Not Everyone Wants a Relationship

By Rick Spitler and Sherief Meleis

Some banking customers — just like consumers who shop at Wal-Mart or fly on Southwest Airlines — are happy to trade style or comfort to get their business expedited on attractive terms.

For one view of what the future of the banking industry may look like, consider the airline industry, where Southwest Airlines Co. has ascended to dominance in just 30 years.

While "full-service" carriers like American Airlines Inc., Delta Air Lines Inc. and United Air Lines Inc. focused on building elaborate jet fleets and "hub" systems at major regional airports, Southwest adopted a discount fares strategy based on older inner-city airports and a zeal for efficiency. To control costs, for example, Southwest re-used plastic boarding passes and handed out peanuts instead of hot meals — and passed along the savings to its customers.

Today, Southwest's market capitalization is roughly seven times that of the nearest U.S. legacy air carrier. Overall, discount carriers have claimed 25% of the U.S. commercial passenger market, according to the National Institute for Aviation Research, based at Wichita State University. That share is expected to soar to 40% over the next few years.

This is a harbinger of things to come in retail financial services. Operating with superior efficiency and offering various combinations of high yields on deposits, low rates on loans and low service charges, a number of large banks already fit the "discount" mold. And they are strongly outgrowing their traditional rivals.

For example, between 1998 and 2003, the 58 discount institutions identified in a recent study of large U.S. commercial banks (more than $1 billion of deposits) by Novantas LLC grew deposits nearly 50% more rapidly than the 239 traditional institutions identified in the merger-adjusted analysis. And even though they paid sharply higher rates to achieve this growth, the discount banks still were able to deliver superior profitability because of their extraordinary efficiency.

Of course, not all of the banks that we place in the discount category necessarily define themselves in that manner. But they do share a general set of characteristics, including exceptional efficiency that enables them to pay high rates on deposits and still achieve healthy profitability. Notable examples include Fifth Third Bancorp, Cincinnati; Charter One Financial Inc., Cleveland; and Citizens Financial Group Inc., Providence.

These discounters are succeeding by drawing on an often overlooked and yet broad-based customer preference for utilitarian simplicity. It's an approach that contradicts a prevalent view in the market, which finds many institutions focused on building high-touch relationships. The assumption is that most customers value personal interaction with their financial institution and are receptive to consultative selling. Huge investments have been made in staff resources and product capabilities to pursue such strategies.

But that premise is not supported by a recent national study conducted by BAI and Novantas, which found that roughly half of all deposit customers fall into a "utility market" that prefers basic services and attractive prices and yields. Not unlike customers of Wal-Mart Stores Inc. and Southwest Airlines, banking utility customers just want their business expedited on attractive terms.

Based on experiences in other industries, we believe that discount banks, as a broad category, eventually could capture roughly one-third of the retail banking market. This poses a huge problem for what we'd consider generalist retail financial institutions. Operating with large networks of full-service branches, these "network banks" are dependent upon high volumes of general business to support their standardized franchises. With a more costly operating model that is not attuned to utility customers, they are already losing business to discount banks and stand to lose even more if they don't take immediate action.

Discount Inroads

Changes in any industry usually occur gradually, and it was perhaps understandable that executives at the dominant air carriers tended, at least early on, to view the rise of Southwest and other discount carriers as isolated successes rather than as a challenge to their tried-and-true business model. The response from United, American, Delta and other legacy carriers — tactical tweaks to routes, prices and marketing messages — proved insufficient to address the systemic shift.

The discount carriers launched hundreds of new planes into the sky, leaping from a 15% route overlap with major carriers in the early 1990s to an estimated 55% overlap in 2003. Popular with customers, they also proved more financially resilient in the wake of 9/11 and the U.S. economic recession, and investors accorded them nearly half of the airline industry's market capitalization at the end of 2003.

The airline industry's experience echoes that of retailing, where discount outlets have made huge inroads and are outperforming traditional generalist chains. Prominent discounters Wal-Mart and Target Corp., for example, respectively posted compound annual revenue growth of 12.7% and 10% between 2001 and 2003. Meanwhile, Sears Roebuck & Co. limped along at 0.2%; J.C. Penny Co. shrank by 0.85% and Federated Department Stores Inc. shrank by 1.24%.

This pattern is now repeating itself in retail banking as discount players erect hundreds of new branches in high-density markets, cultivate an unconventional image and make technology-intensive service a selling point. With their low overhead and attractive high rates on deposits, they are following in the footsteps of the discount air carriers and retailers, converting a huge banking customer segment that is willing to forfeit amenities and complex services for a good deal.

As highlighted in a study by BAI and Novantas, utility customers tend to have fewer resources, are pressed for time, and are generally uninterested in financial service relationships. Standing in sharp contrast to people in the "relationship market," whose resources and receptivity warrant in-depth service, utility customers think more in terms of bang for the buck.

