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RETAIL BANKINGACADEMY

303.Achieving Profitable Growth

Course Code 303 - Achieving Profitable Growth

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45© Retail Banking Academy, 2014


Course Code 303Achieving Profitable Growth

Introduction

In the process of financial intermediation, retail banks channel savings into loans to individuals and SMEs that finance investments in the real economy. By implication, the expected growth rate of gross domestic product (GDP) and similar measures of economic activity provide a macro constraint on the anticipated loan growth rate of the retail banking sector. At the level of a retail bank, profitable growth begins with growth in total revenue. In addition, as shown in the footnote below*, growth in interest-sensitive assets is a key determinant of a bank’s profitability. In particular, it is shown that the growth rate of net interest margins is positive if the growth rate of interest-sensitive assets is higher than the growth rate of interest-bearing liabilities. But these growth rates must be aligned to meet external and internal constraints on asset growth. For example, the growth rate of loans (for example) is constrained not only by macroeconomic activity but also by the Basel III leverage ratio and the bank board’s risk appetite statement. For example, the risk appetite statement may place limits on the loan to deposit ratio or loan concentration ratio. The latter may lead to a limit in the loan to deposit ratio or loan concentration ratio.

Achieving profitable growth is an important strategic objective of retail bank globally. Here are two examples from both developed and developing economies.

Ingrid Johnson, Group Managing Executive, Retail and Business Banking at South Africa’s Nedbank reported in January 2011 on Charting a new path toward sustainable profitable growth at Nedbank, Retail and stated that profitable growth is stymied, in part, by the bank’s relatively low market share of the mass market, and consequently a low participation rate in a relatively attractive source of economic profit. In other words, Nedbank has the potential to grow profitably within its home market with its existing product portfolio and channels.

Banks may aspire to grow profitably as part of their business strategy, but achieving profitable growth is not so easy. For one thing, customer experience is a dominant determinant of

* The algebra to demonstrate this important point is as follows: Let Y = yield on interest–sensitive assets (A); K = cost of funding by interest-bearing liabilities (L). We assume for simplicity that Y and K are constant.

Then This states that the growth rate of net interest margins is positive if the growth rate of interest-sensitive assets is higher than the growth rate of interest-bearing liabilities.


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consumers’ choice of a bank. Hence, growth certainly depends on customer experience. This sentiment is echoed in ING’s 2006 document entitled Building on the momentum for profitable growth where it is stated, “a successful strategy can only succeed if we continue to build on the momentum of profitable growth and if costs, risk and reputation are properly managed.”

But profitable growth is more than just growing the top line of the bank’s income statement. A bank can actually grow at a loss.

What is meant by profitable growth? There are two main measures of profit in a retail bank. The first is called ‘accounting profit’ which is the difference between total income (which is mostly net interest margin, NIM and fee income) and expenses (which are mainly operating expenses, OPEX). Profitable growth refers to increasing a selected measure of market share (e.g., revenue per customer) with associated expenses that are increasing at a lower rate and so leading to increasing profit growth. In essence, revenues are growing at a faster rate than expenses.

But this measure of profit has a defect in that it does not consider the full cost of the capital that is utilised to create profit. In a typical income statement, only interest costs are included as financing costs. The full cost of capital is not. For example the cost of equity is omitted and hence accounting profit may be positive but the business unit may not have covered the full cost of capital. This is the basis for another measure of profit – economic profit. Economic profit is equal to accounting profit less the cost of equity capital. Creating positive economic profit is identical to the concept of value creation in the ‘managing for value’ literature.

In summary, profitable growth is a process whereby the bank typically experiences positive accounting profit along a path that eventually leads to achieving positive economic profit.

