Improving Performance in Local Markets
BY SHERIEF MELEIS AND LEO D’ACIERNO
A locally-nuanced understanding of customers, markets and competitors is needed to make the most of today’s vast retail banking franchises.
Consolidation in the U.S. banking industry has produced a new generation of large-scale institutions that span regions with their branch networks. In the pursuit of efficiency and standardization, these banks tend to base market decisions on system-wide averages; conduct blanket marketing campaigns across regions; price uniformly; and overlook micro-markets in branch resource allocation. Consultants at Novantas LLC say improved performance can be obtained by using new analytical tools and a less centralized “federal” management style to unlock the revenue potential in local markets.
The consolidation of the U.S. banking industry has spawned the creation of numerous large-scale institutions that span multiple states or regions with standardized branch networks. This merger-driven consolidation has been hugely beneficial in lowering costs as it enables the elimination of duplicative functions and the paring of corporate staff.
There is a downside, however. While franchises may have been standardized, local markets, competitors and customers have not. This is a growing source of tension as centralized giants strive to cope with myriad variations in the communities they serve. Today’s top banking companies typically serve between 50 and 150 metropolitan statistical areas, with a few of the largest players ranging up to 300 and beyond.
For efficiency’s sake, many large franchises base market decisions on system-wide averages. Yet performance can deteriorate when many aspects of planning and goal-setting overlook varying conditions in regions, cities, communities and individual branch trade areas. A bank serving North Carolina, for example, should be mindful of differences between Durham, where deposits have grown at a 5% annual rate, and Raleigh, where the rate is 10%.
In a similar vein, critical marketing resources tend to flow into broad campaigns that blanket entire regions, despite extreme skews in the local opportunity. It is not unusual for up to two-thirds of the retail branch revenue opportunity to be concentrated in one-third of the branch footprint. In turn, a blanket campaign risks devoting two-thirds of its resources to areas that contain only one-third of the revenue opportunity.
Then there are uniform pricing strategies, which use internal averages to impose standard deposit rates across major territories. Many of the largest banks differentiate their prices by no more than 50 to 60 basis points among localities they serve, despite facing competitive price variations ranging up to 125 basis points.
A final trap is to sprinkle branches across broad regions while neglecting specific requirements in each “micro-market,” or area where target customers live, work and shop. As measured by local convenience and balance formation, we estimate that a third of the branch network within major banks is misallocated and underperforming.
Addressing these four flaws was far less urgent in the roaring retail banking market of a few years ago. But the current squeeze on retail growth and profitability has changed the frame of reference in branch banking. As growth stalls, many banks need to refocus strategies and resources on the very best remaining opportunities.
Distancing an institution from the pack requires unlocking the hidden revenue potential in local markets. Using centrally-generated analytics and strategies, it’s possible to pinpoint situations within the overall branch network where regional and local refinements will significantly improve growth in balances and revenues.
Such differentiation of markets is likely to become a new plane of competition in retail branch banking. Indeed, Novantas research indicates that most of the top twenty U.S. banking companies are actively pursuing at least one of the four local performance initiatives highlighted in this article.
Tracking Market Differences
The tendency to manage branch networks by state or region reflects the lingering influences of obsolete banking laws based on state political boundaries and age-old geographic definitions, some predating the Revolutionary War. Yet in many respects, it makes a lot of sense to expand territorial management practices to include entire regions. For efficiency’s sake, no one wants to go back to separate management teams, separate back-office systems and separate menus of products and services.
The drawback is that customers and markets are anything but homogeneous and it is actually quite easy to sub-optimize revenues with uniform initiatives. Consider how a statewide orientation affects a hypothetical initiative centered on “the Florida retirement market.” A campaign on jumbo certificates of deposit might play well in Sarasota, where the median householder is 58 years old and well into the stage of asset accumulation. The campaign will likely achieve less traction in Gainesville, however, where the median householder is 44 and still midstream in the process of building savings and investments.
Instead of being blindsided by such market variations, some banks have established systematic ways of recognizing and profiting from them.
The emerging standard in branch network management is to track markets by metropolitan statistical areas, which are major urban locales with high population density. With annual deposit growth rates ranging from zero to nearly 20%, it is clear that MSAs need to be individually analyzed - all opportunities are not created equal.
The most advanced banks go a step further by analyzing micro-markets, tightly-defined areas where target customers live, work and shop. Within major metropolitan areas, for example, these institutions distinguish between burgeoning suburbs and mature center cities. In the Dallas area, for example, Highland Park and Frisco are both wealthy suburbs. But close-in Highland Park has been built out for decades, while Frisco is situated in open land to the far north of the city and has been growing madly.
These more precise market definitions set the stage for advanced market metrics. It is critical to monitor local differences in competitive prices, underlying growth rates, population demographics and business conditions.
