Leveraging Human Capital

By Kenneth Cline

Disappointing performance of front-line employees reflects on banks' lack of rigor in managing human resources as an intangible asset capable of driving market capitalization, says consultant Jeffrey Schmidt.

Now that the dissatisfaction has been acknowledged (see "Front-Line Performance Gap"), what's the solution to the disappointing performance of the industry's front-line staff?

BAI Research's The Front-Line Factor found a fundamental disconnect between banking's adoption of increasingly sophisticated customer relationship strategies and management's satisfaction with the ability of its front-line employees to successfully implement those strategies. While the survey of more than 500 retail banking executives surfaces some ideas for dealing with this problem, we've turned to consultant Jeffrey A. Schmidt for added perspective.

In 2000-2001, while a managing director at Towers Perrin in Chicago, Schmidt collaborated with Baruch Lev, a professor of accounting and finance at New York University's Stern School of Business, on a study that demonstrated how intangible assets such as human capital can influence a company's financial performance and market capitalization. Schmidt, today a partner with Third Path Management Research and Consulting in Wilmette, Ill., continues to study the topic and was intrigued by The Front-Line Factor data.

The results, Schmidt contends, are the byproduct of banks' poor investment decisions when it comes to human resources (HR) issues. Banks lack a sufficiently rigorous analytical framework to drive those decisions, according to Schmidt. "How does a bank know for certain that the money it's going to invest in specific programs will really make a difference?" he asks. Given heavy reliance on anecdotal evidence and guesswork, most institutions don't know, according to Schmidt.

He says bankers need to apply the same rigor to HR decisions as they apply to other types of financial analysis. In an era when intangible assets are driving market capitalization, he adds, it's imperative that "banking companies understand how to create and leverage their intangible assets, including their front-line human capital."

Banking Strategies: The Front-Line Factor study exposed management disappointment in the way banks apply relationship strategies on the front lines. What does that say about banking's use of "human capital"?

Schmidt: The apparent inability of front-line bank employees to deliver on increasingly sophisticated customer relationship strategies is fundamentally a human capital issue. Misaligned incentive plans, high turnover, and inadequate communications and selling skills identified by The Front-Line Factor are all manifestations of this issue.

Now, it's one thing to say that front-line employees are not able to deliver on relationship strategies, but to know why is another matter altogether. The study doesn't always explain the problems it identifies. For example, is high turnover among bank tellers a consequence of non-competitive base pay programs, unrewarding career opportunities, toxic people managers, multitasking work overload, bank bureaucracy or other factors?

A knee-jerk response might be to say: Our bank doesn't execute strategy well, so let's put more money into recruiting or training. In fact, as The Front-Line Factor study suggests, the most important investment a bank can make is in its front-line employees. But how does a bank know for certain that the money it's going to invest in specific programs will really make a difference?

A wiser approach is to first understand how current or prospective investments in HR programs shape front-line employee attitudes and behaviors, especially those likely to cause growth in retail deposits or achieve other business objectives. Stated another way, managers need to understand how people investments connect with the bank's economic model. When they do, bankers can make smart, informed, decisions about which investments in front-line employees will address the human capital issue surfaced by The Front-Line Factor.

Banking Strategies: Please define "human capital" and how it translates into financial performance.

Schmidt: Human capital is a form of intangible assets. By definition, an asset is something that creates future economic value. Competencies of front-line employees and the organizational capabilities of a bank are intangible assets. These assets drive future bank performance as measured by new account openings, deposit growth and customer retention.

A typical bank has a lot of tangible assets, virtually all of which are financial in nature. From a financial accounting standpoint, these tangible assets account for a bank's book value. But most banks trade above their book values, which can be attributed to the fact that the capital markets recognize some future value in these banks beyond what's on their balance sheets. That difference is the value of their intangible assets, which include structural capital, such as the proprietary software a bank uses to manage its back-office operations; external capital, such as brand value or customer relationships; and human capital, or the know-how and creativity of the people who work in the bank. These intangibles are interrelated. For example, a bank's brand promise is conveyed largely by the interaction between retail customers and front-line branch employees.

The banks that have higher-value intangible assets are the ones that create the largest market premium to their book values. The capital markets recognize banks that have the best prospects for achieving the highest future earnings growth and the best returns on investment. So, it becomes imperative in this era when intangible assets are driving market capitalizations that banking companies understand how to create and leverage their intangible assets, including their front-line human capital.