In this module, the focus is on being practical and emphasises managerial actions to achieve profitable growth. Whereas the Business Strategies for Retail Banking module (course code 302) presents the choices for selecting a business strategy via an Ansoff matrix, this module shows what steps to take to increase the likelihood of achieving an important business strategy – profitable growth, either through product development or market development. As was recommended in module 302, a strategy of entering new markets with new products is potentially very risky and the bank will likely face general uncertainty. We conclude this introduction by emphasising that achieving profitable growth is driven by positive and consistent customer experience. This was the main point made by Nedbank and corroborated by another retailer:

“Despite the challenging economic environment, Starbucks is profitable, has a strong balance sheet and generates solid cash from operations,” said Schultz. “Our customers’ connection with, and trust in the Starbucks brand remains at a high level. We are laser-focused on delivering the finest quality coffee and getting the customer experience right every time.” “We’ve also been putting our feet into the shoes of our customers and are responding directly to their needs,” said Schultz. “Our customers are telling us they want value and quality and we will deliver that in a way that is both meaningful to them and authentic to Starbucks.”

Source: Starbucks CEO and chairman, Howard Schultz, commenting on the company’s strategy for profitable growth to Bloomberg, 18 March 2009.

In retail banking, the role of customer experience in achieving profitable growth is underlined by the famous quote by Nobel Laureate Ronald Coase in 1937 who described the purpose of business as “fulfilling customer needs via the relationships you maintain”.

Open Question #1

Do you agree that compensation plans should reward profitable sales and not just sales revenue?


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The rest of this module is organised as follows:

Chapter 1: Streamlining existing product portfolio and adding new products in the bank’s home market and existing channels.

Chapter 2: Rationalising existing channels and adding new channels in the bank’s home market and the existing product portfolio.

Chapter 3: Adding new markets within the bank’s existing business model - i.e., focused and related diversification.

Each of these strategic initiatives will now be discussed.

This module concludes with a summary and multiple choice questions.


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Chapter 1: Streamlining the Existing Product Portfolio and Adding New Products

We consider a strategy of achieving profitable growth that comprises actions to streamline the existing product portfolio and then adding new products if required. The main assumption underlying this strategic initiative is that there is no change in the bank’s set of channels and that it operates in its existing (i.e., home) market. This scenario may be illustrated in the following diagram:

3

Chapter 1: Streamlining the Existing Product Portfolio and Adding New Products The main assumption underlying this strategic initiative is that there is no change in the bank’s set of channels and that it operates in its existing (i.e., home) market. This scenario may be illustrated in the following diagram:

New Product Existing Product

Existing Channels New Channels

Home Market The arrow in the above diagram illustrates a strategic objective whereby decision makers first streamline the current product portfolio of the bank for the home market with existing channels. We now summarise the key success factors under this ‘new product’ strategic objective. a. Be Client and Market Focussed. First, obtain an assessment of the size and profitability of the product market. Note that decision-‐makers seek opportunities for profitable growth and hence should profit from economies of scale (i.e., size). One important guideline is that approximately 80 percent of retail banking profits is in savings and mortgages. In addition, in the design of the new product obtain a review of the competitor product offering. The key objective is to add customer value for money, beyond that offered by the competitor. Hence, seek to differentiate on the basis of price; product features and options; transparency in the sense that customers are not confused by ambiguous terms and conditions; simplicity of product and of process in delivery (i.e., lean process to accelerate delivery). These all contribute to customer experience – the key determinant of a consumer choice of a bank offering. Coupled with the design features of the new product, is an assessment of the market potential. This is a market research activity that is based on both quantitative (i.e. data mining to obtain customer and market insight) as well as qualitative research based on,

303.1: Home Market

The arrow in the above diagram illustrates a strategic objective whereby decision makers first streamline the current product portfolio of the bank for the home market with existing channels.

We now summarise the key success factors under this ‘product development’ strategic objective.


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Be Client and Market Focused

First, obtain an assessment of the size and profitability of the product market. Note that decision makers seek opportunities for profitable growth and hence should profit from economies of scale (i.e., size). One important guideline is that approximately 80 percent of retail banking profits is derived from savings and mortgages.

In addition, in the design of the new product, review the competitor product offering. The key objective is to add customer value beyond that offered by the competitor. Hence, seek to differentiate on the basis of: price; product features and options; transparency in the sense that customers are not confused by ambiguous terms and conditions; simplicity of product and of process in delivery (i.e., lean process to accelerate delivery).

