make profits.

Revenue management is about estimating and maximizing the amount of money the bank can earn, mainly through interest, fees, and other charges from products like loans. To do this, banks analyze market demand using several methods and processes:

Methods and Processes to Analyze Market Demand for Loans:

Market Research and Surveys:

• Process: The bank collects data through surveys, interviews, and market research to understand customer needs. This could include asking questions like:
• Outcome: This helps the bank understand how much demand exists for a new product, and if there’s enough market potential to launch it.

Competitive Analysis:

• Process: The bank looks at what its competitors are offering. It studies the loans and interest rates other banks are providing, and evaluates customer satisfaction with those products.
• Outcome: By understanding the market offerings, the bank can adjust its loan terms to be more attractive or competitive.

Historical Data Analysis (Trend Analysis):

• Process: The bank uses past data to predict future demand. For instance, it looks at previous loan sales, interest rate changes, and economic conditions (e.g., during economic downturns, fewer people may borrow).
• Outcome: Historical data helps banks forecast how many loans they can expect to issue and what the interest revenue will be. The bank also examines patterns, like how interest rate changes affect demand for loans.

Customer Segmentation:

• Process: The bank divides customers into groups based on their characteristics, such as income levels, loan requirements, age, and financial behavior. It can then tailor products to meet the needs of each group.
• Outcome: By offering the right product to the right segment, the bank increases its chances of attracting more customers and, therefore, more revenue.

Once the product is active in the market, revenue begins to flow in through fees (e.g., loan processing fees, service fees), interest income (from loans or investment products), and other charges (e.g., penalty fees, late payment fees).

Let’s break this down with a simple calculation:

• Interest Income: If a customer borrows $10,000 at 5% interest, the bank will earn $500 annually in interest. Over the life of a 5-year loan, this adds up to $2,500 in interest revenue.
• Fees: Let’s say the bank charges a 2% processing fee on the loan amount. For a $10,000 loan, that’s an additional $200 in revenue.

Accounting Treatment:

• Interest Income: Recognized as revenue in the Income Statement.

Debit: Loan Receivable $500 | Credit: Interest Income $500 (Yr.1) so on..

• Fee Income: Fees are recognized as revenue when earned (e.g., loan processing fee, penalty fee).

Debit: Cash/Bank $200 | Credit: Fee Income $200

Financial Statement Impact:

• Income Statement: Revenue from interest and fees increases Net Income.
• Balance Sheet: Loan Receivables increase as the loan balance grows, and cash from fees or interest payments increases the Cash balance.

Together, these fees and interest payments generate the bank’s income. The key here is balancing the interest rates, loan amounts, and fees so that the bank’s revenue covers its costs while still being attractive to customers.

Banks must also forecast how many loans will be paid off early, the effect of prepayments on interest income, and the impact of defaults. Proper revenue management ensures that products like personal loans or mortgages continue to generate profits.

Example:

Loan Forecasting: A loan portfolio with $1 million in loans may generate interest income of $50,000 annually (at 5% interest).If the bank expects 10% of loans to be paid off early, it needs to adjust its revenue forecasts:

Adjusted?Interest?Income= 50,000 × (1?0.10)= 45,000

Impact on Financial Statements:

• Income Statement: Revenue adjustments (interest income) are made.
• Cash Flow Statement: Early repayments affect the cash flow from operating activities.

Impact on Financial Statements for Other Financial Products

Mortgage:

• Mortgages are long-term loans, and their structuring (fixed-rate or variable-rate) affects the interest income, provisions for credit losses, and servicing costs.
• Mortgage-backed securities (MBS) can also impact the Balance Sheet, as they are sold as assets, generating income from both fees and interest.

Investment Vehicles:

• When a bank designs investment products (e.g., mutual funds or structured products), it must calculate expected returns, fund fees (management fees, performance fees), and potential market risks.
• Income from fees is recognized in the Income Statement, while the performance of the investments is tracked on the Balance Sheet.

Credit Cards:

• Banks earn interest on outstanding balances and may charge fees (annual, late payment fees).
• Interest Income and Fee Income are recognized in the Income Statement, while the outstanding credit card balances are reflected as Assets.

and many more to list down...

Note:

1. No revenue is recorded at this stage since it's the initial phase of product development.
2. Loan Calculation: At this stage, no revenue is recorded yet, but the bank begins to estimate the potential revenue based on the loan amount and the interest rate.
3. Revenue Recognition: Once the loan is disbursed and the associated services are activated, the bank records the revenue in its financial statements.
4. Interest income is recorded periodically (e.g., monthly or annually).
5. Processing fees are recognized when the loan is processed.
6. Revenue from bundled products (such as insurance) is recognized when the products are activated.The total revenue from the loan (interest + fees + bundled products) is recognized in the bank’s income statement as soon as the loan is processed and the products are activated.

