Retail Banking 2010

Financial Services Practice

The Future of Retail Banking

The Future of Retail Banking

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Contents

Introduction

Deposit Profits: New Approaches for an Old Standby

U.S. Credit Cards: Looking at the Business Through aLong-Term Lens

New Market Realities for Mortgage Lenders

Rebounding in Small Business Banking

Stepping Into the Breach: How to Build ProfitableMiddle Market Share

Back to the Future: Rediscovering RelationshipBanking

Big Fish in Small Ponds: Why Regional Banks NeedCritical Mass

Improving Branch Performance in Retail Banking

Banking on Multichannel

The Evolving Consumer: Implications for Retail Banks

Profiting Through Simplification

1Introduction

Introduction

Retail banking has historically been a large and stable business. In2007, the U.S. retail banking profit pool was $363 billion. However,over the past two years, a perfect storm of headwinds and cross-cur-rents have changed the landscape for banks. Massive losses across arange of consumer credit products, reduced spending and transactionsin debit and cards, and increased competition for deposits are amongthe forces pressuring bank margins. New regulations will also be dragon profitability, to the tune of roughly $16 billion to $26 billion in 2010.Overdraft regulation alone will likely reduce deposit revenues by $6 bil-lion to $10 billion in 2010. The CARD Act could cost banks $10 billion,and mortgage lending regulation another $10 billion of origination andservicing profitability. The Durbin amendment on interchange fees andthe repeal of Regulation Q will also have an impact, although the extentis unclear as we go to press.

The credit industry has been drastically reshaped, with the disappear-ance or acquisition of specialty finance and monoline players. Mort-gage lenders are facing a near-term market decline, low buildingactivity and a lack of non-agency secondary markets. Card players arestruggling with slow growth, regulatory scrutiny, credit losses andchanging customer behaviors.

These challenges would be formidable enough, if banks could simply resort to the approaches that worked in the past. But this will not suf-fice. Consumers emerged from the financial crisis with altered behav-iors and attitudes. They are paying down debt, favoring debit andcharge cards over credit, and showing increased interest in more se-cure, lower-margin products. At the same time, technology and socialmedia are giving consumers tools and access to information that em-power them to take more control over their financial lives.

To lead now, U.S. retail banks must not only correct past mistakes, re-build broken models and operate in a more difficult regulatory environ-ment, they must also serve the needs of a dynamically changingconsumer base.

2 The Future of Retail Banking

Specifically, winning banks will make progress on five broad imperatives:

• Focus on relationship banking

• Rethink distribution across channels

• Develop new value propositions that capitalize on evolving customer be-haviors

• Reinvent underwriting models

• Ensure flawless sales and service execution

Focus on relationship banking

In the new retail banking environment, in which overall profitability has dra-matically decreased, successful banks will excel at building and leveragingcustomer relationships. This relationship banking approach has implicationsfor the entire organization, across marketing and sales, underwriting, fulfill-ment and collections. It is a proactive stance supported by research on con-sumer profitability and risk. Relationship banking has three hallmarks. First,customers have an integrated sales and service experience. They see the in-stitution as “one bank” across multiple channels. Second, the bank orientsitself to the customer, rather than its own preferences. Lastly, relationshipbanking entails building the right capabilities to enable cross-product deci-sion-making. These features will enhance a bank’s success with both con-sumers and small and medium-size business clients, which represent agrowing source of revenue and profits.

The rewards are significant. Deepening relationships with existing cus-tomers makes for attractive economics. Customer retention increases withstronger relationships. The relationship multiplier – driven by higher bal-ances and usage – can increase profits by up to 25 percent compared toprofits from products sold individually. Risk benefits also accrue from rela-tionship banking. Our analysis has shown a 10 to 25 percent lower riskfrom clients with deeper relationships with the bank. Integrating operationscan also result in 5 to 15 percent cost savings in the relevant areas.

The shift from product to customer focus triggers implications for banks’operating models, organization and product development, as well as a tran-sition toward simplification in processes and structure. The challenges as-sociated with these changes are not minimal, but there are several pointswhere banks can begin to shift focus.

3Introduction

The first is the redesign of important touch points from the customer point ofview. Account opening is a perfect example. This crucial interaction is an op-portune moment for relationship-building that is often squandered because

banks approach clients in a siloed manner.Branch bankers are frequently not fully versed inthe product range, or are operationally unable tooffer the entire product set. A redesign of the ac-count opening process could have an enormousimpact. Mortgage origination is another often un-tapped moment for making deeper inroads withattractive customers. Mortgage customers tendto have higher deposit balances and longer tenurewith their bank. With targeted cross-selling, andthe development of teams to focus on migrating

these applicants to other financial relationships, banks stand to build morelasting, profitable connections.

The second relationship banking leverage point is the silo: breaking downunnecessary and cumbersome divisions within banks is imperative if banksare to truly reap the rewards of deeper customer relationships. In practicalterms, this means consolidating organizational ownership of product group-ings that customers purchase jointly, along with marketing analytics and risk.

The third leverage point centers on building capabilities to support cross-product decision-making; for example, taking a horizontal view of risk andapproving customers upfront for multiple lending products.

Rethink distribution across channels

Across a range of retail markets, consumers increasingly expect to beable to conduct transactions in the channel of their choice and to seam-lessly cross those channels. To meet these demands, banks need to re-duce their dependence on branches by thinking of them in strategic termsas a core element in their broader multichannel distribution. This may notbe a new idea, but few banks have made it a reality. To do so, they mustallow customers to self-select their preferred channel. They need to re-duce broken transactions by linking across channels to improve conver-sion rates, selectively move service and low-value transactions frombranch to lower-cost channels, and, conversely, push higher-value trans-actions to branch and phone channels to improve conversion rates.

The shift from product to customerfocus triggers implications forbanks’ operational models,organization and productdevelopment, as well as a

transition toward simplification inprocesses and structure.


Technology is of course an important part of this work. For example, banksmust offer secure and dependable mobile banking for services such as billpayment and balance inquiries; and mobile transaction execution, such ascard payment via phone.

However, in the drive toward multichannel distribution, banks must not rel-egate the branch to afterthought status. The branch is still a vital piece ofthe distribution matrix. What is required is a more thoughtful approach to

branch density, especially for regional bankswith smaller resources than their giant peers.Crisis-driven acquisitions have led to a top-heavy concentration in the U.S. retail banking in-dustry, with four megabanks accounting foralmost 60 percent of assets. These Goliaths willclearly have advantages. But regional banks canembrace and develop what makes them unique:their local scale. They must become super-effi-cient in designing their branch footprint, with asharp focus on building critical mass in theirhome markets, as opposed to trying to “out-branch” megabanks in markets where the re-turns are suboptimal. Our work has shown thatwhen regional players have branch share that isat or above the saturation point for a market,they outperform the megabanks by 5 percent-

age points in terms of deposit share, even when megabank itself was alsoat saturation point. These regional banks are outcompeting theoreticallymore efficient rivals.

Develop new value propositions

The U-shaped retail banking economic model – in which the majority ofrevenues are generated by low-deposit customers who incur significantfees and high-balance customers – is under pressure. Heightened compe-tition for growth and increased regulation on profit drivers are only two ofthe profit headwinds. Banks must develop new, profitable but customer-friendly value propositions that are less dependent on penalty fees; gener-ate profitable revenues for the majority of customers that do not currentlycontribute meaningfully to bank economics; and encourage higher bal-ances and use of services from high-value segments.

Crisis-driven acquisitions have led to a top-heavy

concentration in the U.S. retailbanking industry, with fourmegabanks accounting for

almost 60 percent of assets. These Goliaths will clearly

have advantages. But regionalbanks can embrace and

develop what makes them unique:their local scale.