These all contribute to customer experience – the key determinant of a consumer choice of bank offering.

Coupled with the design features of the new product is an assessment of the market potential. This is a market research activity that is based on both quantitative (i.e., data mining to obtain customer and market insight) and qualitative research based on, for example focus groups in order to establish the customer propensity (i.e., willingness) to purchase the bank offer. Indeed, this is methodology to estimate the potential market demand. The Retail Banking II module, Direct Marketing, presents specific steps to take in this regard.

Based on the estimated market demand, the decision maker should estimate some key statistics that include:

• Total revenue potential = market reach × customer propensity to buy

• Total investment required initially and over time to support the market

• Three to five year financial projections

These financial projections will establish time to break even as well as financial resources required to achieve forecasted revenues.

Open Question #2

Do you agree that profitable growth and economies of scale are related?

Ensure a Focused Product Portfolio

It is not unusual for major retail banks to have a portfolio of hundreds of active products. But at the same time, the Pareto principle applies – less than 20 percent of products generate more than 80 percent of total revenue.

The net result is that a typical retail bank carries products that are value-destroyers.

The effect on reported profit can be substantial. Here is an example based on the experience of a large European retail bank.


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303.2: Products as Value-Destroyers

The above example is based on an analysis conducted by a bank and is not atypical. A review of the existing product portfolio can increase profit by 30 to 50 percent by eliminating non-profitable and/or subscale products. The steps to follow in a review are as follows:

a. analyse each product in terms of its revenue or profit contribution;

b. eliminate each product that contributes less than three to five percent unless there is a business justification such as:

• The product is key to the bank’s total product offering;

• The elimination will have a large negative client impact;

• There is potential for the product to contribute to greater than five percent of revenue or profit over the next three years.

The important lesson is that the retail bank portfolio should comprise fewer products, each with operational scale efficiencies. This emphasis on fewer products will permit bank staff to have a deeper knowledge of each product that will serve to reduce consumer confusion about product features. An additional benefit is an increase in customer satisfaction leading to client loyalty with a concomitant increase in cross-selling potential.

Other considerations when introducing a new product include:

c. Achieving Operational Efficiency through Scale

Average fixed cost is defined as total fixed cost divided by volume where volume is a measure of scale, such as client product balances. When there is a lower average fixed cost, profits increase. This is because profit = volume * (price – average cost). An additional advantage is that a bank can compete on the basis of price when it achieves operational efficiency.


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303.3: Achieving Operational Efficiency

The impact on profitability may be seen in the calculation of return on equity (ROE). Consider the example of a mortgage product with the following results (stated in bps):

revenue margin = 130

expense = 70

credit losses = 5

Then, profit = 55 basis points

Suppose that the required capital to support risk is 3 percent, then achieved return = 55 bps/ 3 percent = 18.3 percent. Note that an increase in operational efficiency will reduce expenses and hence increase ROE.

Apart from operational efficiency gains, a key consideration for a new product is whether it will generate enough volume to provide the retail bank a leadership position in the market segment.

Open Question #3

Do you agree that market share is critical for achieving profitable growth?

d. Achieving a Market Leadership Position

This is an important issue since top market leadership leads to higher volumes and hence lower average cost. The professional literature has linked market share to profitability. For example, a Harvard Business Review article* from 1975 concludes that market share is key to profitability. Indeed, the Australian and New Zealand (ANZ) bank reported (Bloomberg, 17 August 2012) an increase in profits arising from market share gains. Finally, a McKinsey study reveals that profitability is directly related to the bank’s leadership position in the market. The top three market leaders make the best profit while a bank that is placed below the tenth position is marginally profitable or makes losses.

The final success factor affecting new product introduction is a program to assess and mitigate risks.

* “Market share — a Key to Profitability”, by Robert Buzzell et al, Harvard Business Review, January 1975.


