Mixed Signals

By Bill Stoneman

Customer profitability analysis sparked a revolution in bank marketing. Was it properly understood and utilized?

In a hopeful quest for growth, banks all over America spent a good part of the '90s slicing and dicing their customer bases to identify which retail relationships were profitable and which were not. Pursued under the banner of customer segmentation strategy, the profitability-based analytical framework and its associated responses seemed to address some of banking's deep-rooted problems.

Pamper profitable clients and move the rest to low-cost electronic channels, experts said, and banks could rejuvenate themselves.More than five years into the experiment, however, it appears the optimism was premature — if not misplaced.

Many institutions have attempted retail strategies based on profitability segmentation, and although anecdotal success stories abound, it's difficult to see bottom line improvement — either for individual institutions or for the industry at large. Executives increasingly are realizing that profitability analysis, by itself, will not get the job done. "Many organizations thought they found the Holy Grail when they discovered relationship profitability," says consultant Robert Hall, chief executive of ActionSystems Inc., Dallas. "It is an important tool, but not the complete answer."

This is not to suggest that profitability-based segmentation is without merit. On the contrary, the insight that a handful of clients contributes more than 100% of retail earnings at a typical financial institution is profound, since it means that most client relationships are unprofitable. This revelation has sparked deep soul-searching among bank marketing strategists. Confronted by the now-famous "profitability skew," they realized that the "one-size-fits-all" approach to serving customers was no longer valid. The industry got serious about upgrading information management capabilities and began targeting specific groups of customers for marketing and retention efforts.

At least a few major players apparently have taken meaningful advantage of profitability segmentation. First Manhattan Consulting Group president James McCormick, who did more than anyone to develop and popularize the concept, insists some large institutions are generating 3% annual growth in deposits on the strength of marketing strategies guided by profitability segmentation. Memphis-based First Tennessee National Corp. cites a 97% annual retention rate for its best clients.

Still, scattered successes are something different from an industry breakthrough. Instead of fueling an overall expansion, profitability segmentation became a guerrilla weapon that institutions used in an ongoing fight among themselves over the most lucrative banking customers. Cumulatively, after adjusting for acquisitions, the nation's largest banks reported zero growth in checking, savings and money market balances from 1993 to 1998. Says McCormick, "The industry continues to have a revenue momentum problem."

In contemplating how to respond to these developments, managers should consider three factors. First, capitalizing on profitability segmentation requires far more work than many people probably realize. Adherents must be committed to substantial organizational change and be prepared to deal with a host of transition issues, such as re-pricing products and re-thinking service and delivery. In retrospect, many institutions probably held unrealistically high expectations about what their segmentation projects could accomplish in the near term, especially given all of the implementation issues.

Second, relationship profitability metrics must be put in their proper context. Such metrics often work best as a supplement to other decision factors, such as customer needs. Institutions must look beyond statistics to the individual. Relationship profitability is dynamic, reflecting the unfolding financial situations in which people find themselves.

Third, the industry needs to redouble efforts to stake out places in the fastest-growing areas of financial services, such as brokerage and mutual funds. How much long-term value can be derived from the profitability segmentation framework when people are making less use of the major types of banking products on which it is based? In many cases, investments in elaborate segmentation schemes offer less return than comparable deployments of organizational resources in new product areas and value propositions.

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Are institutions simply failing to execute segmentation strategies effectively, or is the profitability analysis itself flawed? A lot hangs on the answer to that question. For two decades, banks have been losing both deposit and loan business to nonbank competitors. Many managers were counting on segmentation strategies to help reverse those trends.

Consensus is now hardening around the view that profitability analyses and associated remedial programs are helpful only to a point. They do not substitute for more sweeping retail banking imperatives, such as lowering overhead expenses and expanding affiliated brokerage and mutual fund businesses. Also, when dealing with profitability segmentation, managers need to understand that analysis does not necessarily provide prescription.

The profitability skew — 20% of customers contribute most retail profits — would seem to suggest a strategy of coddling the best customers. But profitability metrics provide no guidance on whether high-value customers will be flattered or annoyed by regular calls from account managers. Nor can they predict the next account a customer will open — let alone whether the new account will be used in a way that is profitable to the bank. For people in the unprofitable relationship segment, the emphasis is on getting them to pay their way by maintaining higher deposit balances, paying steeper fees and using lower-cost delivery channels. But here again, profitability metrics don't reveal how to pull that off.

Decision support is another area where profitability metrics fall short. In a vacuum, profitability measurement might help determine the financial consequences of a re-pricing decision. But in the real world, customers react to product re-pricing in unpredictable ways, throwing off the projections. For example, profitability measurement sheds no light on which customers are likely to decamp following a price hike. And it offers no guidance about the best way to communicate changes to customers.