Additionally, leaders measure their branch network strength in each market. It takes a certain level of branch density for standout performance, given the important role of local networks in customer convenience and overall market impact. By evaluating local branch presence, banks can gain critical guidance on where to expand or cut back and where to adjust prices in accordance with local network strengths and weaknesses.
Goals and Resources
It does require additional effort to track the salient differences in local markets. But fortunately there are ways to take immediate advantage of new market analytics with minimum changes to the current configuration of the branch system.
One of the most promising performance improvement opportunities lies in planning and goal-setting. A perennial challenge in managing a vast branch network is setting realistic goals for regions, markets and individual branches One of the most promising performance improvement opportunities lies in planning and goal-setting. A perennial challenge in managing a vast branch network is setting realistic goals for regions, markets and individual branches (see chart “System-wide Performance Targets Skew Expectations”).
Consider, for example, the regional bank that sets a uniform deposit growth target across the franchise. Inevitably, certain outlets are mired in low-growth markets. Branch managers in these markets, strive though they might, simply will not be able to acheive their goals. Such undue pressure can cause banks to lose skilled managers. By contrast, managers in high-growth markets will coast to victory. Though portrayed as heroes because they exceeded the corporate average, their results often flunk on a local comparative basis, falling well short of true market potential.view recent financial results, relative to similar market profiles elsewhere in the branch network. Along with goal-setting, this type of in-depth analysis also can provide immediate payoffs in precision resource allocation. Key questions about staffing and hours of operation, for example, are best guided by local market potential.
Another consideration is advertising and promotion. Many retail banks are laboring under advertising and promotional restraints, reflecting margin pressures and lowered sales expectations. But the winners in this exercise won't be cutting an even percentage across the board.
Instead, with the benefit of more precisely defined micro-markets, banks can refine both the level and type of marketing expenditures in accordance with local opportunity. In some cases this will entail tradeoffs between the big metropolitan daily newspapers, local weeklies and direct mail and between various types of deposit and loan products. In other cases it will mean suspending advertising in some areas to fund an all-out push in select growth markets.
Precision Pricing
Many of the very largest regional players also have learned to analyze pricing in each of their local branch markets. They choose where to compete with rates, based on the relative cost of funds in each market as well as the bank’s position within it. And they use precise calculations to strike the right trade-off between balance growth and profitability enhancement, based on price elasticity of customer demand. These techniques can provide immediate revenue gains, not only within established franchises, but also in acquisitions.
Consider a hypothetical bank that is active in both Philadelphia and Boston and sets a uniform rate on 18-month certificates of deposit. Based on market rates seen in mid-August, the effect surely would have been competitive misalignment. On balances greater than $90,000, the weighted-average market rate was 3.48% in Philadelphia, compared with 4.25% in Boston - higher by 77 basis points, or 22%, according to research by Novantas and Market Rates Insight.
Customer sensitivity to interest rates can vary dramatically by market as well, influenced by factors such as local population demographics and competitive dynamics. As the bank deepens its understanding of these variations, it can learn to detect and capitalize on market pockets within the overall franchise that have lower competitive intensity and overall rates, coupled with concentrations of rate-hungry customers who will move balances even for small improvements in yield.
Leading banks have developed three key practices to handle regional disparities in a systematic way. First, they acquire comprehensive rate data by market and then determine a meaningful reference price for each of the different types of banks in their customers' consideration set. Second, they analyze the price elasticity of customer demand, not only by region and product, but also by price type (rates, fees and minimum balances). Third, they analyze the underlying dynamics of local markets, including the impact of macro-economic factors on deposit and loan demand.
Network Configuration
Interwoven with pricing considerations is the strength of the local branch network. For players emphasizing convenience and service, the density of the branch network is a critical determinant of performance. That is to say, two branches within a market boundary typically will realize more than twice the success of a single branch. There are three reasons for this phenomenon:
- Higher density creates a critical mass for reinforcing the bank's brand.
- Customers make decisions on their primary banking relationship based on an assumed need for multi-site convenience (even if they ultimately patronize a single convenient branch).
- Key services, such as weekend hours, private banking, mortgage and the like, can be allocated among several branches in dense networks, attracting customers at a lower cost than providing these services in every branch.
We call these effects “Network Equity”— the extra value generated by the critical mass of distribution resources (see chart “How Branch Density Supports Deposit Formation”). For example, network equity may permit a bank with 20% of branch share in a market to realize 25% of deposit share, plus improve deposit margins by as much as 20 to 80 basis points. In other words, a well-configured network can not only attract more deposits, but at lower cost as well. Network equity is a two-edged sword, however, as it also attenuates patronage at subscale networks. A bank with 5% branch share might top out at 3% deposit share.
The curvilinear relationship between branch share and deposit share reflects the pivotal influence of dense branch clusters on the customer's decision to establish and sustain a banking relationship. Network density has a much greater influence on long-term new account formation than market-leading deposit interest rates, which is especially significant given the widespread desire in banking to build stable customer relationships rather than chase “hot money.”
