The Devil in the Details

By Kenneth Cline

Wells Fargo won a well-deserved reputation as a retail banking innovator. But CEO Paul Hazen discovered that poor execution of an acquisition can trip up the best-laid strategies.

Sometimes innovation is just not enough.

Wells Fargo & Co. has been heralded as the pioneer retail institution among large U.S. banks -- and for good reason. The San Francisco-based company has gone further than most in replacing traditional branches with supermarket outlets. It was among the first to offer Internet banking. Wells is aggressively backing "smart card" technology by serving as the West Coast pilot for Mondex. The bank's revolutionary program of making small business loans through credit scoring and direct mail is so successful that it is being copied nationally.

Such originality notwithstanding, Wells today is regarded as more of a cautionary light for the industry than a beacon. A $13 billion, or 15.5%, deposit reduction -- some planned, some not -- occurred in the wake of its tempestuous acquisition of First Interstate Bancorp. It will take a long time for Wells to overcome negative publicity generated by severe service problems plaguing the hurried merger integration. Strategically, chairman and chief executive Paul Hazen is fighting to regain lost ground as opposed to moving his company forward.

To be sure, great potential still lies with the bank's alternative delivery strategy of encouraging customers to use supermarket outlets, automated teller machines, telephone call centers and PC online banking. The campaign promises to help cut Wells' delivery expenses and win convenience-hungry customers. But merger integration problems have, fairly or unfairly, cast a pall over this ambitious experiment in retail banking.

The situation underscores how even the most carefully designed strategy can founder on the shoals of uneven performance. As Hazen himself says, "The business philosophies we employed are correct, but our merger execution was poor."

Essentially Wells tried to do too much. Not yet finished with its own branch reconfiguration project, the company endeavored to assimilate First Interstate on a rushed schedule while striving to deliver $800 million of expense cuts promised to Wall Street. Migrating customers from traditional branches to grocery store outlets was at the heart of Hazen's plans to realize required savings in the $13 billion deal. The company found itself juggling two major strategic initiatives, even though it temporarily suspended the branch reconfiguration program to complete system conversions. Meanwhile, defections thinned the ranks of managers and customer service representatives, leaving the company unable to respond adequately when integration problems cropped up.

"Things were clearly more complicated from the standpoint of being in the middle of transitioning the distribution network and then taking on the merger," says Joseph P. Stiglich, vice chairman in charge of Wells' physical distribution group.

The deeper strategic question is whether Hazen should have completed Wells' own branch reconfiguration program in California before proceeding with his bid for First Interstate. Originally, Wells did not anticipate being ready to handle a major acquisition until the end of 1996. But the company wound up violating its own timetable by roughly 14 months, launching its First Interstate takeover campaign in October 1995.

A source close to the company says Wells executives thought it would actually be less disruptive to include the First Interstate branches in the reconfiguration project already underway. The desire to preempt other bidders may have also been a factor. "First Interstate had all the tell-tale marks of a takeover candidate," says analyst Thomas F. Theurkauf of Keefe, Bruyette & Woods Inc.

The timing and rationale of the bid can be debated at length. But the lesson for other banks is clear: implement strategy at a realistic pace. While it's important to heed the discipline of the market, setting up high expectations on Wall Street can be risky. "Wells' officers had to promise deep and expedient expense cuts," says Theurkauf. "They didn't have the luxury of time. It added up to tremendous execution risk."

The task before the 56 year-old Hazen is to staunch the hemorrhage of former First Interstate customers and shore up Wells' battered franchise and image, particularly outside of California. During the first nine months of 1997, Wells' loan-to-deposit ratio soared from 82.4% to 91.8% as total deposits fell by $11 billion. A sizable portion of the erosion came as Wells sold branches to allay anti-trust concerns -- but another big chunk represented customers leaving the bank.