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e. Risk Assessment and Mitigation Programme

The Retail Banking I and Retail Banking II programmes cover risk assessment and risk mitigation approaches that are appropriate for new product introduction. In particular, the decision maker must consider:

• regulatory requirements such as capital to absorb risk;

• credit risk – customer’s ability to pay; market value of collateral and hence expected recovery rate should the customer default;

• market risk – asset liability management and interest rate risk;

• operational risk – controls and monitoring tools as described in module 208.

This chapter concludes with a review of a key point:

Profitable growth may be achieved by rationalising the current product portfolio and eliminating value destroyers. Introduce new products that have significant market demand (optimally with a potential for market leadership) that will likely lead to operational efficiencies resulting in higher profits. Importantly, the bank may choose to maintain the same level of profits by lowering its price in line with the gains in operational efficiency. This will likely lead to gains in market share and hence to higher profitability – i.e., profitable growth.

The old adage still works – wallet share is good for growth, but banks grow as customers grow.

Market share is still key.

Now a second important strategic alternative for profitable growth is considered – new channels for the bank’s home market based on its existing product portfolio.


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Chapter 2: New Channels for Existing Product Portfolio in the Home Market

We now consider a strategy to achieve profitable growth within the bank’s home market and add new channels with no change in the bank’s product portfolio. This scenario may be illustrated in the following diagram:

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303.4: New Channels for Home Market

The most important lesson from the discussion that follows below is:

New channels for a bank’s existing products can increase market reach, size, operational efficiency and profitability, but also add risks associated with reputation, cannibalisation and management control.

We present and analyse common success factors for a bank channel strategy. These success factors (i.e., low risk) are as follows:

a. Reach a large potential base of prospects. This is essential for economic viability;


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b. Alignment of interests in case the channel involves third parties;

c. Bank must be able to manage reputation risk;

d. Channel must confer a high degree of client ownership and control;

e. Bank must be able to manage potential cannibalisation.

While we present and analyse each class of channels separately, this is just for exposition purposes. Multi-channel management is highly recommended for overall operational efficiency and optimal customer experience - and, apparently, with the bank branch at the centre.

Indeed, there is evidence that the bank branch may still be at the centre of banking operations for customers. The following summary from the Cisco IBSG Omnichannel Banking Study reveals:

“Consumers globally rejected the idea of highly automated branches with limited personal attention and expertise, with 26 percent of consumers saying they would leave their current bank if personal attention and advice were eliminated from their bank branch. 65 percent of respondents globally (56 percent in developed countries and 81 percent in emerging countries) would be in favour of bank branches that offered an expanded portfolio of financial and advisory services (financial education, legal, accounting, tax, and insurance).”

Source: Cisco, 20 June 2012.

Finally, to emphasise this point, a recent Lafferty management report concluded that:

“The perception of bank branches as under terminal threat from remote banking technologies is simplistic and fails to consider shifting consumer preferences and sentiment. First, the branch remains the location where by far the greatest number of higher value-added product sales takes place – with estimates as high as 80 percent over some product lines. Second, the branch – when best practice design is observed – is reinventing itself as the location where all retail banking channels converge.”

Of course, it is important to recognise that in the pursuit of a multi-channel management strategy, each channel alternative has different degrees of management risk. The following graph presents a stylised relationship between channel alternatives and management risk. The channel categories considered are:

• Internet and mobile channels (under the umbrella of internet)

• Client database access

• Distribution agreement

• Joint venture


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Branch

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303.5: Relationship between Channel Alternatives and Management Risk

But this is an incomplete picture in that the potential benefits of each channel class are omitted. Hence, a comparison of each channel category against each of the list of five success factors is warranted and addressed below.

Database Access

• Potential reach depends on the size of the client database and economic viability is related to the actual client acquisition cost;

• Interests alignment is based on low acquisition cost and fee income per client;

• Reputation risk is manageable since the bank has control of the sales activity;

• Client ownership is negotiated and is crucial for cross-selling rights;

• Cannibalisation is normally not an issue in this case.