As a practical matter, there are all kinds of things that banks spend money on to build human capital — whether done purposefully or not. But research and experience show that some of these investments have low or even negative correlations to economic performance. For instance, incentive plans often have very little impact on employee attitudes and behaviors and as a consequence tend to be tweaked continuously. The Front-Line Factor finds this to be true in many banks.

Banking Strategies: Is building a bank's human capital a job for the HR department?

Schmidt: It should be. Unfortunately, when HR lacks business acumen and financial literacy, or the courage to take on complex human capital issues, it may not be of much help. Ask HR people what the empirical research says about investing in specific human resource programs, and you may well get a blank stare. Many practitioners couldn't even name the relevant journals, much less tell you what the research says. And, while analytical rigor is applied to decisions about tangible assets, decisions about managing human capital tend to be driven more by anecdotal information. If that's the case in your bank, you are pretty much flying blind when human capital and customer strategy converge at the front line.

Addressing the front-line people issues requires a different approach. A bank needs HR people with a strong grasp of the retail banking business, and who understand the intricate relationship between economics and human capital. Equipped in this way, they can help their banks figure out how to leverage the significant ongoing investments in their workforces — particularly, in ways more likely to produce measurable front-line performance improvements.

However, designing, deploying and measuring programs and initiatives to enable front-line branch employees to deliver on the bank's relationship strategies require the perspectives and the accountability of front-line management. Investment decisions regarding incentive plans, sales and communications skills training, leadership development, coaching and feedback, and other people programs should be the province of front-line management, albeit with consultation from the HR and finance departments within the bank.

Banking Strategies: For the bank that does possess that expertise, how might it tackle the problems uncovered by The Front-Line Factor?

Schmidt: The challenge is to understand the root causes for front-line employees' apparent inability to execute on customer relationship strategies. You need to build tools for diagnosing the causal factors and influences and for testing alternatives to address them. Accordingly, banks should employ network analysis to explain and evaluate how front-line employee know-how, attitudes and behaviors influence operating results and financial performance.

Banking Strategies: Network analysis?

Schmidt: Yes. Networks comprise the factors and connections that collectively, along with human capital drivers, make up a bank's economic model. For instance, the right investments in HR programs and practices help to shape front-line employee attitudes and behaviors — both individual and collectively — within a branch. Some of these behaviors, such as the intensity of employee engagement, directly influence customer retention and performance outputs such as a bank's market share, and growth in new accounts and deposits, and customer "share-of-wallet."

A bank's human capital drivers can be mapped at differing levels of detail or complexity. As a practical matter, however, the resulting network provides a summary view, and to some extent, intuitive hypotheses about the configuration of the underlying human capital drivers.

A complete and scientifically accurate picture of the human capital networks, especially for large banks, would be daunting. Fortunately, such precision is also unnecessary. That's because the most important properties of these networks, such as front-line employee engagement and branch manager effectiveness, are characteristics that emerge through the interactions within the model. These interactions can be measured using employee research data and their dynamics investigated through simulations and other forms of statistical testing.

With the modeling tools available today, it is practical for banks to diagram and measure how their front-line employees make relationship strategies happen. In so doing, they can develop fresh insights into the optimal investments for building people skills and organizational capabilities. These investments should focus on areas where the bank has a high degree of confidence that it will be addressing a root-cause problem that has relationship strategy consequences.

Analysis can also help banks avoid chasing cure-alls and repeating past mistakes by allowing their managements to simulate "network effects" before committing to new investments or launching new programs for building front-line skills and capabilities.

At the end of the day, what banks should be looking for in modeling the connections between front-line investments and relationship strategy success is wisdom; specifically, the wisdom about how best to acquire, develop, deploy and manage the bank's front-line employees.

Banking Strategies: Based on your experiences in this area, how does banking rank in the management of human capital compared to other industries?

Schmidt: In some industries, virtually all of the market value depends on intangibles like human capital. Microsoft Corp., for example, understands clearly that its billions of dollars in market capitalization do not depend on the paltry hard assets stated on its balance sheet. Microsoft's value is actually in its people and in the intellectual property they create and sustain.

Most banks, however, still use conventional approaches to managing their front-line people. Employee attitude surveys and simple association studies comparing employee satisfaction with financial measures are used widely to demonstrate the value people add. But, using the same survey research for in-depth studies of how banks create and leverage human capital remains in a nascent state, and far behind some other industries.

That said, the banks that figure out how to leverage the value of their intangible assets, including front-line employees, will have a huge competitive advantage over everyone else. They will know for certain what it means to say "our people are the bank's most valuable asset."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2004 by Banking Strategies, published by BAI.

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