Hazen is responding with a program that pays $5 to any customer who has to wait more than five minutes in a teller line. The policy is in force in Arizona, Colorado, Idaho, Nevada, New Mexico, Oregon, Texas, Utah and Washington. Wells is also working on new advertising campaigns. And Hazen himself has been touring the Wells branch system to rally the troops. His message: the problems are behind us, now let's get on with the job of winning back business. "The challenge," Hazen says, "is very simple. We need to be in a position where we're taking market share from others."

Though visibly chastened by the First Interstate experience, Hazen remains adamant in his pursuit of what is arguably the most aggressive retail strategy in the nation. He wants 55% of Wells' branch network to operate through supermarket outlets by next year, up from an already-high 45%. Wells executives take encouragement from pilot projects in Sacramento and San Diego, where the alternative delivery strategy has been fully implemented.

But there is a subtle change in approach. Banished from the lexicon are such slogans as "High tech, low touch," and "Do it, fix it, learn," phrases that Wells executives once used freely to express confidence in technological solutions. Hazen now says these slogans received exaggerated press coverage and did not reflect the company's emphasis on customer service. More importantly, the transition to supermarket branches will be slowed in states such as Arizona, Nevada and Oregon, where Wells experienced the brunt of merger-related service problems. The final mix of traditional and supermarket branches in those states will also be skewed a bit more to the traditional side than is the case in California.

Wells based its retail strategy on a belief that today's customers uniformly desire speed, convenience and choice in terms of their routine banking transactions. A necessary corollary to that view is that customers uniformly place less value on face-to-face contact in traditional branch offices. In the wake of First Interstate, Wells concedes that customer preferences may vary somewhat by region. "We don't believe customers have different desires in one market versus another. But the transition pace may be different outside of California," Stiglich says.

Could this shift in nuance herald a major change in Wells' strategy down the road? Many Wells critics say the bank risks getting ahead of its customer base. But Hazen refuses to retreat. "I don't call that a change in basic philosophy," he says. "It's an adaptation to market conditions."

Alternative Delivery

Wells has long been known for its penny-pinching style. Former CEO Carl E. Reichardt was fond of such maxims as "Kill for a basis point" and, "Run it like you own it." The quest for cost savings became even more intense in the early '90s when the company found itself carrying a heavy burden from nonperforming commercial realty loans. The physical distribution group, in charge of the branch network, began studying how the bank could improve retail profitability by cutting expenses. By 1994, Reichardt had signed off on a plan to increase the availability of alternative delivery channels -- supermarket outlets, multi-purpose ATMs, 24-hour telephone banking and PC online banking -- while reducing the number of traditional branches.

"We had to come to grips with the contradictory issues in running a large, branch-based network," Stiglich says. "It is questionable whether traditional branch economics are sustainable over the long term. Equally important to running a retail bank, customers are demanding easy access. We were looking for a solution that brought expenses in line and addressed the convenience issue for customers."

Electronic alternatives support Wells' strategy by helping it capture customers willing to conduct their banking business from remote locations. But the majority of customers still want the option of face-to-face contact, which is why supermarket outlets constitute the heart of the plan to lower expenses while offering more convenient access. Assuming parity in functionality and staff quality, such outlets enable banks to offer branch-comparable service in a much more efficient setting. Having already experimented with grocery store branches in major California markets, Wells was comfortable with that business and believed customers would respond well to an accelerated rollout, which began in 1995.

While many other banks around the country are implementing similar programs, few have been willing to go as far as Wells in abandoning the safety of the traditional branch. The Wells transition has been slowed in some areas by problems related to the First Interstate acquisition. But test results in Sacramento and San Diego, where supermarket networks are now fully deployed, provide grounds for optimism. Expenses in those markets fell by roughly 20%, while sales gains ranged from 15% to 20%. Results from Los Angeles and San Francisco, the next two "beta sites," should prove more conclusive, since those markets are much larger and more demographically diverse.