Distribution Agreement (with retailers and agents)*

• Potential reach crucially depends on the size of the client database;

• Interests alignment depends on the commission structure and the likelihood of churning should be addressed in the agreement – churning is particularly harmful for the retail bank as it negatively affects customer satisfaction;

• Reputation risk is relatively higher but can be mitigated by transparent agreement. White labelling is an alternative;

• Client ownership in a distribution agreement is usually reserved for the distributor. This is a serious problem in the insurance industry where distribution agreements are the norm and customers generally feel closer to the distributor/agent;

* “Retail bank branch design is increasingly taking its cue from best practice retailers but is hampered from emulating the experience due to the commoditised nature of bank products. Some banks have attempted to counter this through product merchandising in boxes or tins at branch level. There is also a trend, where space allows, to link promotional displays of real life products with the financial products that enable these lifestyle choices. In terms of space, best practice bank branch design calls for a strong street presence, a customer greeting area and high-impact focal points throughout the store.” –Lafferty management report on The Bank Branch of the Future.


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• Cannibalisation is less of an issue in this case.

Internet/Mobile Phone

• Potential reach can be enormous but, of course, depends on the internet penetration in the market. From an economics perspective, this channel class permits relatively quick entry with a relatively fixed cost – clearly an important dimension on the way to profitable growth;

• Interests alignment is not an issue in the normal sense of dealing with partners but there could be potential misalignment with the traditional branch network;

• Reputation risk is crucial to manage since customer defection is completed by a simple click of a button;

• Client ownership is not an issue here;

• Cannibalisation is a real issue here since internet and mobility channels can offer economies over branches.

Joint Venture (50:50 share)

• Potential reach depends on the partner database and expertise;

• Interests alignment is a big risk in this type of alliance;

• Reputation risk is relatively lower because of separate branding but this may be quite difficult to manage or separate in the market;

• Client ownership can be ambiguous, especially in a 50:50 venture, but the retail bank requires an ability to cross-sell;

• Cannibalisation depends on envisioned client overlap.


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Summary of Key Attributes of New Channels

Internet/Mobile Phone Potentially large reach; reputation and cannibalisation are key risks

Database access Can be arranged quickly and can be economically attractive if the client database is relatively large and clients have a propensity to buy (i.e., a demand for the bank’s products exists)

Distribution agreement

This can also be appealing but the bank must be aware of potentially large reputation and client ownership risks

Joint Venture This takes longer to materialise and can be difficult to manage. Success depends on a potentially large opportunity for each partner.

The summary of the attributes of the four channel classes may be graphed as a relationship between market penetration against time to market. The length of the vertical lines is a measure of the potential for market penetration. For example, database access has short time to market but also has relatively low market penetration. On the other hand, internet channels have a high potential for market penetration but there is high variability as represented by the relatively long vertical line, representing a wide range of possible outcomes.

Market Penetration

High

INTERNET

DISTRIBUTION AGREEMENT

Low

JOINT VENTURE

DATABASE ACCESS

Time to Market

Low High

303.6: Relationship between market penetration against time to market

A satellite model is now presented where the bank branch is at the centre of the four potential categories of new channels that are analysed above. In this model, the branch plays a central part in customer relationship management. This also has to do with the major investment that retail banks normally have in a branch network.


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Distribution Agreement

Internet

Joint Alliance

Database Access

Bank Branch

303.7: Branch role in customer relationship management

To complete our analysis of the strategic alternative of adding new channels within the retail bank’s home market and existing product portfolio, we present a stylised evaluation of each channel based on the five success factors outlined above. This evaluation is in the table below where a higher score (between 1 and 10) indicates low risk or high benefit.

Branch Database access

Distribution agreement

Internet/ mobility

Joint venture

Market reach 7 3 5 7 5

Interest alignment 8 8 5 9 6

Reputation risk 7 8 5 8 6

Client ownership 10 2 4 10 5

Cannibalisation 10 8 7 2 5

Total score 42 29 26 36 27

In this stylised score (based on retail banking expertise and experience), the bank branch stands out with respect to meeting the hurdles of the five important success factors. The second channel category with the next highest score is internet/mobility. This suggests that the bank branch coupled with internet/mobility access would be preferred by customers and offer the best customer reach for the retail bank. Indeed, both of these channels have the highest market reach score. Importantly, the branch ranks high against all success factors. So does the internet channel except for potential cannibalisation.