5Introduction

For example, overdraft regulations mean that banks must now convince cus-tomers to opt in to the service. To do so, they need a better understanding ofthe preferences and behaviors of each customer segment. Banks will also needto create a suite of overdraft products with different credit standards and pricing

and move away from free checking to annual andquarterly fees with low overdraft/ATM propositions.For high-value segments, banks should develop in-novative offerings that leverage the full relationship;for instance, deposit insurance above FDIC limitsfor affluent customers, or tools that help customersmanage their near-term cash flow. The need for in-novation in products and services is particularlypressing today, with non-traditional players increas-ingly competing in the retail banking space. Banks

need to offer packages that customers are willing to pay for, taking into accountthe utility of different deposit features to different segments.

To create successful new value propositions, banks need a clear picture ofconsumers’ changing spending and saving behaviors and of their evolvingviews toward investments and risk. That picture has some obvious broadstrokes – consumers are saving and paying down debt – but banks need tomore finely stratify customer segments. In some cases, this will be the onlyway to fully profit from the bank-customer relationship.

Changes in consumer behavior are challenging, but also offer opportunity.Consumer deleveraging has indeed led to a dramatic shift to debit. Butwhile banks stand to lose profits from penalty and interchange fees, thereare opportunities for innovation on the product side: cards that are moretightly integrated into demand deposit accounts or cash flow managementtools that integrate transaction data with debit and bill pay for sophisti-cated spend analysis.

Reinvent underwriting models

Emerging from the painful readjustment of the financial crisis, underwritingis in need of an overhaul. Getting the underwriting model right – improvingpredictive power across the broader set of lending products – must be apriority for all lenders.

Banks must rethink the mortgage lending model. To succeed in a difficultenvironment, lenders must make critical decisions on origination capacity,

To create successful new value propositions, banks

need a clear picture of consumers’changing spending and savingbehaviors, and of their evolving

views toward investments and risk.


and on the optimal mix of whole loans to servicing assets on their bal-ance sheets.

In the small business market, underwriting models had been primarilyderived from consumer credit, a mismatch that resulted in poor predic-tive power. Banks were using quick scoring models that relied heavily onlimited and low-quality underlying data, and portfolio monitoring was alow priority. Unsurprisingly, a tail of unprofitable accounts developed. In

response, banks have swung to the oppositecostly and unsustainable extreme, manuallyunderwriting all sizes of loans. Now, banksmust redefine the underwriting model in orderto restore confidence and grow. They need todefine boundaries between credit processes,weigh the trade-offs between efficiency and

risk, improve scoring and score-plus models with better data and rigor-ous testing, integrate relationship information in enhanced credit deci-sion processes, and build improved portfolio management capabilitieswith clear triggers, processes and responsibilities.

Underwriting in middle market also needs an end-to-end makeover. Thiscan begin with refining and enhancing inputs and recalibrating models toreflect recent loss exposure, while fixing outputs and reducing cycletime by improving information flow across relationship managers, creditofficers and portfolio managers.

Ensure flawless sales and service execution

As banks make progress on these initiatives, they should also bear inmind that excellence in execution will always be a necessary underpin-ning of success. Branch sales are one example where many banks areoperating well below potential. While the expansion of non-branch chan-nels will continue to change distribution dynamics, the branch is still theheart of retail banking – and the asset of greatest. Banks cannot affordless than optimal performance. But there is a huge variability in perform-ance between the best players and the laggards. For example, our re-search reveals that in the typical urban market, the average bank sells 96non-free-checking accounts per branch per year, while the lowest per-formers sell 65. Best-in-class banks sell 143 accounts per branch peryear. The primary driver of this disparity is execution. To rise to the

Banks should bear in mind that excellence in execution will

always be a necessaryunderpinning of success.

7Introduction

higher-performing level, banks must not only pursue optimal density inpromising markets, but also strengthen sales and service capabilities andstructure metrics and incentives to produce performance aligned with eachmarket’s opportunity.

* * *

The future of retail banking will belong to those institutions that not onlyaddress the shortcomings of the past, but also meet the raft of currentchallenges by building stronger, nimbler and more resilient models. Thefollowing articles provide both food for thought and guidelines for actionas this journey begins.


Deposit Profits: NewApproaches for an Old Standby

Retail banking deposit-gathering is encountering a wave of pressures. Lowinterest rates have dramatically reduced spreads. Customers are moving theirmoney out of lower-interest savings and checking products and into higher-yielding money markets and CDs. Established attackers and potential newentrants are threatening to ratchet up yields, adding even more competitivepressure.

Regulation is also generating headwinds. Overdraft fees, which have ac-counted for a growing percentage of revenues, are now subject to strictrules, while the Durbin amendment on interchange fees will also have an im-pact, although the extent is not yet clear.

There is no single silver-bullet solution to this array of challenges, but bankscan begin to compensate for the seismic shifts in the deposits landscape inthree ways:

• Rethink deposit fees. Banks must embrace more transparency in fees tobetter serve customers, restore trust and respond directly to regulatorychange.

• Revise check and deposit pricing. Banks should balance household mar-gins, household growth and funding requirements to bring a measure ofsanity back to pricing strategies.

• Put the customer first. Banks must break down silos to present valuepropositions that are integrated and tailored to serve high-priority cus-tomer segments.

The deposit landscape

Overdraft fees grew by 28 percent from 2006 to 2009 and accounted formore than 40 percent of total deposit fee revenue in 2009 (Exhibit 1). Cour-tesy overdraft fees comprised the majority of the $26 billion in 2009 penaltyfees, or more than one-quarter of consumer checking revenues. A sizableportion of these fees were paid by the relatively small group of customers

9Deposit Profits: New Approaches for an Old Standby

who make a large number of overdrafts per day. Many banks also increasedoverdraft profits by adjusting the transaction posting order.

Federal Reserve rules will likely make a large dent in these fees. The rulesprohibit banks from charging fees for overdrafts from one-time debit cardand ATM transactions, unless a customer has opted in to the service. Many– possibly most – will not do so. These customers will have unfunded trans-actions denied, resulting in fewer overdrafts and a drop in bank fees. Regu-lators may yet dictate posting order. We estimate that these and otherchanges will result in a 20 to 40 percent reduction in overdraft fees for atypical bank.

In light of these developments, banks need to find ways to replace lost rev-enue, but they must do so in transparent ways that provide value for cus-tomers and not fodder for regulators.

Rethink deposit fees

Increased transparency is an important priority for regulators in drafting rulesgoverning overdraft fees. An amendment to Regulation DD mandates the dis-

2009 consumer DDA revenue by sourcePercent

Penalty38

30

30

2

Maintenance

Transaction

Net interest income

Source: McKinsey U.S. Payments Map 2009-2014

Exhibit 1

In 2009, penalty fees accounted for 38 percent of DDA account revenues


closure of fees on statements. Rules requiring opt-in for courtesy overdraftwill make consumers much more conscious of the cost of the services.

Banks should embrace rather than resist the trend toward transparency anddevelop a marketing-based approach that tailors overdraft services to cus-tomer segments and aligns fees to usage levels.

• Customer-driven approach. Our research shows that customers are byno means uniform in their needs and attitudes related to overdrafts (Ex-hibit 2). Some resent the fees and blame the bank. These customersare, of course, least likely to opt in, but may be open to some form ofoverdraft protection services. Other customers – “dice rollers” – pay littleattention to their finances and acknowledge they occasionally run therisk of needing overdraft protection. They are likely to desire some over-draft services, at least for their most important bills. They may also valuenotification services that let them know when they run the risk of over-drafting. Finally, some customers use overdraft deliberately, value theability to pay bills when their deposits are low, and thus are most likelyto be satisfied with the status quo.