Of course, strategy isn't implemented in a competitive vacuum. Rivals pounced on the alternative delivery campaign as evidence that Wells doesn't care about customers. California thrifts have been particularly aggressive in using negative advertising to lure away Wells' customers. Attacks took on a renewed sting in the wake of horrendous service problems attending the First Interstate conversion.

Wells, obviously, considers the criticism unfair. The bank doesn't force customers to use supermarkets or ATMs -- although reducing the number of branches could have that effect. The strategy, rather, is to use price incentives to encourage customers to use alternative delivery. Wells bundles some of its account packages in such a way that customers get price breaks when they transact routine business via ATM, PC or telephone. Supermarket outlets inject more convenience into the total "value proposition" because retail customers get more physical access options. The reconfigured Wells network also includes a prototype investment center for mutual funds and securities sales, and business banking centers for small business customers requiring face-to-face handling.

"There's a tendency for competitors to hang us with the label of being just a transaction bank," Stiglich says. "That's not the case. We are different, however, in that we think routine and relationship banking are two different things and ought to be treated that way. We think we can address the relationship piece by solving the transactional piece in a way that's both cost-efficient for us and faster, more convenient for our customers."

Even as direct competitors criticize the Wells approach, banking peers and analysts salute the innovative strategy. A 1995 Bank Administration Institute/First Manhattan Consulting Group survey of senior executives at 38 major banks ranked Wells the "most progressive" retail distribution bank. "This whole delivery system change is the most important thing going on in banking," says analyst Thomas K. Brown of Donaldson, Lufkin & Jenrette.

Indeed, even as the new retail strategy gained momentum, the combination of commercial real estate recoveries and strict cost control transformed Wells into the most profitable large bank in the country by 1995. The banking company delivered a 2.03% return on assets and a 29.7% return on equity. The stock, having attracted high-profile investors such as Warren Buffet, climbed to $216 a share at year-end, up 274% from $58 at year-end 1990. Wells could do no wrong.

Then came First Interstate.

Hazen Takes Over

When Hazen replaced Reichardt as chairman and CEO on Jan. 1, 1995, he had already spent 11 years as Wells' number two executive. While he often seemed overshadowed by Reichardt's more gregarious personality, Hazen's contributions to the company were well recognized. He was credited, for example, with Wells' 1986 acquisition of Crocker National Corp., commonly regarded as the most successful merger integration of that era.

Observers wondered, however, when Hazen would put his own mark on Wells. Did he intend to launch the company in any new directions?

The answer was not slow in coming. On Oct. 16, just 10 months into his tenure as CEO, Hazen launched a full-scale hostile bid for First Interstate, a risky and rarely attempted maneuver in banking. Reichardt had already conducted inconclusive merger negotiations with First Interstate, in early 1994. But it was Hazen who took the bull by the horns and drove the deal to a successful conclusion, despite having to fend off a competing bid by First Bank System Inc., Minneapolis.

First Interstate, in one fell swoop, gave Wells 6 million new retail accounts and a presence in nine additional states. Paying for the $13 billion acquisition, however, required Wells to cut expenses dramatically. The bank's strategists saw an opportunity to achieve some $800 million in savings by dovetailing the First Interstate conversion with Wells' ongoing branch reconfiguration project. Plans called for shrinking the combined base of 900 First Interstate and Wells branches to 400 by the end of this year, while deploying nearly 800 supermarket outlets at the same time. Analyst Brown believes the branch reconfiguration numbers tipped the First Interstate bidding war in Wells' favor. "They could reduce the cost basis at First Interstate even more because of what they had just decided to do with their own delivery system," Brown says.

But a decision to rush the conversion schedule left little room for error. And three-fourths of First Interstate's top 500 officers took advantage of generous severance contracts to bail out at this critical time. In the process of switching First Interstate accounts over to Wells, deposits were not recorded, checks got bounced, and angry customers besieged customer service representatives, who proved too few to handle the complaints. Wells ended up reporting $180 million of operating losses in the second quarter of this year as it reimbursed First Interstate customers for lost monies and booked additional merger integration charges.