A final point is worth repeating – the conclusion reached in the Lafferty management report on The Bank Branch of the Future is now rationalised. That conclusion is: “the branch – when best practice design is observed – is reinventing itself as the location where all retail banking channels converge.”

Our scoring in the table above validates this conclusion and is in line with the satellite model.


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Chapter 3: New Markets Based on Existing Product Portfolio and Channels

New markets may be regional or international. As was recommended in the Business Strategies for Retail Banking module, it is not recommended that retail banks enter new markets with new products. This is seen as a source of general uncertainty and hence highly variable financial results. We illustrate this strategic objective as follows:

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303.8: Strategic objective entering new markets

Before considering an expansion into a new market, potential size matters since subscale expansion destroys value. But, even if economies of scale exist, there are other important constraints that matter even more.

These include the regulatory and legal environment, consumer behaviour and, most importantly, cultural affinity.* Recent evidence shows that culture plays an important role even in technology

* The academic literature refers to ‘cultural affinity’ as ‘cultural distance’. A higher cultural distance increases the likelihood of failure, and evidence shows that this factor is predominant in foreign investment in India. How is


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acceptance.* Hence there is a double source of uncertainty arising from cultural affinity when a bank seeks to enter new markets. There is also evidence that straying too far away from regional markets increases the effects of uncertainty related to foreign consumer behaviour – a key to success. Indeed, the presumption is that when there is a high degree of cultural affinity, bank managers can easily understand customers’ local customs and social norms. This reduces information asymmetry and hence can make for better credit decisions and enhanced financial performance. (Alessandrini et al, 2005).†

Open Question #4

“Cultural affinity is key in the strategic decision to enter new markets so as to achieve profitable growth.”

Do you agree?

New Market Entry

There are several options available for entry into new markets. They include:

• Specialist or full product offer. Specialist offers may include credit cards, consumer credit, mutual funds, savings and mortgages. This is a recommended approach. A full product offering is risky since it requires a substantial investment in distribution and branches (recall the satellite model of channels), IT infrastructure, the right people and time taken to gain critical mass. A specialist product offering reduces these risks significantly.

• Distribution agreements with partners.

However reputation and client ownership risks are multiple times higher when the bank ventures into foreign markets. The distributor would likely co-opt the customer but poor customer service may be attributed back to the bank.

• Start up. A bank may consider a startup in the case where no acquisition options are available. The bank may set up a representative office to gather market intelligence or initiate deal leads for the bank to consider and conduct basis regulatory supervision. A representative office may in fact be a first step to a bigger market entry via setting up a branch that is subject to local supervision but mostly home country supervision. A branch in a new market is suitable for retail banking (however, usually not for retail savings) and for specialised corporate banking business.

There are decided advantages to a start-up. These include full control and, importantly, not having to deal with legacy issues. There is relatively lower investment required and the bank can build the business to suit its business strategy and develop a culture to match that of the foreign market and hence reduce cultural dissonance.

Of course, there are obvious disadvantages. There is a potential for slower market penetration as it takes time to build the business. Accordingly, brand equity is built slowly and may be perceived as weak – a determinant in building market share, which is necessary for profitable growth. There are also people and operational risks associated with building a business from scratch. This type of market entry is often used for commercial banking and product specialists.

culture defined? “The collective programming of the mind which distinguishes the members of one group or category of people from another is defined as culture.’’ (Hofstede, 1997, p. 5)* Abbesi et al “Internet Banking Technology Acceptance Model: A focus on Hofstede Cultural Dimensions”, International Conference on Management Science and e-Business Engineering, (2011).† Alessandrini et al: “The geography of banking power: the role of functional distance”, BNL Quarterly Review 235, pp. 129-167 (2005).


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Finally, the bank may acquire a subsidiary and introduce specialist products into the market. Of course, it would acquire a savings portfolio and a set of channels. However, acquisition price is highly correlated with franchise value and the bank may have to pay a high premium to acquire a suitable subsidiary.