Highest credit card penetration

Around half have a mortgage

Roughly one third have a car loan

Like to “balance hop” on credit cards

Roughly one third have a mortgage

Some use payday lending

Low credit card penetration

Typically no mortgage

Minimal investment products

Comfortable with overall financial situation

Pay fairly close attention to account, but often surprised when they overdraft

Typically upset with the bank when overdraft occurs

Consider themselves good money managers

Pay close attention to account and are aware when they overdraft

Take personal responsibility for overdrafts

Spenders who do not like to stick to a budget

Don’t pay close attention to balances

Willing to have higher levels of debt

Less likely to opt in to courtesy overdraft

May be more interested in overdraft protection products

More likely to opt in to courtesy overdraft

More likely to opt in to courtesy overdraft

Characteristics

Attitudes toward finances

Likely response to regulations

Dice Rollers Deliberates Blindsiders

Source: GCI/McKinsey Consumer Financial Life Survey, July 2009

Exhibit 2

Not all overdraft customer segments are alike


• Tailored overdraft offerings. As overdraft policies become more transpar-ent, banks should tailor these offerings to customer segments as they doother products. Customers could choose from a suite of overdraft serv-ices, based on their individual preferences and risk profile. For instance,overdraft protection (as opposed to courtesy overdraft) typically has anannual fee and modest charges per overdraft. We expect overdraft pro-tection to become a more prevalent alternative, particularly for lower-riskcustomers. Another option likely to grow is overdraft protection tied to an-other of the customer’s accounts, such as credit or savings.

• Other fee changes. Free checking has been subsidized in large part byoverdraft fees. This model has now run its course. More banks will revisethis fee structure, considering other “pay for services” models that alignfees to usage levels.

To do this successfully, banks need a more sophisticated understandingof the costs of particular checking services and of the value customersplace on them. As an example, our research indicates that checking ac-count holders fall into four different groups we label: brick and mortar in-tensive, fee averse, online intensive and interest sensitive (Exhibit 3, page12). Customers in each segment are willing to pay more for the servicesthat they value most. As banks migrate away from free checking, they willneed to develop checking products that meet the needs of these specificsegments.

Revise check deposit pricing

In the low interest rate environment, banks have struggled to define theirpricing strategy. Broadly, banks need to bring more sophistication to thetask of synchronizing deposit and lending volumes and to understandingall the profit drivers underlying pricing.

• Coordinated target-setting. Over the past several years, as other fundingsources rose to prominence, deposit funding was de-coupled from thefunding requirements for lending. Now deposits are once again the criticalfunding source, but banks lack the coordination to synchronize depositvolumes with lending volumes. As a result, deposit growth targets mustbe more frequently and systematically reviewed in conjunction with lend-ing, given the recent volatility in lending volumes.

We also find that there must be a commonly accepted picture of depositprofitability to generate agreement among treasury, finance, marketing


and product managers. This is not as simple as it may seem, particularlyin a low-rate environment where current deposit spreads may even benegative. To succeed, banks need an end-to-end present value view ofproduct profitability, which incorporates several factors: current and futureinterest margins based on yield curves and expected future repricing;benefits of cross-sell for new-to-bank customers; operating and acquisi-tion expenses; and attrition rates.

• Sophisticated relationship pricing. Many banks take a siloed approach topricing which results in policies that do not place sufficient value on thecustomer relationship. For instance, profits from cross-sell should bequantified and factored into overall pricing strategy. However, becauserate deposit product managers often have difficulty accessing productsales and profitability data tied to their account holders, this critical analy-sis is frequently not performed.

Maintenance/usage fees

Online access

Interest

Fraud protection

Bricks & mortar

These core categories are important to all segments

Segment membership is driven by a singular priority

Fraud protection/bricks & mortarintensive

27% of population

Highly fee averse

38% of population

Highly interest sensitive

15% of population

Online intensive

20% of population

2

3

4

1

Source: GCI/McKinsey Customer DDA research

Exhibit 3

DDA account holders fall into four needs-based segments


• Cross-region pricing optimization. Many banks have sophisticated regionalpricing models. However, these models can turn into black boxes that dolittle to inform the intuition of the product managers and marketing, fi-nance and sales leaders who must ultimately make the pricing call. Addi-tionally, these models often compute elasticity but do not incorporate theother factors that ultimately drive profitability and optimal pricing decisions(e.g., absolute price by market, local marketing spend, cross-sell and at-trition rates). An approach that transparently and simply lays out the criti-cal components of the pricing decision by region would drive moreprofitable decisions (Exhibit 4).

• Coordinating marketing, sales and pricing. Many banks continue to strug-gle with the link between marketing spend, pricing and sales incentives.As a result, the sales force may be rewarded for an increase in sales, evenwhen more aggressive pricing and higher marketing spend were the real

0.70

0.90

0.90

1.00

1.00

1.00

1.20

1.20

1.70

1.70

5

10

15

10

10

15

20

20

30

30

Region 10

Region 9

Region 8

Region 7

Region 6

Region 5

Region 4

Region 3

Region 2

Region 1

1.55

1.60

1.50

1.35

1.40

1.25

1.30

1.30

1.10

1.20

Normalized elasticity by region

Percent balance increase per 10% change in price

Average market price by region

Percent

Optimal price by region

Percent relative to average market

In this example, combination of price elasticity and absolute price by region drives optimal price recommendation

Source: McKinsey analysis

Exhibit 4

Regional pricing models should transparently display multiple factors to help management determine the optimal price


drivers. Further, the sales force may be generating low-quality churn asopposed to high-quality new-to-bank sales. Banks can no longer affordthese inefficiencies and must have systems to solve them.

The first step is to put in place the factors discussed above to make thedrivers of profitable pricing more transparent. Then, a deeper understand-ing of the relationship between marketing spend and rate deposit prof-itability should be used to determine the level of sales opportunity. Onlywith this understanding can a bank reward its sales force appropriately foropportunity-adjusted performance.

Put the customer first

Deposit products are fairly commoditized in the United States, which meansthat competition is based primarily on price and convenience. To break out ofthis constraint, banks must develop more innovative propositions, based oncustomer needs and desires. There are three areas where we see opportunityfor this kind of innovation:

• First, banks are increasingly considering integration of products acrosssilos. This idea goes beyond mere bundling. An example might be a ho-listic rewards program that offers benefits for total deposit and lendingvolumes with the institution. Banks can offer creative account transferfeatures, such as free checking overdraft tied to the credit card, or auto-matic transfers from checking into savings for specific goals, such assaving for a car. Another example, Bank of America’s “Keep the Change”program, generated more than 1 million new current accounts in its firstyear. This was a clear case of product development from a customer-value standpoint.

• Second, banks can better target value propositions for specific segments.For instance, older affluent customers are driving most deposit growth.These customers are likely to be interested in guaranteed income solu-tions, such as ING’s Orange CD ladder, which provides an online optionthat allows the customer to put dollar amounts into different CD terms toreceive separate interest disbursements. Younger customers might prefera CD that pays out interest immediately, rather than at the end of theterm. For customers who have difficulty saving, banks can offer progres-sive rates that reward them for meeting savings goals.

• A third area ripe for innovation is individual customization. When Com-pass Bank introduced its “Pick Your Own Features” checking account, it


received credit from consumers for providing a fully customizable de-posit product and it also implicitly received permission to provide eachfree feature only to a subset of customers. Customers who opt for freeATM usage are implicitly accepting that they will pay for other services(e.g., overdraft protection). By embracing the concept of choice, Com-pass also created a mechanism for maintaining and improving the prof-itability of new deposit accounts.

* * *

Banks cannot rely on their old models to compensate for profits lost to com-petitive or regulatory pressures. Instead, they should take this opportunity torethink value propositions, fee structures, pricing and distribution to create amore sustainable – and profitable – deposit model.


