Mass Movement

By Steve Klinkerman

Though Internet banking is barely out of its infancy, institutions must anticipate its mass market destiny.

Only a few short years ago, executives were having difficulty conceiving of online financial services as a legitimate niche market. Now, even as niche platforms are proliferating, strategists are confronting an even larger challenge: dealing with the online medium as a true mass-market phenomenon.

It seems like so much hyperbole until you consider the projections. International Data Corp., for example, predicts that the portion of U.S. households banking online will double to 20% by 2003. Fifty-eight percent of top financial services executives surveyed globally believe that the Internet will be the top priority for information technology investments by then, according to Cap Gemni Ernst & Young. And McKinsey & Co. estimates that half of retail banking transactions will be influenced by online information by 2003.

This places the Web migration in a whole different light. With so many people doing business online, questions about bandwidth, interactive capabilities and technology platforms take on added significance. So too do questions about reconfiguring delivery systems and online economics. Instead of an addendum to traditional operations, online activity is becoming the new fabric of the organization.

To flesh out the implications for senior managers, Banking Strategies sat down with two accomplished players in financial services: Peter Currie, vice chairman and chief financial officer of Royal Bank of Canada; and Toos Daruvala, a senior partner in McKinsey's New York office. The roundtable session was part of the agenda at BAI's spring 2000 Internet banking conference held in Miami Beach.

In a candid exchange, the executives portrayed an industry increasingly pressured to re-orient itself to the demands of the online customer. Along with the strategic intricacies of new online business models, institutions will have to cope with the challenge of reconfiguring capacity in a much more anticipatory way, while demand is still nascent. And although much of the imagery surrounding the Internet is about new customers and new markets, Currie and Daruvala cautioned institutions not to over-reach, saying many ventures ultimately will be aimed at retaining customer relationships already established in the physical world.

Banking Strategies: What are the key dimensions along which the online financial services market will grow?

Daruvala: I think the short answer to that question is "all." This no doubt will become a mass market. My take is that it will explode across a multitude of dimensions. Based on recent research, about 1% of all financial services revenue currently is booked online. That number is expected to climb to 10% over the next three years.

That's pretty dramatic growth. But what's even more interesting is that a much larger percentage of overall financial services revenue, something like 50%, will be influenced by online activity. Which means that, three years out, roughly half of the industry's revenue will be coming from customers who supplement their purchase decisions with a lot of online research.

That is why providers have to start preparing now. Today's 1% number can be deceiving. Senior executives at financial institutions look at that and scratch their heads and say: "Why would I want to invest tens of millions of dollars in online development right now, when the market, frankly, is embryonic?" But when you examine where the growth is going to come from, this is the channel. You have to move now in order to maintain competitive parity.

Currie: Our industry became very comfortable with a relatively predictable rate of change over the last century, but now we're in an environment where we can't predict change. So as firms, we have to be prepared to take risks that we would have considered imprudent only a few years ago. And the successful companies five years from now will be the ones that began taking those risks today.

At Royal Bank of Canada, nothing has a higher developmental priority right now than e-business. It pervades our various product lines. Our corporate bank has an e-business approach. Our discount brokerage and other wealth management units have Web strategies. It's the same thing for personal financial services. Within our information technology organization, we've established a facilitating group that supports these ventures and ties them together.

In terms of the percentage of our corporate developmental budget, I would say that somewhere between 10% and 15% is virtual banking-specific. There is a halo effect though, so the figure probably doubles if you think about everything it possibly touches. I can see a time in the not-too-distant future when virtual banking essentially dominates our development stream.

Banking Strategies: What sorts of market breakthroughs might be needed to unleash the kind of growth you're talking about?

Currie: Technologically, I think the bottleneck lies in the constricted bandwidth of the network. Currently, the bulk of retail customers do their online banking through conventional telephone lines and modems operating at 56 kilobytes per second. You can't transmit a lot of rich interactive data over a conventional phone line.

So broadband is critically important in being able to distribute the kinds of functionality that customers want in retail banking. I'm talking about one-to-one image transmission, the customization of the approach to individual customers, the real-time video interaction, that will make each person think that the bank is strictly customized to his or her needs.

Ultimately, I think you are going to see the major telecommunications players adopt coaxial cable, supplemented by high-speed wireless local networks. But that's in the future. Most telcos aren't yet there in the majority of their distribution networks. To get things going, we might have to try to deploy broadband capabilities in test markets ourselves, in partnership with either telephone or cable carriers.

We're also going to have to find a way to get low-cost access devices in the hands of our customers. People today are reasonably satisfied with sitting down at their personal computers, and using a keyboard and a wired mouse, and connecting over slow telephone lines. I guarantee that in a few years, they are going to say that kind of setup is absolutely prehistoric and highly unsatisfactory.

Customers are going to want, in their homes, a wireless access device that works much like a cordless telephone does today. A unit that doesn't use a keyboard and instead is either voice-activated or uses a touch screen. These devices are in development today by a number of manufacturers.