This type of market entry is best suited in fragmented markets and offers a viable market position relatively quickly. But, as we mentioned above, there might be a high premium to pay for a good franchise. The risks include off-balance sheet items, an opaque balance sheet and uncertainty about true asset quality, pending litigation, and, importantly, legacy issues and brand positioning.

You do not always get what you pay for. Information asymmetry and ambiguity can lead to hidden costs that will arise after purchase.

This type of market entry is best suited for full retail and commercial product offering. To summarise the key issues involved in new market entry:

• Entering new markets can lead to potentially profitable growth but a lack of awareness of the risks can lead to disappointing results. The key factor is cultural affinity. This is why retail banks should not stray too far away from its local markets. Apart from this variable, it should be noted that expansion into new markets is complex and requires thorough market and customer research. Due diligence is mandatory.

• As in all expansions, economies of scale matter and subscale expansion leads to value destruction. In this case, a lack of scale raises average total cost. As we pointed out earlier in this module, operational leadership is crucial for sustained profitability.

Here is the key point:

When entering new markets: build on the bank’s strengths to reduce risk and enter with a focused portfolio to increase profit.

Summary

This module presented three strategic alternatives for achieving profitable growth in retail banks. The main points are summarised as follows:

Strategy #1: Streamlining the existing product portfolio and adding new products within the home market and for the existing set of channels

It is recommended that profitable growth may be achieved by rationalising the current product portfolio and eliminating value destroyers. The bank should introduce new products that have adequate market demand (optimally with a potential for market leadership) since this would lead to operational efficiencies resulting in higher profits. Importantly, the bank may choose to maintain the same level of profits by lowering its price in line with the gains in operational efficiency. This will likely lead to gains in market share and hence to higher profitability – i.e., profitable growth.

The old adage still works – wallet share is good for growth, but banks grow as customers grow. Market share is still key.

Strategy # 2: New channels in the home market and for the existing product portfolio

We presented the advantages and disadvantages of each distribution channel measured against key success factors, the most important of which is market reach. We repeat the summary of risks and reward for each channel.


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Internet/Mobility Potentially large reach; reputation and cannibalisation are key risks

Database Access Can be arranged quickly and can be economically attractive if the client database is relatively large and clients have a propensity to buy (i.e., a demand for bank products exists)

Distribution Agreement This can also be appealing but the bank must be aware of potentially large reputation and client ownership risks

Joint Venture This takes longer to materialise and can be difficult to manage. Success depends on a potentially large opportunity for each partner

In a stylised valuation of all success factors for each channel category, the branch and internet channels are ranked the highest. The satellite model of multi-channel management envisions the branch as its centre. We recommend that a branch with internet access is the starting point for a proposal of the ‘Branch of the future’. But note that the internet suffers from one important risk – cannibalisation.

Strategy #3: New markets using the same business model

As in all expansions, economies of scale matter and subscale expansion leads to value destruction. There is also general uncertainty, especially when the strategy involves new products in new markets. This is why it is suggested that the bank remains focused and builds on its strengths. A core competency gap that is too wide is disastrous. Due diligence is a mandatory.

As stated in the introduction, a retail bank in a developed economy is likely similar to a utility business with relatively low growth rates. A retail bank is involved in a ‘utility’ business with growth rates that are correlated with savings rates in a country, all else being equal. Ambitious ROEs are usually not feasible. But profitable growth is. This module showed that profitable growth is achieved by leveraging the key strengths of a bank to reduce risk and remain focused for profits. Entering new markets with new products is risky and, based on the content of this module, is not recommended without due diligence and a consideration of the bank’s risk appetite statement.

Home market bias can be rewarding in retail banking.


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Multiple Choice Questions

1. In achieving profitable growth, one measure of success requires an estimate of market demand for new products in existing markets. This measure is typically calculated as follows:

a) Total revenue potential = market reach x customer propensity to buy b) Total revenue potential = market demand x customer propensity to buy c) Total revenue potential = market reach x size of market segment d) Total revenue potential = market demand x size of market segment

2. In reviewing the product portfolio, it is suggested that a bank takes the following steps. Which is not one of recommended justifications?