Yet many bank networks remain scattered, particularly those built through prolific acquisition. Once a deal is done, executives typically turn their attention to major cost-cutting opportunities, including corporate and back-office consolidation. There’s a hesitancy to shed newly-acquired branches and customers, which is a healthy instinct in many situations, but not necessarily with isolated “orphan branches,” which are condemned to structural disadvantage.
Handicapped by subscale network density, isolated branches must pay higher deposit rates to attract new customers, often paying from 30 to 50 basis points more to attract the same new account volume than they would if the branches were more densely aggregated. Alternatively, if they offer average market rates, they will suffer balance attrition and loss of market share. Assessments of franchise strength based on state-level analyses can be helpful as a general guide but often do not tie into the reality of local market impact. Instead of five branches placed in each of four counties, for example, it might be much better to have 20 branches in a single county or five in one county and 15 in another.
The ramifications for branch efficiency are significant. Some markets may be dominated by convenience-sensitive customers who reward network equity handsomely. Other markets may hold a preponderance of rate-sensitive customers who are willing to forego branch network convenience. By discerning these different types of markets, banks can focus distribution resources on the most promising opportunities.
A further nuance is the interaction of various micro-markets in an overall area. For example, some cities exhibit highly random daily commuting patterns that demand blanket branch coverage. Others are characterized by a hub-and-spoke commuting pattern, permitting the bank to concentrate on commuter-defined pairs of downtown work destinations and suburban residential locations.
Instead of a diffused effort to lattice entire regions with branches, therefore, the bank should focus on achieving peak network configuration within a series of local markets. De novo branches no longer are scattered across a region, but rather are selectively placed in locales where the overall network presence needs to be strengthened. In other cases, the bank can consolidate the branch presence in markets where it has over-saturated networks, or where network presence is not a critical factor. This strategy ultimately lowers total branch requirements and dramatically reduces costs.
To capitalize on these concepts, there are four steps that banking companies should take. The first is to determine the role of network equity in the bank’s strategy. A convenience play demands high levels of network equity. By contrast, segment- or rate-driven strategies typically substitute other attributes for branch coverage.
Second, the various micro-markets within an overall franchise need to be defined and assessed in a way that reveals network strengths and weaknesses and local potential. This step should also determine whether the interplay between micro-markets demands high levels of overall area coverage or permits selective micro-market targeting.
Third, the company needs to set priorities within its portfolio of local markets, based on opportunities to capitalize on branch density and convenience, and then establish an overall strategy for branch performance improvement. Fourth, each micro-market should be individually analyzed and have its own improvement plan, including de novo branches, closures, relocations and renovations.
Competitive Advantage
While it is true that the current slump in retail banking adds urgency to the quest for local market responsiveness, this movement goes far beyond the ups and downs of a particular business cycle. Though by no means the complete answer, nuanced local responsiveness is clearly an emerging source of competitive advantage for large institutions. Benefits can be realized in the short term (pricing and marketing allocation), medium term (planning and goal-setting), and long term (branch network optimization).
Along with doing a better job of managing established networks, banks also will be better positioned for mergers and acquisitions. Equipped with advanced tools for local market analysis and branch network management, they will have a significant advantage in scouting for deals, bargaining and implementing transactions in a way that yields real revenue synergies, not just one-dimensional cost saves.
But new capabilities and management transitions will be required to move ahead. For one thing, the typical bank will need to beef up its central analytical capabilities. There is immense power in being able to evaluate local markets from multiple perspectives, yet quality data and robust methodologies are absolutely critical to the exercise. And we're not just talking about massaging internal data; myriad sources of market and customer information from outside the bank must be harnessed as well.
Then there is the question of corporate governance. The pendulum has swung back and forth between centralization and decentralization. We advocate a “federal” model, with shared responsibilities. The central team should play a leadership role in defining micro-markets, analyzing differences, setting goals and developing branching and pricing strategies. Realistically, though, many market nuances are only apparent to local managers, who also should have a voice in regional management decisions.
Care will be required as new concepts are introduced into traditional processes. Skilled and influential executives, who have been handling performance planning (or pricing or marketing campaigns or branch planning or M&A strategy) a certain way for many years, rightfully will require substantial evidence that new concepts offer quantifiable advantages. Even then, tools must be rolled out in a manner that truly augments decision-making and wins broad support and usage.
Taken together, these factors do constitute a significant management shift within the institution. Instead of being glossed over, differences in local markets are systematically analyzed and the findings are used for decision-making in multiple areas of the bank. This is not an abandonment of the principles of centralization and standardization, however, but rather an affirmation that winning ultimately requires a locally-nuanced understanding of customers, markets and competitors. Anything less works to the detriment of the overall branch network.
Mr. Meleis and Mr. D'Acierno are managing directors in the New York offices of Novantas LLC, a management consultancy.