U.S. Credit Cards: Looking at the BusinessThrough a Long-Term Lens

The U.S. credit card industry has a long history of strong growth, prof-itability and innovation. From the early days when cards were a conven-ient payment device, through their role as an easy borrowing vehicle, tothe more recent incarnation as a reward-based loyalty tool, the sectorhas proven consistently resilient. This was a business, after all, that ac-tually grew revenues and profits through the recession of 2001-02, ashigher charge-offs were more than offset by the lower cost of funds. Webelieve the latest economic downturn presents a very different chal-lenge: the sector can no longer rely on its traditional strengths, it mustreinvent its business model.

Credit card issuers are operating in a maturing industry in which growth isslowing and credit losses are rising. They face increasing regulatory scrutinyand consumers who are deleveraging and favoring their debit cards.

The traditional tactical responses to these macroeconomic challenges –repricing, cost-cutting, etc. – will not be enough. The direct-mail domi-nated, balance-transfer driven business model that has served the sectorso well for so long is unlikely to suffice. Players must take a “through-the-cycle” view with an eye toward long-term sustainability.

The end of business as usual

Over the past 20 years, the industry’s return on assets (ROA) has heldrelatively steady at between 2.5 and 4.6 percent, driven by net creditmargins (gross revenue minus cost of funds) rarely falling outside 8.5 to10.5 percent of receivables. However, charge-offs rose dramatically be-tween June 2007 and June 2010, from approximately 4.6 percent to10.3 percent. For the first time, structural changes in the funding mar-kets mean that the traditional buffer to rising charge-offs – falling cost offunds – is not materializing.

17U.S. Credit Cards: Looking at the Business Through a Long-Term Lens

Issuers responded quickly and dramatically to the deteriorating economy –but also predictably. Most have undertaken a strategic review of their port-folios and are abandoning unprofitable products, cutting credit lines andrevamping credit standards and models. They are also aggressively cuttingcosts across the board and improving reward scheme cost structures.Even formerly taboo topics, such as off-shoring or IT platform in-sourc-ing/out-sourcing, are being openly discussed. We estimate that in 2008these cost-cutting measures generated industry-wide savings of more than$3.6 billion and that the industry likely stripped out another $2 billion orpossibly even more in 2009.

All this is necessary, but insufficient. Issuers need to understand how to com-pete in the shifting landscape rather than merely react to immediate shocks.To survive in the long run, players must adapt to changing consumer atti-tudes and the rapidly evolving regulatory environment.

Consumer attitudes have changed forever

Between 2000 and 2007, U.S. household debt grew 18 percent faster thanincome. Since then, consumer confidence in the use of credit and in theeconomy more broadly, has been shattered (Exhibit 1). Americans are now

37

25

24

23

26

24

20

9Subprime

Superprime

Primetransactor

Prime revolver

Subprime

Superprime

Primetransactor

Prime revolver

40

48

61

65

53

63

68

71

Have cut back on spending

Concerned about income during retirement

On track to meet long term financial goals

Percent of respondents who strongly agree

Economy will be much better in 6 months

Source: McKinsey Consumer Financial Life Survey, March 2009

Exhibit 1

Concerns about the economy and its long-term effects are felt by cardholders across the credit spectrum


saving more. The average consumer saved 1.8 percent of discretionaryspending in 2008, triple the 0.6 percent in 2007. We expect that number tonearly triple again in 2010 and to remain high for the foreseeable future.Cardholders are also voluntarily paying off balances and closing accounts:voluntary attrition in December 2009 was 9.3 percent, an increase of 30 per-cent over the average for 2008. Finally, the use of revolving debt was downby 13.3 percent in September 2009, the largest drop since December 1976.

Furthermore, consumers are leaving their credit cards at home in favor oftheir debit cards. Visa and MasterCard’s second quarter 2010 credit chargevolumes were down 4 and 15 percent, respectively, compared to the secondquarter of 2008, while debit volumes rose 26 and 4 percent, respectively.Visa reported that total dollar volumes of purchases made with its brandeddebit cards exceeded credit card purchases for the first time ever in thefourth quarter of 2008.

We expect this reduction in consumer debt and shift in spending behavior tolast, with enormous consequences for the card industry. Issuers are going tobe forced to think beyond their traditional notion of growth in outstandingbalances if they are to attract this new breed of debt-averse consumer.

8.3

2005

8.3

2006

7.4

2007

1.8

2009

5.4

2008

Mail solicitations U.S.$ billions

-67%

Source: Mintel Comperemedia

Exhibit 2

Direct mail credit card solicitations fell 67% in 2009


Evolving regulatory environment

Regulators have been seeking to protect consumers through measures thatwill have a significant impact on the industry, especially the move to limitrisk-based repricing. The Durbin interchange amendment will further de-press industry revenues. These new regulations will either prompt financialinstitutions to find new sources of income by pricing differently (e.g., moreupfront balance-transfer fees), reducing fee waivers or steering customersto more profitable products; or they will force them to reinvent the businessmodel. The industry may even have to take a new perspective on revolvingcredit: instead of having the freedom to manage risk and return throughoutthe life of the product, issuers will need to think about cards as a series ofinstallment loans, where each change in terms will lock in future balancesto that return.

Winning through the cycle

Direct mail has been slowly declining as a source of new accounts, and thestructural changes to the industry are turning this gradual slippage into asteep decline. Mail volumes were down a staggering 67 percent in 2009and are likely to fall further in 2010 (Exhibit 2). While issuers will continue touse direct mail, it is unlikely to be the engine of industry growth and prof-itability it once was.

We believe three new business models are likely to emerge over the next fewyears as issuers rethink both the product and the channel interactions with

customers. Issuers will need to rediscover rela-tionship-based sales through traditional channels,as well as to develop new and cheaper forms ofdirect marketing. Relationships will be increasinglyimportant to acquiring new customers, as will de-veloping new value propositions and deliveringexperiential benefits. Specifically, the emerging

models we see are a) relationship-based bank sales, b) partnership relation-ship sales and c) reinvention of the product for the digital world.

Relationship sales: Going multichannel

Maximizing existing customer relationships allows banks to target productsmore effectively, reduce churn and improve profitability. Issuers with largecustomer bases and branch footprints will enjoy a natural advantage asthey can focus on cross-selling with deposit accounts and other products.

Maximizing existing customerrelationships allows banks to targetproducts more effectively, reducechurn and improve profitability.


On average, U.S. banks have sold credit cards to 20 to 22 percent of theirretail banking customers, with leading institutions reaching penetrationrates of 35 to 40 percent. These numbers leave a great deal of room forgrowth: outside the U.S., some banks have achieved penetration rates of

more than 50 percent despite operating in lessdeveloped credit card markets.

To improve cross-selling rates in the new envi-ronment, bank issuers need to understand whichchannels to emphasize, improve the marketinginfrastructure, and ensure the products are suit-ably integrated.

Multichannel: Although some institutions todaygenerate nearly 30 new accounts per brancheach month, the branch alone will not be

enough. Issuers will also need to use their online, call center and even ATMchannels to push acquisition rates higher.

Marketing infrastructure: Issuers must do a better job of using the relation-ship data and information they have on customers to tailor and target prod-ucts and offers and evaluate credit. For example, bank issuers couldpre-qualify their entire retail customer base for credit cards so sales staffcan offer customers the product knowing they will be accepted. These de-cisions will then need to be pushed out to frontline branch, call-center andonline channels.

Product: The card offering could be integrated more tightly with retail bankofferings – e.g., with overdraft credit lines, integrating transaction data withdebit and bill pay for spending analysis, direct debit of payments, integratedstatements, etc. This would enhance cross-sell appeal, but new capabilitieswould need to be developed.