Financial services providers need to get out in front of that trend. We'll have to make big investments in those technologies and take a lead role in deploying them to our customers, much in the way that communications players rolled out cellular phones. Institutions have to move that to the top of the list of investment priorities and say: "Yes, we're going to have to over-invest in these things in the short run, because we are going to have to create the market."

But it's not enough just to create the vehicle. You also have to create a different experience.

Banking Strategies: That sentiment is expressed with increasing frequency. But what is a compelling online experience all about, from a customer perspective?

Daruvala: People don't want a stale translation of the physical world into the online world. They want something innovative, something that leverages the power of the electronic medium. For example, customers want to be able to obtain information and get responses in real time. They appreciate conveniences such as point-and-click balance transfer capabilities and instantaneous links with customer service.

Non-financial companies are leading the way. You have only to go to Amazon.com to understand what a truly interesting customer experience means.

Currie: An overarching customer requirement is transparency, and this has multiple implications. For one thing, customers are indifferent about how providers are organized internally. They don't care about the operational distinctions between the personal financial services unit, the credit card unit, the mortgage unit and the discount brokerage. These demarcations should be absolutely minimized online. The interface should be about effortlessly fulfilling customer needs, as opposed to enforcing organizational schematics.

Another perspective on transparency is that people want to be able to blend financial services with a variety of other online capabilities to achieve their business and personal objectives. Small businesses, for example, have need for procurement services, accounting services, consulting services, legal services and payroll services. A truly competent small business site would incorporate these requirements. Ignoring demand for this type of multifunctional integration places customer relationships at risk and leaves institutions open to attack from new competitors.

Third, customers want transparency in assembling the desired selection of brands. They would like to go to one place to fulfill their needs, but they don't want to be limited to a single provider's product set. The response is to move to an open finance model, which permits customers to access the host institution's offerings along with a variety of complementary and/or competing offerings from other entities. The open concept is alien to many financial institutions, but it is prevalent in the online world and other retailing environments.

Banking Strategies: You're talking about an experience that ideally is effortless for the customer, but that might take tremendous internal thought and effort to compile. What are the dimensions of the organizational challenge?

Daruvala: Three aspects come to mind. One is that financial institutions have always viewed the world through silos — specific channels, specific products. How do you make the transition to a cross-channel, cross-product view of the customer, and array your online capabilities in a way that is truly integrated and interactive?

I think it is inevitable that the legacy systems, which are essentially product based, and the delivery channels will need to be interconnected. This can be done with a unifying technological/informational layer that allows you to assemble the full customer view across all products for any given channel. So if customers step up to an automated teller machine, or dial into a call center, or walk into a store, or connect with a Web site, they can view all of their holdings with the institution. That's going to require a discerning investment in technology. Many financial institutions are migrating towards this solution. But there's a lot more to do.

Account aggregation plays into the integration question as well. People want one-stop shopping. But they also want the ability to compile information from multiple providers. That's why you're seeing major financial institutions gearing up to provide cross-institution account-aggregation capabilities to their customers.

The second factor is the one that Peter alluded to, which is the open finance model. To support the seamless provision of non-proprietary products, you need a network of outsourcing agreements, alliances and partnerships. Collaborative solutions will be needed to build distribution and product capabilities, erect systems and develop critical technologies.

The movement still is in the early days. But from what I can see, the incumbents certainly aren't thinking as aggressively and broadly as their attackers. There has to be more willingness on the part of traditional financial services providers to pick things off the shelf, tailor, customize, modify and plug them into their business systems. They need to pay more attention to the new mindset that says "I don't need to make it all in-house," because that's the key to speed-to-market. And speed is king.

The third issue — and this also applies more to the incumbents than the attackers — pertains to the composition of the workforce. You need people who are Internet-savvy. You still need the mature business judgment and seasoned context from folks who have been in the industry for a while. But you also need people who have a completely fresh perspective — the ponytail and pierced-ear perspective. That is something that the incumbents have had a harder time doing than the attackers. So these are three dimensions along which organizations must change more aggressively.

Currie: We have to stop thinking as manufacturers and start thinking from the customer's perspective. And that calls for a re-thinking of internal business units — not necessarily to disassemble them, but to create a lot more bridges between the various silos in the company. We won't tear those silos down, having spent a century putting them into place, but we will create more cross-fertilization.

Each online thrust has to be driven by a business unit, by a group that's dealing with the customer. Otherwise, you're going to wind up doing things that are interesting but not really relevant.

Another challenge is disinvesting in certain things. As Web volume grows, for example, we'll be further streamlining the branch delivery system. It's a principle with broad applicability. Even though an institution has been involved in payroll processing for decades, for example, that activity now might be a distraction, something that ties up human resources and capital.

Refining the focus, farming out the things that are neither core operations nor vital to the future, and being prepared to do that on an ongoing basis, is absolutely essential. It has huge upside potential. We can embrace that approach and actually accelerate the transformation.