Indeed, the discount banks identified in a separate study by Novantas offered a weighted average yield of 1.25% on savings and money market deposit accounts in 2003, nearly twice the 0.67% yield offered by the network banks. And at 0.52% of average deposits, their service charges were nearly one-third lower than the 0.74% levy imposed by the network banks. With inducements such as these, it's little wonder that discount banks grew transaction balances nearly half again as quickly as the network banks — 8.3% compound annual growth, compared with 5.6%.

And how did the discount banks afford to compete on price? The answer is rigorous efficiency. Compared with a 56.9% weighted average ratio of operating expenses to operating revenues posted by the network banks in 2003, the discount banks operated at a 51.6% efficiency ratio.

When all was said and done, the discount banks posted a 19.7% return on average common equity in 2003, overshadowing the 15.3% return at the network banks. The rise of the discount banks is factual and undeniable. It presents a challenge that the network banks cannot ignore.

When a traditional airline operates a big jet, it looks forward to the premium revenues that can be generated from first-class service. But the jet still can't be operated profitably unless coach class also is filled. The situation is much the same for network banks. They do a great job with many relationship-oriented customers and earn handsome rewards from that book of business, yet their branches can't be operated profitably unless they also handle high volumes of utility customer business.

The upshot is that as the discount banks lure away more utility customers, the long-term profitability of the network banks comes under increasing pressure.

Making the Transition

Our experience suggests that a few network banks are beginning to recognize this threat. And we believe that the rest will gradually follow as the discount threat begins to strike home. Just as the major airline carriers have been forced to create discount subsidiaries of their own, so will the network banks be compelled to adjust their traditional business model to the new competitive forces.

Strategically, we see the retail banking industry headed into an era of transition from standardized, production-centered franchises to variegated, segment-centered franchises. There are three major phases to this transition: merchandising, market management, and distribution and branding. Each step holds the possibility of improved customer responsiveness and institutional profitability if handled correctly.

These three stages represent degrees of difficulty. To get started, the most realistic approach is to tailor products, prices and packaging for utility customers. This in itself will be tough; tougher still is the next phase, when the management structure of the organization must change so that regional executives play a larger role in responding to local markets and specific customer segments. Toughest of all is the ultimate transition, when separate brand families and distribution models are deployed to serve specific segments of the market.

In the merchandising phase, providers will need to use segment insights to tailor various customer-facing aspects of their businesses, including prices, packages and targeted campaigns. Through skillful permutations of established offerings and practices, they will begin to capitalize on the pronounced differences in needs, sensitivities, preferences and attitudes among major customer groups.

The "free checking" product has provided a good start for many institutions, although it can be improved and should not be viewed as a complete or final solution. BAI and Novantas work shows strong demand for combinations of deposit and credit products, reflecting the working capital needs of utility customers. As banks cross-sell loans to free checking customers, the revenue reliance on exception fees on items such as overdrafts can be lowered. Customers will be pleased by the reduction in penalty fees and relationship profitability can be upheld through cross-sales.

Network banks also could do a better job of reinforcing the concept of tradeoffs with free checking, so that customers more clearly see that they are giving up some benefits in order to gain others.

Tradeoff-based marketing is at the heart of discount success in other industries. At Southwest, for example, there is no reserved seating and customers have learned to show up early at the gate to get seated where they want. This principle is beginning to be applied with free checking, for example, as some institutions require direct deposit as a condition.

Utility Segment Strategy

Even a refined version of free checking is not the complete answer, however, because discount banks will figure out multiple ways to attack the market over time. They have myriad options for leveraging their positioning and efficiency advantages in market competition. Southwest Airlines couldn't be stopped through competition on isolated air routes, and discount banks can't be stopped through competition on isolated products.

In this light, a suite of responses is needed to court the utility segment. It does no good to position 95% of the brands and products as being relationship-based when only 50% of the market is interested in that value proposition. The time has come to specifically tailor offerings for the vast pool of customers that does not want all of the bells and whistles. Modern segmentation tools permit much higher accuracy in targeting particular customer groups, facilitating campaigns aimed at utility customers.

For example, major retail banking institutions operating in the East Coast, Midwest and West Coast are beginning to offer selective discounts to utility customers. Twenty years ago, major airlines instituted computer-driven "yield management" programs to fine-tune pricing on routes and individual flights. In today's variation in banking, institutions are using segment information when negotiating renewals on certificates of deposit and money market deposit accounts, and in formulating direct offers on new accounts.

Also, research shows a broad-based opportunity to bundle credit and deposit products for utility customers, and not just within the context of free checking. This type of product bundle is especially attractive because utility customers are less sensitive to lending rates than they are to deposit yields — healthy margins on the former can help offset slim margins on the latter.

Such tailored merchandising initiatives set the stage for phase two, characterized by changes in market management. As offers are more closely tailored to specific markets and segments, success increasingly will hinge on the execution of local managers and staff who are close to customers. This has huge management implications.