Partnering for mutual benefit

Issuers do not have to be a bank with an extensive branch network toplay the relationship game. They can also partner in developing distinctivevalue propositions and use partners’ low-cost acquisition channels. Theold co-brand partnership model should be a thing of the past. The newparadigm is about meeting a partner’s core business needs and buildingreal customer loyalty, rather than focusing on points and “10 percent offfirst purchase” deals.

To improve cross-selling rates in the new environment, bank

issuers need to understand whichchannels to emphasize, improve

the marketing infrastructure, and ensure the products are

suitably integrated.


When designing partnerships, issuers need to consider both the needs oftheir partners and the needs of their partners’ customers.

Deal structure with partners: Issuers will have to become more attunedto the core business needs of their partners. For example, the partnermay be trying to enter new markets, drive trip frequency, or get cus-tomers to buy new categories or try new channels. Meeting a partner’sneeds will likely lead to more partner engagement and better card eco-nomics. Another solution could be to strike profit-sharing deals thatallow partners to benefit from the true upside rather than the traditional“bounty” payment for new accounts and purchasing points.

Value proposition for end customers: Customers want a positive ex-perience from the partner, and partners want to improve customer

loyalty. The two should not be hard to matchup, assuming the card issuer understands theunderlying motivations. For instance, tieredpoints-based airline programs could be re-vamped to support an airline’s goal of raisingrevenue through baggage fees and on-boardfood sales, while delivering meaningful experi-ential rewards to customers, such as frequentflyer status, upgrades, or priority boardingrather than points. Some partnerships have al-ready experimented with this:

Continental/Chase gives cardholders their first checked bag free,while Delta/American Express awards elite qualifying miles that counttoward higher status. These are still only targeted efforts and fallshort of being fundamental changes in the core value proposition toharness the power of experiential rewards, but they are a step in theright direction.

Reinvention in the digital age

Issuers should consider how digital technologies can enhance the cus-tomer experience while stripping out costs. Moving to digital marketingalone could reduce the overall cost structure by 30 to 40 percent. This isstill a business that relies too heavily on paper: direct mail, statements,check remittances, etc. Issuers should embrace the full capabilities of theWeb and other digital technologies. Imagine what the user interface wouldlook like if Apple issued an “iCard.”

Issuers should consider how digitaltechnologies can enhance the

customer experience whilestripping out costs. Moving todigital marketing alone could

reduce the overall cost structure by30 to 40 percent.


To date, most issuers have only recreated their paper statements online,making no attempts to use the full capabilities of the Web. But taking paperout of the system means more than just having a PDF version of a state-ment for download.

There are also clear business benefits beyond cost-cutting. Steering cus-tomers towards direct debit to pay card bills actually improves the risk profileof the customer and takes the check remittance out of the system.

* * *

The credit card industry has been incredibly resilient and innovative overmany decades. It developed rewards and affinity value propositions, per-fected direct mail in financial services and took analytics-based marketingand pricing to a new level. The challenges facing the industry today aredaunting and have brought it to another crossroads. It is time for the industryto find innovative ways to serve consumers and to reinvent the business forcontinued growth and profitability.

Note: This article is an updated version of an article of the same title that appeared in McKinsey on Payments, June 2009.

23New Market Realities for Mortgage Lenders

New Market Realities forMortgage Lenders

The refinancing boom of 2009 and 2010 delivered a much needed lift toearnings and spirits alike in the beleaguered mortgage lending market.This optimism, however, may be short-lived. As with the private label mort-gage boom following the 2001 recession, the current market owes more toU.S. economic and monetary policy than to any fundamental improve-ments in the housing market. In fact, as the refinancing wave subsides andhome purchase incentives go away, there may be little that can keep thecurrent momentum going until the fundamentals of housing supply and de-mand balance out. This could take until 2013 or 2014. At the same time,the passing of the Dodd-Frank Act marks the beginning of potentiallysweeping changes to the mortgage market. This process will culminatewith the reform of the government-sponsored enterprises (GSEs). Aslenders think about strategy for the next 18 to 24 months, they should an-alyze the substantially altered market landscape and outlook. There is noshortage of challenges: declining market size, legislative uncertainty con-cerning GSEs, increased regulatory scrutiny, and competitive trends. Thedays of turning lead into gold from the private-label era are over. The taskfor mortgage lenders now is to build a model for success that meets thedemands of this new reality.

Scanning the new mortgage landscape

Mortgage lenders will face an array of challenges even when the U.S. econ-omy and housing market start to show glimmers of life. Across almost everydimension, the market is being reshaped, and to succeed, lenders have tounderstand how these changes are playing out.

Several factors are leading to a decline in the size of the mortgage marketthat is likely to persist for the next few years. Low interest rates and bondyields, government support in the form of mortgage-backed securities(MBS) purchases, and tax credits for first-time homebuyers may be obscur-ing the degree of this decline, but the signs are evident: about one-quarterof borrowers had negative equity in their homes at the end of 2009 (an ad-


ditional 20 percent of mortgages had a combined loan-to-value ratio greaterthan 85 percent).1 To make enough from a sale to afford a new down pay-ment, these homeowners will have to stay put until prices improve. In addi-

tion, consumers with damaged credit histories,including borrowers with modified mortgageloans, will have severely limited (or zero) accessto credit, reducing mobility and further loweringthe demand for new home purchases.

Several macroeconomic factors are also likely todepress the mortgage origination market over thenext two to three years. Home prices hit a peak-to-trough decline of 30.6 percent through latesummer 2010.2 And historically low interest rates

today will suppress refinancing potential over the next few years. Originationloan-to-value ratios are also down, from an average of 80 percent at the endof 2008 to 74.5 percent in 2009.3

The non-agency secondary market is unlikely to make a return for perhapsanother two years. After peaking at over $1 trillion in 2005 and 2006 and dip-ping to $10 billion in 2008, non-agency MBS are forecasted to reach roughly$250 billion in the next few years.4

Finally, building activity is at a historical low. Monthly housing starts havedropped by 50 percent and were running at below 50,000 per month in mid-2010 compared to over 100,000 in 2007.

Another salient feature of the mortgage market is unstable pricing equilibrium.The financial crisis triggered unprecedented consolidation, with the top fourlenders now accounting for over 60 percent of the origination market. Thelarge monoline originators that flourished during the pre-crisis mortgage boomare, for the most part, gone and are unlikely to return in force, given the col-lapse of the private-label market. And now that the ability to originate high-margin non-conforming loans is limited, the conforming loan is no longer theaccommodation product it became in the private-label era. These factors may

Managing the convexity riskassociated with the servicing assetwill require renewed focus on riskmanagement and balance sheet

optimization through moredeliberate allocation of capital to

the mortgage assets.

1 First American Core Logic, Fiserv/MBA

2 Case-Schiller, economy.com

3 FHFB

4 Estimate based on deal information and general publications from SIFMA, Bloomberg, Fannie Mae, Federal Reserve, Freddie Mac,Ginnie Mae, First American Corelogic Loan Performance, Thomson Reuters.


lead to a period of more rational pricing in the conforming market, which hasonce again become the bread-and-butter segment for lenders. At the sametime, the decline in refinancing production in 2010 may lead to a scramble forvolume as lenders struggle to downsize or integrate their origination platforms.

With the steep, simultaneous decline of servicing, origination and investmentincome in 2007 and 2008 undercutting the “macro hedge” (increased pro-duction earnings offsetting the losses in servicing during refinancings), mort-gage lenders will need to refresh risk management and capital allocationstrategies. Even if increased production income at least partly offsets the re-alized impairment of the servicing assets, the unrealized impairments willcontinue to create significant earnings volatility for most lenders in the origi-nate-to-sell business. Managing the convexity risk associated with the servic-ing asset will require renewed focus on risk management and balance sheetoptimization through more deliberate allocation of capital to mortgage assets.