Wells' problems may have been exacerbated by the nature of First Interstate's customer base. At the time of the merger, the Los Angeles-based bank had been experiencing net account attrition, which is common for large banks. But First Interstate also enjoyed some of the cheapest funding in the industry, owing to a high proportion of demand deposits. First Interstate stressed personal service in its marketing campaigns, and it appears the bank attracted many customers placing greater importance on responsiveness than deposit yields. Were they alienated by Wells' "high tech, low touch" approach?

The evidence is ambiguous. Wells' alternative delivery strategy certainly received extensive press coverage following the merger. And Wells has been building a lot of supermarket branches throughout the former First Interstate franchise. But actual branch closings didn't begin until the second quarter of this year -- after system conversions were completed. Also, the majority of deposits lost by Wells fell in the large corporate and small business categories rather than retail, and much of the erosion can be traced to regulator-prescribed branch divestitures.

Wells executives like to point to California, where the branch overlap was greatest and First Interstate customers experienced the most merger-related change. California is also where Wells has been most aggressive in replacing traditional branches with supermarket outlets, particularly in Sacramento and San Diego. Yet, Wells has gained deposits in the Golden State, even though First Interstate customers experienced the same service problems there as in other states.

The problem outside of California may not be too much alternative delivery but rather too little. "In California," Stiglich says, "we had rolled out an extensive network of supermarket outlets and ATMs. Even when the branch system broke, we had other positives for customers. In other markets, the core system broke and customers had nowhere to turn. To the extent that it's harder there, it's not because customers are resistant to what we're building -- it's because we can't deliver it fast enough."

Retail Conundrum

Debate still roils the industry, however, about whether supermarket outlets and other alternatives can truly replace the traditional branch. The question reflects a basic conundrum of retail banking. On the one hand, research clearly shows that banks lose money on at least half of the households they serve. Since raising fees is dangerous, for competitive and political reasons, the only alternative is to try to get unprofitable customers to transact more of their business via cheaper delivery channels. On the other hand, research also suggests that the most profitable customers tend to favor face-to-face interaction at local branches and may resent having to enter a supermarket to conduct their banking business. Banks won't make headway with efficiency if they are forced to maintain both traditional and new channels at full strength.

"So far, many early adopters using food store, telephone and PC channels are unprofitable due to their low balances and higher transaction volumes," says James M. McCormick, president of First Manhattan Consulting Group. "Studies of grocery store locations show an over-concentration of low revenue households. This raises marketing issues. How critical is the traditional branch to the value proposition perceived by profitable households?"

Wells itself won't be able to answer that question conclusively until next year, when the California branch reconfiguration is completed. In the wake of the First Interstate problems, meanwhile, it remains difficult to distinguish flaws in execution from flaws in strategy. Hazen himself admits Wells probably didn't have enough well-trained employees available to handle customer complaints since the bank's staffing models had been oriented to a lean-and-mean style of operation.

"It is probably true that our staffing models may not have included sufficient training, particularly with former First Interstate employees who had to adapt to the Wells system. So in that sense, we were under-staffed," Hazen says. "But there was not an intentional business strategy or philosophy to under-staff."

In any case, the problems at First Interstate should not obscure Wells' achievements in alternative delivery. The supermarket branching experiments, combined with progress in PC online banking and direct mail small business solicitations, suggest Wells may yet be able to show the industry how retail bankers can provide convenient access and good service to customers while reducing the cost of delivering that service.

Despite the chastening experience of the First Interstate merger, Wells still remains committed to a full-speed-ahead style. Bumps along the way are simply accepted as part of the cost of doing business in banking's brave new world. Says Hazen, "If you're going to be aggressive and innovative, not all of your results will fit within a narrow spectrum of expectations."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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