Finally, obsessing about the 20% to 40% of customers who are the least profitable may lead to seriously misguided pricing decisions. When subtracting from individual relationship revenue an expense calculation that includes both variable costs and an allocated share of fixed costs, large numbers of customers appear unprofitable. Significantly, this profit drain nearly disappears when only the variable cost of servicing an individual customer is subtracted from the customer's revenue. Institutions may, in fact, ameliorate this problem by simply reducing overall institutional overhead.

Coming up with the optimal measurement system is no small accounting issue. Banks that use flawed metrics to drive product design and pricing decisions may self-destructively encourage "low value" customers to take their business elsewhere. The result will be unchanged fixed costs spread over a smaller customer base, thereby impairing the profitability of all the customers who remain. "In theory, an infinite number of things can be done with customer relationship profitability information," says Peter Carroll, a consultant with Oliver, Wyman & Co., New York. "In practice, the number of decisions it can support is limited."

Segmentation's Promise

Banks didn't have to worry much about relationship profitability in former decades, when interest rate regulation virtually guaranteed them attractive returns. The removal of rate ceilings in the 1970s, however, brought banking into a more competitive environment. Bankers responded by emphasizing selling. Virtually every institution heralded its new "sales culture."

Sales programs didn't seem to work as well in banking as in other businesses, however. Bankers gradually came to understand that profitability in this industry depends on the complex interaction of balance levels, fees paid and transaction patterns of individual customers. Furthermore, the contribution of individual customers to bank earnings varies widely. Though the math works out differently in individual cases, the most profitable customers generally keep high balances and/or pay substantial fees, and make modest use of live tellers.

With this insight came the idea that banks should employ different strategies for different customer segments, depending on their profitability contribution. The ultimate promise of this exercise was that institutions could boost earnings by improving the selection and retention of high-value customers while at least bolstering the contribution of everyone else.

A typical program was introduced by PNC Bank Corp. in the fall of 1998. PNC offered price incentives to customers who would bring more of their financial business to the Pittsburgh-based bank, and it imposed fees for heavy teller usage. While teller fees raised the cost of banking for customers who visited PNC branch offices day after day, the price breaks rewarded many clients having high current or potential relationship profitability. The minimum balance threshold for interest-bearing checking was lowered. In addition, instead of granting free checking to customers based only on deposit balances, the bank began counting loan and brokerage account balances toward the target.

Early results are promising, according to Joseph C. Guyaux, executive vice president and head of PNC's retail business. After a period in which deposits grew by less than 1% annually, they rose by nearly 3% in the first eight months of 1999. Average balances per savings account rose by 10%, while related teller transaction volume fell by 20%. "Our business will produce double-digit net income gains in 1999," Guyaux predicts.

Analysts are divided, however, on whether such projects really make a difference. Taking the positive view is analyst Robert Patten at Lehman Brothers. He says banks "have gotten much better at moving customers to non-personal channels," and cites increased usage of direct payroll deposit, automated teller machines for cash withdrawals and automated phone systems to check account balances. Lowering the volume of transactions handled by tellers has helped drive down efficiency ratios at many banks, Patten asserts, allowing significantly more revenue to reach the bottom line.

A contrary opinion comes from Lawrence Cohn, director of research for Ryan, Beck & Co.: "The companies keep telling me they are doing this and how wonderful it is. But when you look at the aggregate revenue growth in their retail banking business, it doesn't seem to be any different than anybody else's."

Carrots and Sticks

Though it is difficult to establish linkages between profitability segmentation strategies and bottom line improvement at individual institutions, analysts do cite certain companies where some benefit is apparent. These include Centura Banks Inc., Rocky Mount, N.C.; BB&T Corp., Winston-Salem, N.C.; Firstar Corp., Milwaukee, Wisconsin, and First Tennessee.

Profitability segmentation "is ingrained in the way we develop our retail strategies," says David W. Miller, senior vice president for customer information and delivery strategy at high-performing First Tennessee. The institution grew earnings per share at a 14% compound annual rate from 1996 through the first half of 1999.

First Tennessee is addressing both sides of the profitability skew. The bank provides priority call center service to top customers, for example. When these clients key in their account number on a touch-tone phone, their calls get priority routing and are answered by the most skilled operators. Customers also receive rewards for progressively higher balances. These benefits include free overdraft protection, the waiving of stop-payment fees, $25,000 in accidental death insurance and 5% discounts on brokerage commissions.

At the low end, products have been re-priced and re-packaged to encourage customers to consolidate their accounts at First Tennessee, keep higher balances, and either do more of their business through self-service channels or pay extra for continuing to use the branch. As part of First Tennessee's ongoing data mining project, customer service representatives in the branches will soon be able to access profitability rankings of customers on their computer screens, which may help guide them in allocating their time and energy. "It's not necessarily a good business decision to spend a half hour with certain customers helping to balance a checkbook each month," Miller says.