The decline of the broker channel and stand-alone home loan centers isleading to a much greater emphasis on retail channels. This shift will forcelenders to enhance their branch sales capacity, increase the effectiveness of

loan officers (LOs) and develop strong direct ca-pabilities. Banks will also need to innovate andfind ways to lower retail commission expensesand manage the attrition typically associated withthe LO channel.

Originators are likely to experience increasedcosts of mortgage production as consumer pro-tection is at the top of regulatory and legisla-

tive agendas. A sharper focus on quality by GSEs will require lenders togo to greater lengths to identify fraud and reduce underwriting and pro-cessing defects. At the same time, market-driven activity (e.g., a ramp-upof repurchase requests) is adding to the overall cost burden of mortgageloan production.

Several trends are conspiring to create a very challenging credit loss environ-ment. Deeply underwater borrowers who are not responding to existing lossmitigation modification programs, along with more than $800 billion of floatingHELOCs at historically low interest rates, represent a looming challenge fordefault servicers. In addition, continuously high rates of unemployment andunderemployment are contributing to delinquency and foreclosure levels thatare likely to remain above historical averages for several years.

The decline of the broker channel and stand-alone home

loan centers is leading to a much greater emphasis on

retail channels.


Current legislative and regulatory initiatives will affect several market prac-tices, likely reducing production revenues and increasing the cost to origi-nate and service mortgage loans. Increased state regulation, certification ofloan officers, bans on certain types of sales commissions, greater disclo-sure requirements and stricter regulation of borrower fees (including pre-payment penalties), are among the potential and confirmed changes thatlenders will face (Exhibit 1). But the most significant impact of regulationmay come from possible changes in regulatory capital requirements – bothfor whole loans and securitizations. Investing in whole loans seems unlikelyto be more profitable on an ROE basis, while under the Dodd-Frank Act,private-label securitization of non-qualified mortgages has already becomesignificantly more capital intensive, leaving lenders at the mercy of the con-forming MBS market.

Funding risks, and in particular the challenges associated with the conformingMBS market, may become the big surprise over the next 12 to 18 months.Since the majority of the conforming production in 2009 was effectively fundedthrough government purchases as part of its quantitative easing program, therecord low yields in the conforming MBS market and the resulting massive

Bank balance sheets have contracted

Further contraction possible due to higher risk weights

Proposal that issuers retain material interest in securitized credit exposure

Share of exposure retained and other conditions still unclear

Potential for servicers to require “skin in the game”

Government funding programs have provided significant liquidity to MBS market

These programs have prompted concerns over the size of Treasury/Fed balance sheets

From 2000 to 2007, GSEs’ retained portfolios grew considerably in size and risk, with a 53% increase in mortgages on balance sheet, prompting concerns over future systemic risk

Anti predatory legislation pending approval would require creditors to determine borrower's ability to pay

Consumer Financial Protection Agency could increase productspecific regulation

Bank capital require-ments

First-loss legislation

Government funding programs

Legislation reducing GSE size

Consumer protection laws

Heightened bank capital requirements and proposed first loss legislation will fundamentally impact the role and size of bank balance sheets and private label MBS in future housing finance.

Consumer protection laws will be strengthened to prevent a repeat of lending practices leading to the crisis

Likely outcome

Source: SEC as reported by SNL; company 10Qs; The Roles of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks in Stabilizing the Mortgage Market (6/18/09); FHFA; Press search

Exhibit 1

Mortgage lending faces increasing regulatory pressure


wave of refinancing early in the year are largely a by-product of U.S. economicand monetary policy (Exhibit 2). In the first half of 2009, the U.S. governmentpurchased the equivalent of 97 percent of all MBS issued and 82 percent of alloriginations. In total, the Federal Reserve’s program has purchased over $1.25trillion in agency MBS, approximately 60 percent of total 2009 originations. Theannounced completion of the Fed’s MBS purchase program in 2010, com-bined with what appears to be a muted investor appetite for fixed-rate U.S.mortgages, could lead to significantly higher MBS yields for conforming pro-duction, resulting in margin pressures or higher rates for borrowers. In themost extreme scenario, increased MBS yields could push the mortgage rate tolevels that would virtually halt most refinancing activity, leaving lenders scram-bling to win in the slowly recovering purchase market.

Imperatives for mortgage executives

The basic outline of what is required for mortgage players to succeed in thenew market environment is not wholly unfamiliar. Near- and mid-term condi-tions call for a return to fundamental strengths such as high-quality under-writing and processing, and in certain areas, a shift in emphasis or objectives

Mortgage originations by source of fundingU.S.$ billion

Portfolio lending

Other MBS purchases

Freddie Mac purchases

Fannie Mae purchases

Treasury purchases

Fed purchases

18%

FH 2009

995

3%

2%9%

8%

60%

22%

67%

2008

1,500

5%

5%2%0%

MBS Issuances

Source: Inside Mortgage Finance, Federal Reserve Bank of New York, US Treasury, Freddie Mac and Fannie Mae monthly summary

Exhibit 2

The federal government has been funding most of the mortgage market


(e.g., for secondary market execution). Most mortgage lenders will need tomake explicit choices and trade-offs and increasingly approach mortgagestrategy as part of overall consumer banking strategy.

Redefining business objectives

The U.S. mortgage business is both cyclical and volatile (Exhibit 3). This facthas been well-documented. Unpredictable swings in production volume, as-sociated pricing expansion and contraction, significant operating leverage andthe changes in the fair value of mortgage servicing rights (MSR) are amongthe usual drivers. Then there is the industry’s love affair with market share andcurrent earnings. The impact of making these metrics primary business objec-tives is unmistakable: market share targets exacerbate pricing pressures,while the focus on current earnings typically leads to suboptimal through-the-cycle decisions, excessive risk-taking and ineffective use of capital.

We expect that lenders will begin pursuing a more comprehensive set ofbusiness objectives. While mortgages will undoubtedly represent an impor-tant earnings stream for many banks and hence call for market share, volumeand profit objectives, other measures of success will become equally impor-

4 6

19 20+Current point in cycle

12 14

Estimated future industry ROE Percent

Bottom of the refinance cycle

Refinance boom

Through the cycle

Cycle timing


Exhibit 3

Industry cyclicality contributes to a highly variable ROE


tant: earnings and value at risk, capital usage, ROE, through-the-cycle earn-ings and overall customer franchise value.

Most lenders will need to make several trade-offs to rebalance this broaderset of business objectives and realign their origination, servicing and balancesheet strategy. Decisions on retaining servicing will be very important. Book-ing servicing at production implies higher current earnings, but also placesmore earnings and value at risk. Funding whole loans on the balance sheetstabilizes the earnings volatility associated with a servicing book, but will alsoincrease capital consumption, may drag ROE below the cost of equity andcan result in the build-up of credit risk. Selling loans on a correspondentbasis, in turn, frees up capital, eliminates the earnings volatility and risk asso-ciated with the servicing asset altogether, and boosts ROE. However, it candiminish the franchise value of customers, who will now receive mortgagestatements from another retail bank (Exhibit 4). Three actions will be particu-larly important in the near term:

• Set the originations capacity target. Two of the most critical decisions inpractice will be to determine the optimal mix of whole loans and servic-ing assets on the balance sheet and to determine the maximum size of

ROE after tax Percent

Balance sheet approach

Revenue drivers

Costdrivers

Key risks/considerations

12 14

5 8

15 20

Upfront origination fee income

Earn NIM throughout duration of the loan (3 5 yrs)

Upfront income from origination fees, gain on sale and MSRs

Servicing strip and ancillary fees/income throughout duration of loan

Upfront income from origination fees, gain on sale and MSR sale

No ongoing income

Origination & servicing costs

Credit provisions

Origination & servicing costs

Mark to market gain/loss on MSR & hedges

Origination costs

Significant capital requirements to hold whole loans

Duration and convexity risk

Credit/delinquency risk

Capital required to be held against MSR

High MSR convexity

Significant MSR volatility and hedging

Limited capital requirements

Hold wholeloan on balance sheet

Sell whole loan and retain MSR

Sell whole loan and release MSR


Exhibit 4

ROEs differ significantly for different business model choices


the overall mortgage portfolio relative to originations capacity. The firstdecision will determine the risk-return profile of the business, while thesecond will protect the franchise from runoff risk, i.e., the risk that amortgage will get refinanced, resulting in the loss of net interest or serv-icing income. Given the preoccupation with the opposite risk today –that loans will stay on the balance sheet longer due to their low interestrates – lenders will need to exercise an even greater discipline in manag-ing portfolio growth in the near term.