While it is true that centralization has been of great help in streamlining large institutions and improving overall quality and consistency, it can work against market responsiveness. In coming years, significant responsibility and authority must be shared with regional managers, both to assure local responsiveness and to configure and manage branch capacity so that outlets do the best possible job of serving particular markets and segments. This movement is already underway inside a few major institutions.

Regional variations in deposit pricing provide an excellent example of why this is necessary. In early 2003, for example, the market price offered on money market deposit accounts ranged from 1.20% to 1.37% in Michigan, while the range in neighboring Illinois was only 0.86% to 0.97%. Elsewhere, two-year CD rates fell by 10 basis points in Massachusetts during the first quarter, but climbed 45 basis points in Rhode Island. For the institution operating in these regions, there clearly was no "single price" that would be competitive and profitable.

To be prepared to be able to respond appropriately in each region and for each major customer group, regional managers must take the lead in understanding local competitors, analyzing customer elasticity and assessing local markets. Central management should develop overall strategies for regions and customer segments, with explicit local management input, using local data on customers and competitors. Local management should be responsible for effective execution to achieve the agreed-upon growth and profitability performance targets.

As competitor initiatives create new threats and opportunities, central management should work with local management in determining how to adjust the strategy to respond. Most important, we believe there should be shared accountability for achieving targeted growth and profitability goals.

Another aspect of this second phase is that branches in dense urbanized markets, which offer the business volumes needed to support specialized offerings, will be managed differently (perhaps even separately) from branches in sparse rural markets, which offer only enough business to justify a more standardized approach.

Branded Segments

In the third phase, it is entirely possible that some major banking institutions will evolve into a family of branded segment offers, some of which might be supported by their own unique blends of employees, operations and distribution systems. Though not mutually exclusive, segment considerations will be prominent in the management and configuration of the enterprise.

Marriott International Inc. illustrates the brand family concept in the hotel industry. It sticks with general appeal brands in low-traffic markets, where you will see the flagship Marriott Hotels (often with far fewer features than in major urbanized centers), the Fairfield Inn and Ramada International. In high-density markets that justify more segment-target offerings, you additionally will see Ritz-Carlton, Marriott ExecuStay, Courtyard by Marriott, SpringHill Suites, TownePlace Suites, and so on.

An example of the brand family approach in financial services can be found in Canada at President's Choice Financial. A partnership between Loblaw Companies Limited, Canada's largest food distributor, and Amicus Bank, a subsidiary of Canadian Imperial Bank of Commerce, President's Choice operates primarily online and has outposts in the vast chain of Loblaw grocery stores.

Adhering to the principle of tradeoff-based marketing, President's Choice customers forfeit a wide-ranging ability to conduct financial transaction with the assistance of a live representative. Even at the kiosks within Loblaw stores, services are limited to demonstrations, product and rate information, accepting applications and servicing plastic cards. The reassuring human face is indeed there, but financial transactions are primarily done either electronically or by telephone.

In return for the tradeoff of limited live service, President's Choice customers are offered the rewards of no-fee accounts, "high-interest savings and low-cost borrowing," and "free" virtual services, either online, by phone or through automated teller machines. The marketing message: "There are no bank branches…savings on overhead mean that costs are much lower than traditional banks…and savings get passed on to you."

President's Choice does not invoke the CIBC brand in its pitches, has a separate work force and supporting business system, and is implicitly targeted to utility customers. The unit has more than C$9 billion of assets under management and more than 1.2 million customers. Founded in 2000, it turned profitable in the fall of 2003.

As the CIBC/President's Choice example demonstrates, network banks do have the capacity to respond effectively to the discounters without a huge modification of their existing franchises. Their competitive advantages include deep penetration in the best markets, vast developmental resources and expertise, and compelling systems and production capabilities. There is no reason that generalist institutions could not reconfigure their approaches to accommodate the needs of important customer segments.

That said, the recent history of American industry is littered with examples of once-dominant companies that could not see far enough beyond their own walls to sense major shifts in how customers view the market. In their heyday, traditional air carriers and retailing chains did a terrific job of operating within their business models. But the models themselves got out of step with the market, leaving the generalists in the position of "efficiently" producing something on which the public placed progressively less value.

For network banks, the number one priority is to dig deeply to understand the utility market as fully as possible. Who are these customers? What do they need? How do they make decisions? What messages resonate with them? What tradeoffs are they prepared to accept? Along with this is an assessment of niche competitors: Who are they? How are they positioning themselves? What is their operating model?

Combined with self-knowledge about the direction and strengths of the institution as it stands, this groundwork sets the stage for utility market initiatives that will help fend off the discount banks and contribute to long-term growth and profitability.

Mr. Spitler and Mr. Meleis are managing directors at Novantas LLC, a management consultancy based in New York.

Copyright © 2004 by Banking Strategies, published by BAI.

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