Saturation Point?

By Bill Stoneman and Kenneth Cline

While many banks have announced ambitious de novo branching plans, only a few are likely to earn much of a return on their investment.

The branch is back, but will there be room for everybody?

One of the distinguishing trends of 2002 in financial services was a plethora of announcements from major banks of their plans to build new branches. This trend, known as "de novo branching," marks a clear divergence from the prevalent practice in the previous decade of growing mostly through acquisitions and then consolidating branches to squeeze out cost savings.

Now, institutions such as Bank of America Corp. and Washington Mutual Inc. are talking about opening hundreds of new branches in selected markets over the next few years. Substantial expansions also have been announced by Bank One Corp., Wachovia Corp., Fifth Third Bancorp, Harris Bancorp, Commerce Bancorp Inc., TCF Financial Corp., Colonial BancGroup Inc. and Hibernia Corp.

The rationale is clear: after a decade of experimenting with alternative delivery channels, banks have rediscovered the primacy of the branch. "Physical distribution is still the most important channel for acquiring customers. If you want to grow your business, retail stores are essential," says Liam McGee, president of Bank of America's national consumer bank in San Francisco.

Yet the de novo branching strategy is also fraught with considerable challenges and risks. Branches are expensive to build and generally require several years of operation before attaining profitability on a standalone basis. Even Commerce Bancorp, whose success story was built around de novo branch expansion, has been flagged by some analysts who worry about diminishing returns on its enormous investments in brick-and-mortar capacity.

Furthermore, although most retail customers center their banking relationships around the branch, recent studies have tracked declining usage over time, which leaves bankers with a smaller window of opportunity to cross-sell other products to those customers.

The upshot is that only banks with finely sharpened sales, service and marketing skills will have a chance at achieving healthy returns on their de novo expansion strategies. Institutions that can't distinguish themselves in the marketplace may simply be saddling themselves with additional overhead. And that danger could be magnified in certain "hot" markets that have been targeted by multiple de novo builders, such as Chicago and New York City.

In Chicago, possibly the most extreme case, seven banks have planned a total of 170 new branches for this year alone, a number that balloons to 400 over the next couple of years. Those new offices will have to compete with the 2,110 branches already established in the metro Chicago area. "You can't open up hundreds of branches in Chicago and expect all of them to succeed," says Paul Miller, a thrift stock analyst with Friedman, Billings, Ramsey Group Inc. in Arlington, Va. "Not all of those institutions are going to be able to make money."

To be sure, announcements don't always translate into actual brick and mortar; some companies may adjust their plans after re-assessing the competitive environment. At the very least, however, the building spree will test whether de novo branches really are a cost-effective means for generating internal growth, as many strategists hope.

It will further test whether "new-style" branches — offices that look more like retail stores — can do a better job of attracting customers than more traditional designs. Players such as BofA and Wamu have largely built their expansion programs around redesigned branches. All in all, a lot of money is riding on the de novo branching trend.

The Density Debate

The conventional wisdom in the '90s held that the United States was "over-branched," and the consolidation of expensive overlapping branch networks was cited as a major rationale in countless regional bank mergers. But has the banking industry over-corrected?

Even as executives reawaken to the importance of the branch in anchoring customer relationships and acquiring all-important deposits, they are emerging from an era when population growth actually outstripped growth in the total number of branches by a wide margin. The U.S. population grew by 42 million people, or 19%, between 1987 and 2002. Yet the bank branch network grew by 1,703, or only 2% in the same period.

There were 86,549 bank and thrift offices around the country at mid-1992, according to the Federal Deposit Insurance Corp. While that seems like a lot, the number takes on a different light when measured against population, which is 288 million. That amounts to one branch for every 3,300 people. Compared with other developed economies, the U.S. density doesn't appear excessive. Although Hong Kong has just one branch for every 4,600 people and the United Kingdom one for every 4,000, according to First Manhattan Consulting Group, the average branch in France, Italy and Germany serves 2,300, 2,000 and 1,900 people respectively.