• Set the secondary execution strategy for servicing. The pursuit of currentproduction earnings has pushed most lenders into booking servicingrights on their balance sheets. At origination, the value of the right to serv-ice the loan is capitalized if a lender decides to retain it, and recognizedboth as an asset and as current period revenue. More servicing rights,therefore, means more production profits. The servicing rights, however,consume capital and produce significant quarterly earnings volatility. Tomaximize production revenues, lenders are frequently tempted to bookexcess servicing rights – over and above what Fannie Mae and FreddieMac would require them to hold – increasing capital consumption, causingmore earnings volatility in the future, and reducing the ROE of the mort-gage business. Some lenders are starting to reevaluate how they makesecondary market decisions around servicing and beginning to considerROE, liquidity and long-term earnings implications. We expect morelenders to follow suit.

• Understand the implications of the new objectives for business processesand incentives. Finally, balancing business objectives will require deeperstructural changes to business models and processes. In particular,budget and business planning processes will need to include a discussionof returns on capital and its underlying drivers. Management incentivesacross sales, operations and capital markets (typically based on originationvolumes, revenues or, less frequently, income) should be reevaluatedthrough the ROE lens and cascaded through the organization appropri-ately, calling for required changes to the MIS and reporting systems.

Clarify originations strategy and align the sales model

The increased emphasis on retail channels creates its own challenges, as re-tail production does not come cheaply. In particular, LO originations continueto be expensive. As retail networks consolidate, lenders must manage high at-trition rates among their loan officers, while incurring 55 bps to 60 bps of


commission costs in the channel. One alternative is to migrate customers todirect channels. Several lenders are already receiving up to a third of their re-tail production through the Web and telesales channels. Some banks arestarting to experiment with consumer direct technology and telesales inbranch. While there have been few notable successes thus far, the reward forbanks getting consumer direct right will be significant. For banks that continuerelying on loan officers, managing sales effectiveness and containing attritionwill be ever more important, as cost pressures begin to mount with the declinein refinance volume. The good news is that opportunities for improvementsabound, given the wide dispersion of sales performance, limited focus on keydrivers of productivity and the frequently mercenary culture of the channel.

While reports of the death of the broker channel have been exaggerated, itdoes present a formidable challenge. While lenders have typically managedthis channel for volume, getting it right will require either adopting B2B man-agement standards and applying commercial lending principles or movingupscale in the broker space and focusing on the most reputable partners.The latter approach has enabled a handful of lenders to maintain a smallernumber of handpicked broker relationships managed for end-to-end eco-

nomics with strict quality and risk managementcontrols in place. Those that can maintain theirpresence in this channel and manage the associ-ated operational and credit risk will have an ad-vantage in a market with a declining share ofrefinance volume.

A number of correspondent lenders have enjoyedstrong margins. The move by many communitybanks and credit unions to offload convexity risk al-lowed correspondent lenders to purchase deeplydiscounted servicing assets. The correspondent

channel will continue to be an important element in managing run-off risk, butcorrespondent lenders will need to assess their own levels of convexity risk anddetermine the optimal size of the correspondent channel. Increasing pricingcompetition will likely require correspondent lenders to develop value proposi-tions based on benefits other than price alone (e.g., private-label servicing).

Overall, sales strategy needs to fit the desired size of the mortgage and serv-icing assets on the balance sheet. As lenders continue to exit the wholesalechannel, they will be less able to manage run-off risk through increasedwholesale originations during refinancing periods. While extension risk (i.e.,

Some banks are starting toexperiment with consumer direct

technology and telesales in branch.While there have been few notablesuccesses thus far, the reward for

banks getting consumer directright will be significant.


risk of borrowers less likely to prepay) dominates prepayment risk in the nearterm, a three-year mortgage strategy should balance originations capacitywith the size of mortgage and servicing assets.

Reengineer the operating model

The current business environment calls for a more flexible operating model.Cost-effectiveness, scalability and pull-through rates will be a priority forlenders, if significant declines in origination volumes materialize. Successfuloriginators will also stand out through their excellence in customer service(e.g., by providing accurate terms to borrowers). Cost takeout and downsiz-ing will be priorities, especially for banks that have recently acquired mort-gage platforms. Platform and system integration, along with rationalization ofsites and production overhead, will regain the priority status they lost in themiddle of the 2009 refinancing cycle.

Process reengineering can also improve lenders’ cost positions. A significantbut hard-to-measure cost in most origination shops is that associated with re-working applications to correct processing and underwriting errors. The needfor rework and multiple file touches by underwriters and processers reflects thelarge share of agency origination, lower-than-expected appraisal values andmultiple layers of condition requirements. This may be where originators havethe most potential to innovate. There are multiple opportunities in virtually anyoriginations shop: more accurate condition generation, better feedback loopsbetween condition and application underwriting, upfront identification of appli-cation segments with high expected fallout rates, staging the use of third-partyresources and the associated costs to match the probability of closing, build-ing fail-safe rules into workflow to reduce rework, better prioritization of condi-tions clearing, balancing automated workflow rules and manual processing andownership of file, and applying lean disciplines to reduce waste and create flex-ibility. Customer document collection in particular has become increasinglyproblematic. Making it easier for customers to track the status of an applica-tion and to clearly identify and submit documents – or to allow lenders to ob-tain documents on their behalf – would dramatically increase pull-through rateand allow lenders to close loans in a more accurate and timely manner.

The growing regulatory burden, as well as cost and operational risk associ-ated with loan originations, may encourage banks without the requiredeconomies of scale to shift to some variation of lending on a correspondent oreven broker basis. In this model, the mortgage could become an accommo-dation product to existing customers, eliminating the challenge of managing


capacity through the cycle, as well as reducing the convexity risk associatedwith the servicing asset. This shift could offer additional opportunities forlenders in the wholesale channel to innovate their value propositions.

At a practical level, many mortgage lenders have an integration of somescale underway. It is critical that lenders do not let shifting integrationtimelines, proliferation of IT systems and fragmented vendor relationshipsundercut their execution of required process changes. With significant vol-ume declines likely, cost efficiency and process effectiveness will be ofcritical importance.

Preserve capital through next-generation default servicing strategies

While troubles in subprime and Alt-A have stabilized somewhat, high unem-ployment continues to lead to delinquencies and foreclosure rates that ex-ceed historical levels (Exhibit 5). History shows that unemployment continuesto rise for months after the National Bureau of Economic Research declares arecession to be over, and mortgage investors and servicers need to be pre-pared for further trouble.