But therein lies one of the potentially costly pitfalls of profitability segmentation: while there is little risk in pampering the best customers, remedies for the unprofitable segment can easily backfire.

The basic objective of most segmentation strategies at the low end of the profitability skew is to keep these less-valuable customers from getting too much face time with high-cost tellers. But some institutions have been accused of using blunt tactics to get these customers to use ATMs and other automated delivery channels. First Chicago Corp., for example, touched off a firestorm of controversy in 1995 when it imposed fees for teller transactions. Mac Rabb, a consumer financial services partner in the Chicago offices of KPMG Peat Marwick LLP, says one $40 billion-asset bank lost a third of the 210,000 checking accounts it held in a certain territory within a year of re-pricing them.

To avoid similar backlashes, banks are using less stick and more carrot. Centura Banks, for example, created a checking account having no minimum balance requirement and a fee structure that rewards the use of alternative delivery channels. By arranging for direct payroll deposit and avoiding using a teller in a given month, the customer reduces the monthly account fee from $8 to $1, a setup that emphasizes the carrot of reduced fees rather than the stick of penalty charges.

Effective communication between front-line staff and customers may be even more important in making a smooth transition. This requires schooling tellers and call center operators in the thinking behind segmentation strategies. Beginning in October 1998, bankers at PNC spent nearly a year calling all 1.8 million retail deposit customers to tell them about impending account changes. Guyaux says the calling program succeeded in convincing customers to roll small accounts into larger ones and created goodwill among customers who were pointed toward better deals.

Even so, such elaborate groundwork underscores the enormity of the commitment that profitability-based segmentation requires. Essentially, institutions are using profit metrics as a basis to recast relationships across the full spectrum of retail customers. That's a big job, with the analytical portion being only a small part. To make the most of the exercise while avoiding myriad pitfalls, managers must re-think products, information systems, pricing strategies, sales and service practices, delivery channels, marketing campaigns, and so on.

Acknowledging that bankers haven't used profitability segmentation as productively as he envisioned, First Manhattan's McCormick now advocates a simpler initial approach. He advises banks to form two groups to address profitability issues: one to think up ideas for bolstering the business of high-value customers; another to focus on the least profitable customers. Eventually, he says, research will identify other useful groupings within these broad segments.

Limits to Profit Segmentation

Beyond tactical adjustments, there are clear limits on what an organization can do with relationship profitability insights. Banks will always have a difficult time achieving breakeven with low-balance, high-transaction customers. Consumer groups and politicians are already steamed by the escalation of fees on routine transactions. Moreover, banks are required by law and regulation to serve everyone in their market area. In the name of community service, banks must offer low-fee checking accounts and loan pricing concessions for low-income people, and that's not likely to change.

Retaining the most profitable customers may prove no easier than cutting losses on the unprofitable ones. Retention programs alone are unlikely to reverse the continuing flow of funds from insured deposits to uninsured investments that pay higher rates. To deal with that problem, banks need to do a better job of marketing their own brokerage and mutual fund services. It's true that some people still keep unusually high levels of deposits in relatively low-interest accounts. But it isn't clear why they do so, or where to find more of them. Nor can a bank be too confident that it knows how to keep such customers satisfied.

Some banks, such as BB&T, have their relationship officers call the highest-value customers quarterly, just to check in. BB&T executives claim this practice helps boost annual retention rates on top customers, all the way up to 95%. But some experts question whether this tactic will work well over an extended period. "The first time you get that kind of call, it probably feels OK," says consultant Hall. But for the time-pressed customer, repeated calls that bring no value to the relationship may soon be viewed as a nuisance.

There's also this paradox to consider: the very effort banks make to retain their most profitable customers will almost certainly reduce that profitability. Higher service levels cost the bank more. Revenues decline when customers are granted concessions on interest rates or fees, or are encouraged to move bank deposits into non-insured investments. Banks are further encumbered by their need to cover the costs of their branch networks. The higher an institution's overhead ratios, the less flexibility it has to offer concessions to price-sensitive, high-value customers.

Even though profitability-based segmentation schemes alone won't cure sluggish revenue growth, they still remain valuable in helping marketers assess individual customer relationships. As long as banking organizations introduce new services and new delivery channels, as long as they cut costs by removing services that some customers want, and as long as they craft new marketing campaigns, customer relationship profitability will be a key factor in measuring whether these ventures are paying off.

Mr. Stoneman is a freelance writer based in Albany, N.Y.

Copyright © 2003 by Banking Strategies, published by BAI.

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