But it isn't easy. It's hard to say to the people in a unit currently generating a 25% return on equity, "That's interesting, and we want you to continue to do that, but we'll be cutting back the capital reinvestment in your group." And they'll say, "Wait a minute, we're generating a 25% ROE." And you'll say, "That's right, but we know that over time the return will drop to 18%, and we have to disinvest in this business." That is what technology firms have done for years. And the players who best handle disinvestments have less volatility as a result, because they manage transitions more smoothly.

We also need to flatten our organizational structures and take steps to accelerate internal decision-making processes. This is what's needed to be responsive to the market, and to attract the types of personnel needed to drive the online migration.

Banking Strategies: People talk about the growing importance of online service. What importance do you place on it, and how do you make decisions on configuring service capabilities?

Currie: We try to be very specific in our thinking about service. By that I mean that we connect with customers to hear firsthand about their priorities and concerns.

For example, our discount brokerage subsidiary has experienced the same kinds of service problems that have afflicted all of the players in online brokerage. In formulating a response, we started by talking with clients. They said they didn't necessarily want advice, just someone who could talk them through the details of executing an online trade. They also said they didn't want to have to wait 20 or 25 minutes to get help. So we took it upon ourselves to expand our call center by an order of magnitude.

In doing that, we got "out in front of the headlights," meaning that we didn't wait around until business volume financially justified the exercise. In this market, you have to be prepared to make the investment in the support structure before you see the revenue stream. That approach is alien to traditional financial services providers, who like to do things the other way around, but we no longer have that luxury. Extra care is required to anchor customer relationships established primarily online.

Banking Strategies: That raises the question of priorities. Although online revenues can be quite spec- ulative, the expenses are quite real. How do you decide how to allocate resources?

Currie: I'll share one technique we use to deal with the issue. We sit down on a regular basis and try to model exactly how much of our customer population we think is at risk from attacker brands or attacker companies. They may be dotcoms. They may be conventional banks. They may be discount brokerages, or full-service brokerages. We then ask: "What level of resources are we prepared to commit to preserve a given customer set?"

But the answer is specific to each organization. If your strategy is to be a market defender, or maybe even to position yourself to be acquired over the next three to five years, then you will have a starkly different spending and deployment profile than a company that believes it is in a strong position and wants to take a material thrust into a new market. I don't know how to be more pragmatic than that.

Daruvala: I think the answer is absolutely organization- specific. It is a function of what you are trying to accomplish. What is your objective? Is it maintaining competitive parity? Is it boosting the cross-sell ratio? It might be to acquire new customers, or to build new types of revenue streams, or to establish a new business model that enables you to move beyond conventional financial intermediation. Then you ask: "How do I align discretionary resources with our company's unique portfolio of initiatives?"

But you can't do everything. Some institutions will emphasize customer relationships. Others will choose product innovation. Still others will build infrastructure, for example, for business-to-business payments.

And I would submit that for the majority of small and mid-sized institutions, the answer is that this is about maintaining competitive parity, about minimizing attrition. That may not be an answer that people want to hear, frankly, but I suspect that is the reality. Most management teams are thinking in terms of avoiding attrition.

Banking Strategies: It's defensive.

Daruvala: It's defensive. And I want to make one more comment on this. You notice that neither of us has mentioned cost reduction as a rationale for investment. In my view, that's because there's a relatively low potential for that in the near term. Three years out, there may be significant opportunities as customers flock to the Internet in droves. But not today. All of the industry's experience with new channels points to this conclusion — that Web banking will spark additional usage, as opposed to replacing business done through older and more expensive outlets.

Currie: But you still have to find ways to pare back existing infrastructure in order to be able to afford to spend in the new environment. In our case, we are driving down our efficiency ratio by 500 basis points this year. We're taking some of the proceeds from cost-saves and reinvesting in virtual banking and other areas.

I think the days of the large, vertically-integrated universal bank are waning. Banks may continue to offer an all-encompassing range of products and services, but those offerings won't be integrated in terms of manufacturing. You simply can't afford the cost of vertical integration any more. You have to pick and choose — harvest some businesses in order to invest in others downstream.

Banking Strategies: What are your closing thoughts?

Daruvala: To prepare for the rapidly-approaching day when online banking is a true mass-market phenomenon, you've got to make judicious, thoughtful investments based on your specific strategy. One size does not fit all. Think about the metrics that will help you gauge whether you're moving in the right direction. And approach the online market through a holistic view of the customer, instead of through the lens of a given silo.

Currie: One thought is to maintain a certain level of anxiety on this topic. We tend to forget about the continuum in which we operate. Look at telecommunications. It took 75 years for basic telephony to achieve the level of penetration that wireless technology achieved in 10 years. Look at banking. Automated teller machines have been deployed for roughly 30 years, but Internet banking will achieve the same transaction level in about five or six years. Be very anxious about anticipating change, and dealing with change.

Also, be prepared to take a lot more risks going forward. Again, balanced risks, but be prepared to take risks. And be totally dissatisfied with being a follower. Because there will be losers in this marketplace. There is no more comfortable pew; there is no more comfortable environment. Any kind of view that there is a regional or national oligopoly in our industry has been shattered.

Mr. Klinkerman is editor-in-chief of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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