Eliminate each product that contributes less than 3 to 5 percent of profit, unless there is a business justification such as:

a) The product is key to the bank’s total product offeringb) The elimination of the product will have a large negative client impactc) There is potential for the product to contribute to greater than five percent of revenue or profit over the next three yearsd) Some salespeople find that the product has potential, but not immediately

3. Consider the example of a mortgage product with the following results (stated in bps):

Revenue margin = 100Expense = 45Credit losses = 5

Suppose that the required capital to support risk is three percent, then achieved return on equity is closest to:

a) 15%b) 16.7%c) 19.7%d) 15.6%

4. There are several factors for a successful bank channel strategy. Some factors are key risk indicators while others are key performance indicators. Which one of the following is a key performance indicator?

a) Reach a large potential base of prospectsb) Alignment of interests in case the channel involves third partiesc) Bank must be able to manage reputation riskd) Bank must be able to manage potential cannibalisation

5. Which bank channel would likely have the highest degree of management risk?

a) Bank branch b) Database accessc) Distribution agreementd) Joint venture


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6. To achieve profitable growth, it is recommended that banks enter markets regionally before entering international markets. One important factor to consider in this decision is:

a) Power distanceb) Cultural affinity c) Gender differences d) Ethnic differences

7. In a recent report (2 August 2013), CEO Maris Ramos of Absa Bank stated that, as part of the bank’s growth strategy, “expansion to Nigeria remains on the radar screen. It is a tough market dominated by local banks. They know the customer and the markets. But we need to know that we can do it. The other component of that is to make sure that we have the right business to acquire.” Which of the following factors is likely to have the greatest influence on ABSA‘s decision to expand to Nigeria?

a) Cultural affinityb) Geographical distancec) Type of banking business d) Competitive pressure

8. Senior executives of a retail bank are currently assessing a strategy for profitable growth that is based on the opening of new branches in new markets. The new business development team obtained information showing that the farther away a branch is from the headquarters, the more difficult it is for senior managers to monitor new branch managers. Furthermore, it is proposed that the new branches be led by bank managers who understand the location issues although they are relatively inexperienced in branch management. Senior executives know that inexperienced branch managers typically feel strong pressure to achieve profitability as quickly as possible.

Which of the following statements is incorrect?

a) Geographical distance between bank headquarters and bank branches increases management risk for the bank b) Inexperienced branch managers are likely to create local branch management riskc) Return on equity is an appropriate measure of financial performance of the distant bank branchd) Inexperienced managers who feel strong pressure to achieve profitability as quickly as possible create a potential for mis-selling to customers


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9. A retail bank is considering adding a new channel to increase its current market reach for its existing products. Bank staff created a score for this new channel as compared to the current portfolio of bank branches in the market. The scoring system is based on a selected set of key success factors when adding new channels and is presented below. (A high score indicates an alignment with the success factor – high benefit. A low score indicates high risk. Scores range from 1 through 10.)

Portfolio of Bank Branches New Channel

Market Reach 7 8

Interest Alignment 8 9

Reputation Risk 7 8

Client Ownership 10 10

Cannibalisation 10 2

Total Score 42 37

Based on this analysis, which statement is incorrect?

a) The new channel is expected to meet the bank’s objective of large market reach b) There is a high potential for positive reputation benefitc) The bank staff expects that the new channel will not cannibalise business from branchesd) The new channel permits significant customer ownership and control

10. There is considerable research showing that banks which have the largest market share also have the highest level of profitability. A retail bank in Eastern Europe adopted the following strategy that is intended to increase market share in existing markets with existing banking products. The bank is considering different strategies to achieve higher market share and profitability. Which strategy is most risky?

a) Reduce loan rates to attract new customers b) Add new channel with a high consumer reachc) Invest in customer service qualityd) Promote the bank’s unique selling proposition

Answers:

1 2 3 4 5 6 7 8 9 10

a d b a d b d c c a