Branch density varies rather dramatically among specific U.S. markets, which is why expansionists must be careful about where they place their bets. Los Angeles, for example, has one branch for every 5,251 people, while Pittsburgh has one for every 2,605, according to First Manhattan. Obviously, demographics and economic growth have to be considered in these analyses. But based on the branch density tables, one might fairly conclude there doesn't seem to be a lot of room for growth in places like Philadelphia, Pittsburgh and Washington D.C./Baltimore. On the other hand, opportunity clearly exists in a number of major metro markets.

Chicago and Atlanta, for example, are about middle of the pack in branch density, and New York ranks near the bottom. Keefe, Bruyette & Woods Inc. analyst Thomas J. Monaco, in a recent report, describes New York City as ideally positioned for banking interlopers due to its low branch density, the damage wrought to customer relationships by past mergers and some current distractions suffered by the two big incumbents, Citigroup Inc. and J.P. Morgan & Chase Co. No wonder players such as Wamu and Commerce Bancorp have targeted New York City for aggressive branch expansions.

There is a question of timing, however, given the sluggish state of the national economy and uncertainty over the direction of interest rates. Banks have been flooded with cheap deposits in the wake of the three-year stock market slump. Will the new branches be able to keep attracting deposits if that money flows back to the markets? And how would that affect the expected payback on the new facilities?

Bankers involved in these expansions point out that they're being selective about where they put their new branches; in most cases, they're targeting markets that tend to grow faster than the national economy. "Even in tough times, you've got to grow your revenue, and we think this is a very good use of our capital," says McGee at BofA.

Retailing Experience

Beyond perceived opportunity in selected markets, there's another reason banking institutions have become so keen on building new branches — it may be critical to their prospects for future growth.

While bankers certainly haven't sworn off acquisitions, they do recognize that mergers do little to generate internal growth and in some cases actually harm it by alienating customers. Consolidations have also saddled acquirers with a grab bag of mismatched branches that don't communicate a common branding message. Meanwhile, electronic channels such as online, wireless and telephone banking have done little to attract new customers, although they do contribute to customer retention.

Turning to the branch, bankers see continuing customer loyalty. Studies show that customers continue to use branches even after opening an account in person and then re-directing some of their activities online. A 2001 survey by the American Bankers Association, for example, found that 90% of bank customers use a branch, at least occasionally, in any three-month period, while 51% use it often. Last year, a Synergistics Research Corp. survey found 80% of consumers overall visiting bank branches to perform routine activities.

Thus, when companies such as Harris Bank look to grow their retail business, branches still top the list of options, despite recent experiments with wireless banking. Harris Bank, the U.S. subsidiary of the Bank of Montreal, expects to grow its network of 145 branches in the Chicago market by 50 over the next four years, with most new branches placed in faster-growing outer suburbs. "We want to be in places where our customers need us to be," says Paula Labno-Hintz, senior vice president for branch distribution.

Despite the industry's newfound enthusiasm for branches, however, there is also a recognition that today's facilities can't look like those built in previous decades because of the changing market. Although customers have not substituted electronic channels for branches, they are using electronics more as a complement to brick and mortar.

The Synergistics study highlights this trend by showing a gradual decline since 1995 in the frequency of visits customers are making to their branch, from an average 4.4 visits per month to 2.9 last year. The Atlanta-based research company concludes that banks need to maximize the opportunities for face-to-face sales contacts at their branches, particularly for younger customers who may be looking for financial guidance.

Many institutions are trying to do precisely that. Wamu's new "Occasio" branches, for example, feature coffee bars and couches designed to get customers to relax in pleasant surroundings and (hopefully) contemplate additional product purchases. Something similar is about to emerge from BofA, which plans to open 550 new branches during the next three years, expanding its current network of 4,200 locations by about 13%.

While the size of BofA's program is certainly eye-catching, the design and configuration of the new buildings are equally significant. There are two basic design templates: an enhanced "traditional" branch and an "express" office geared to quick transactions. Since the express branch is designed primarily for office parks — it contains only a few tellers, some self-service equipment and a video-conferencing room — most of the new branches will use the traditional template.