For financial products and services, costs related to research and development are often expensed unless the costs meet capitalization criteria (under IFRS). Once the product is launched and customers start availing the service, interest income and fees are recognized as revenue, while operational costs are expensed. The balance sheet reflects changes in intangible assets, receivables, and cash as the product is developed, launched, and used by consumers.

In banks and financial institutions, the people responsible for designing financial products and services are part of specialized teams that operate much like a product development or innovation team in a manufacturing business. Here’s how it works:

Who Designs Financial Products?

The creation and design of financial products involve several departments working together. Each plays a critical role in ensuring the product is feasible, profitable, and compliant with regulations. These roles include:

• Product Development Team (or Product Managers): Lead the design process, defining features, pricing, and terms.Analyze market needs, customer behavior, and competitive products to create new offerings like loans, credit cards, and investment products.
• Risk Management and Credit Analysts:Assess the risks involved and set credit limits, interest rates, and default management strategies.
• Legal and Compliance Officers:Ensure products comply with financial regulations and standards.
• Finance and Revenue Managers:Analyze profitability and revenue streams from interest, fees, and other charges.
• Technology Teams:Develop the digital platforms and backend systems for automation and efficient delivery.
• Marketing Teams:Position and promote the product to target customers.

Pre-Designed :

Most financial products are pre-designed with standardized terms, pricing models, and risk parameters. Examples include:

• Personal loans, credit cards, fixed deposits, or mutual funds are created based on market research, profitability analysis, and regulatory guidelines.
• These products are approved by management and made available to customers through branches, online platforms, or sales teams.
• Customization within predefined limits (like different credit card limits or flexible loan tenures) allows some personalization.

On-the-Spot Customization:

Certain financial services, especially for large clients, are customized during client interactions:

• Corporate loans, syndicated loans, or tailored investment products are often structured based on negotiations.
• Private banking or wealth management products are frequently designed on-the-go, incorporating unique terms that fit the client's specific needs.

For example:

• A mortgage for a large commercial property might be negotiated with custom interest rates, payment terms, and collateral agreements.
• A tailored insurance policy may be adjusted based on the client's business risks or personal health factors.

Note:

• Retail financial products like credit cards and personal loans are largely pre-designed, allowing for only limited customization.
• Corporate and high-net-worth products are more likely to involve real-time customization to meet unique client needs.
• In banks, the “factories” are the teams mentioned above, using data models, algorithms, regulatory frameworks, and market research to craft the “products” that drive business.

In essence, the factory of a bank involves these specialists working together:

1. Financial engineers design and simulate models.
2. Financial analysts evaluate profitability and market fit.
3. Actuaries assess risks to ensure the product is sustainable.

This holistic team creates, customizes, and manages the financial services and products banks offer.

However, these professionals often form the core of specialized teams responsible for modeling, pricing, and managing the financial intricacies of products-

In financial institutions, collaboration among different roles (financial engineers, analysts, actuaries, lawyers, and compliance professionals) is critical. Products and strategies can be predesigned for retail use but are heavily customized for institutional clients or complex transactions.

In reality, the launch and management of a new loan product are far from a one-off process. It involves constant feedback loops between departments—product development, sales, marketing, operations, risk management, and customer service—to ensure the product remains competitive, profitable, and aligned with customer needs.

Banks must continuously assess market demand, adapt pricing strategies, manage risk, and optimize customer service to drive sustainable revenue and ensure financial stability.

In today’s rapidly evolving financial services sector, understanding how multiple departments collaborate to drive revenue management and balance the bank’s financial health is crucial. Whether you’re in product development, sales, or operations, being part of this cross-functional process gives us all valuable insights into how financial products and banking operations really work.

As we look to the future, this multi-departmental approach will continue to evolve, with more sophisticated tools and data-driven insights guiding how banks create and manage financial products. The digitization of financial services is already changing the way these products are conceived, launched, and managed, and understanding these connections is essential for anyone looking to succeed in the modern banking and financial landscape.

Key Takeaways

1. Designing and launching financial products is a complex process that involves balancing customer needs, operational costs, and profitability.
2. Revenue generation occurs not only from the core product (e.g., interest) but also through fees and bundled services (like insurance or financial planning services).
3. Financial statements reflect different aspects of the product life cycle-The income statement shows revenue and expenses generated from the loan and associated services.The balance sheet tracks assets (loan receivables) and equity (net income).
4. Revenue recognition is not immediate; it spreads over the life of the product (loan term), and expenses are recorded as incurred.
5. Bundling additional products increases revenue but also impacts the cash flow, especially if it leads to an immediate inflow of fees.

By carefully managing the product development and tracking these metrics across all three financial statements, banks can ensure that the products not only meet customer needs but also contribute significantly to profitability and long-term financial health.