There are no prototypes of this new branch yet available for inspection, since construction won't commence until mid-year. But some of the amenities to be included can be seen at the experimental branches BofA has been building in the Atlanta region. These include a host station, or kiosk, at the entrance where customers are greeted; conference rooms rather than desks for personal consultations; an investment-oriented reading area with financial news broadcasts; and television monitors above the teller line showing CNN.

The idea here is to emulate top retailers such as Nordstrom and Starbucks, whose "destination" stores attract customers to browse and buy with a combination of distinctive design and top-notch service. McGee sees the sales-and-service component as critical. To improve that part of its retail effort, BofA has been putting all of its employees through a training program called Bank of America Spirit, developed with the help of the Walt Disney Co.

"Our job now is to create a far superior service experience and to have more of a retailer's mindset," says McGee, the top retail executive. "You can't have great sustained sales results without superior service."

Costly Deposits?

New-style branches may indeed promote some additional cross-selling. But will they really do much to attract new customers? Compared with people who shop for clothes or latte, bank customers are notoriously hard to budge; once they've set up a checking account with one institution, they are reluctant to take on the hassle of moving it to a competitor. Deposits, in other words, are very sticky and few banks are able to move the needle much in terms of wresting market share from competitors.

Another challenge is balancing revenue growth expectations with the enormous cost of building physical capacity.

One institution that appears to be meeting those challenges is New Jersey's Commerce Bancorp, which probably has the purest track record of de novo branching in the nation since it doesn't muddy its financial profile with acquisitions. Commerce follows a classic retailing strategy of using its "stores" to build brand recognition. All of its branches are based on a cookie-cutter design, featuring common floor plans; an easily recognized logo; well-lit, uncluttered interiors; free coin-counting machines; and lavish, responsive service. By building these offices at a furious pace (40 in 2002) across New Jersey and into Pennsylvania and New York, the Cherry Hill, N.J.-based company has been able to grow its deposits at an off-the-charts rate of 25% a year.

Commerce chief executive Vernon W. Hill 2d has grown so confident in his branching strategy that he has taken it into the heart of metro New York, where the average branch costs about three times what it does in suburban New Jersey. Commerce plans to expand its existing network of 18 offices in New York to 400 over the next ten years.

Analyst Tom Brown, who is skeptical of de novo branching in general, cites Commerce as one of the few banks that can pull this off. "If any bank can build new branches successfully, it's Commerce," says Brown, president of Second Curve Capital, a New York City-based hedge fund that specializes in financial stocks.

Yet, while Commerce has been undeniably successful in growing deposits, some analysts are posing the question: at what cost? Although Commerce pays below-market rates for deposits, its high overhead ratio makes those deposits actually rather expensive; the company's annual investment in branch premises has exceeded its net income in recent years, according to Keefe, Bruyette's Monaco. He questions whether the branch building program can be sustained, given that Commerce has to build ever more branches to generate the revenue gains investors have come to expect. Already, deposit growth is showing signs of slowing.

"It's the equivalent of being on a treadmill," Monaco says. "Ultimately, you're going to get tired and hit a wall."

Commerce's Hill disputes Monaco's analysis, but the debate is complicated by the fact that he and Monaco use different financial assumptions. Still, other analysts, such as Robert Lacoursiere at Lehman Brothers, also see deposit growth and profitability trending south at Commerce. This should throw up a warning flag for other would-be branch expanders: there is no free lunch here. De novo facilities, even when accompanied by the most skillful retailing strategies, carry significant costs that may possibly outweigh whatever gains are achieved.

Brown estimates that a 350-branch institution opening 75 new facilities over five years could lose $30 million during that period after accounting for all the expenses and the typical three-year payback. He says most banks are "too optimistic" about the growth prospects at new branches because they are assuming that the inflow of deposits the industry has seen in the last three years will continue.

Clearly, some of the planned de novo branches will succeed. But with so many banks pursuing roughly the same strategy in the same markets, there will also likely be some significant losses. It would not be surprising to see a number of institutions pull in their horns a couple of years down the road in the wake of a bruising battle for market share.

"The branching done by better and more effective players is going to drive some of the smaller and less effective players to the wall," predicts Peter Carroll, a consultant with Oliver, Wyman & Co. in New York.

Mr. Stoneman is a freelance writer based in Albany, N.Y.; Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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