Estimates

2

4

6

8

10

12

1.5

1.0

0.5

0

4.0

0.3

Delinquency ratePercent of outstanding loans

Foreclosure ratePercent of outstanding loans

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Mortgage Banker's Association: National Delinquency Survey; Economy.com

Exhibit 5

Delinquency and foreclosure rates are expected to stay above historical levels over the next few years


Despite the early successes of the Home Affordable Modification Program(HAMP), it appears the majority of borrowers delinquent 60-day-past-due ormore will either remain ineligible, fail the net present value or debt-to-incomeratio tests, or fail to complete the trial period. Contact rates with borrowersremain low, and borrowers are notoriously slow to return the required modifi-cation documentation. The future performance of modifications remains un-certain, prompting questions about how many losses will be averted and howmuch pushed into the future periods. Most servicers have put a tremendousamount of effort and investment and expense dollars into building better loanmodification factories, but increasing the adoption rates of HAMP and deliv-ering non-HAMP treatments represents a significant opportunity for most.

Dealing with these challenges will require a more fundamental understandingof borrower motivations and behaviors. Some questions servicers need topose are: Why are borrowers unwilling to talk to the bank? Why do borrowersdecide to give up on the property? How do they view modification offers? Isthere a sense of entitlement? What drives low modification rates? What arethe main behavioral barriers to broader adoption? What behavioral factorstrigger re-defaults and how can they be reduced? Servicers need more in-sight into attitudes toward banks and debt, emotional and cognitive factors inborrowers’ decisions, as well as the impact of negative equity and borrowers’balance sheets.

The next generation of treatment strategies will need to build on lessonslearned as well as new consumer behavior insights generated through re-search. The latter will play an even more important role in a world where in-creasing numbers of losses will come from a new segment of mortgagees –prime borrowers.

Create franchise value from retail mortgage relationships

Despite much lip service paid to the idea of incorporating mortgage moretightly into the retail banking franchise, many of the largest mortgage origina-tors – and even most regional banks – have treated residential mortgagelending as a separate business. This will have to change.

Lenders must capture the full value of the mortgage relationship. Mortgagecustomers tend to have higher deposit balances, stay with the bank longerand perform better on the bank’s other credit products. Recent efforts alsosuggest that mortgage can be an acquisition product for new customersthrough targeted cross-sell executed at the right time during the applicationand product cycle. Consumers do, of course, view mortgage purchase as a


distinct transaction in which rate plays a dominant role. But while rates areparamount, mortgage buyers are also willing to reward the lender with more oftheir business in exchange for real value – convenience, speed and certainty,and rate discounts.

To create franchise value from mortgage relationships, banks can look moreclosely at their retail banking customer base and improve cross-sell efforts for

new-to-bank mortgage customers. Customertransfer teams, which would work during the origi-nation process to encourage attractive customersto migrate other financial relationships to the bank,are a good start. The originations and sales strat-egy should take into account the bank’s brand andphysical branch presence. There are also opportu-nities for product innovation, predominantly in the

jumbo/non-conforming and home equity space. Retention and modificationstrategies will play an important role in preserving the franchise value for exist-ing mortgage and deposit customers.

* * *

While it is too early and there are far too many headwinds to call an end totroubles in the mortgage lending market, it is not too early for lenders tobegin a transition from defense to offense, and to begin planning strategy ona longer-horizon timeline. A clear understanding of the current environment,coupled with strategic planning, will position lenders for success in the newmortgage market.

Retention and modificationstrategies will play an importantrole in preserving the franchisevalue for existing mortgage and

deposit customers.


Rebounding in Small BusinessBanking

Small business banking is at a crossroads. The financial crisis exposed weak-nesses across a number of core capabilities in the space, leading to unprece-dented losses. Unsurprisingly, banks retrenched, virtually shutting down smallbusiness lending. While these events have shaken the industry, small businessbanking will recover, and winners will emerge. This is a rich and under-pene-trated market, and banks that are willing to invest in delivering credit, stabilityand a positive customer experience stand to gain significant share.

Small businesses have always been a critical part of the U.S. economy, with anestimated 34 million in the country today. On average, small businesses aremore profitable for banks than the average retail customer, as they often havea steady stream of deposits and many require consistent access to credit. Anestimated 30 percent of total pre-tax profit from U.S. financial services is re-lated to small business, with 10 percent coming from small businesses, them-selves, another 10 percent coming from small business owners, and the final10 percent coming from small business employees. While the latter two seg-

ments are often ignored, they are critical to captur-ing the full value of the small business opportunity.

As recent events have demonstrated, however, thenature of small businesses makes them highly sus-ceptible to broader economic changes. The finan-

cial crisis hit this sector especially hard, with approximately 50 percent moresmall businesses declaring bankruptcy in 2008 than in 2007. Uncertainty con-tinues to limit small business investment.

These difficulties extend, of course, to banks serving small businesses. Rev-enues and profits shrunk from peak levels in 2007 to barely break-even in 2009(Exhibit 1). While this is primarily due to credit losses, tightening spreads havealso reduced overall deposit profitability. Banks are seeing not only the highestcharge-off levels in a decade, but also declining balance growth, as underwrit-ing standards get stricter and fewer small businesses apply for credit. The lowpoint for small business banking profits was likely 2009, with losses reaching

While optimism is growing,uncertainty continues to limit small

business investment.

37Rebounding in Small Business Banking

nearly $25 billion (or 6 percent of loans outstanding), and most banks strug-gling to break even within their small business franchise.

The small business cards market has also been under siege, paying now forthe higher credit limits and relaxed underwriting standards of the boom years.Some institutions have been shuttered due to heavy losses (e.g., Advanta);other major small business card issuers have significantly slowed underwriting.

Despite the challenging environment, the upheaval in the small businessbanking space has created opportunities. Small businesses have historicallybeen an under-served segment, and several large players have slowed theircustomer acquisition rates and cut back on their small business offerings.Customers are likely to flock to banks that can provide the credit and serv-ices they need. And while there has never been a clear market leader in smallbusiness banking (the top 10 small business lenders have only 30 percent oftotal loan volume), the current uncertainty provides the perfect window for fo-cused institutions to gain share.

Banks should be cognizant, however, that not all small business segmentswill recover at the same rate. Pockets of opportunity will begin to emerge,and banks should be prepared to take advantage selectively.

31

22

15

8

2

26

39

2013E2012E2011E2010E2009E20082007 2013E2012E2011E2010E2009E20082007

2013E2012E2011E2010E2009E20082007

2013E2012E2011E2010E2009E20082007

Deposit profitabilitySmall business and business banking profit pool historical and forecast (2007 – 2013E)1

$ billion

2326

34

59

Loan profitability

Credit card profitability

1 Small business profit pool estimates include business with < $10 million in annual sales

Source: McKinsey Small Business Profit Pool Model

Exhibit 1

Small business banking profit pools


Trends shaping the recovery

With the thawing of the lending market, and a return to GDP growth, thesmall business banking market should begin to cautiously recover in 2010and 2011, and return to higher profitability in early 2012. Recent events haveshifted the industry landscape, and three trends will shape the recovery:

• An underwriting model in flux. In the wake of unprecedented small businesslosses in lines of credit and cards, underwriting is going through an over-haul. This is likely to both increase cost and slow overall growth, as banksrevert to manually underwriting smaller loan sizes in hope of reducing de-faults. Score-based approaches have been scaled back (with lower ap-proval limits) and banks are layering in additional attributes andrequirements. There will also be a reduced role for small business creditcards and unsecured lending products in the near term, until underwritingmodels can be trusted again. This will have a particularly hard impact onprofitability, as credit cards bring in more revenue and profits than traditionalloans or credit lines.

Given the expected decline in traditional credit cards, banks are also rethink-ing the card model and moving to innovative charge-card type offerings, inwhich balances are either paid off at month’s end or secured by collateral.While these types of credit products are relatively novel in the United States,countries including Brazil and China have been using non-traditional creditmodels, such as receivables-backed credit cards, for years.

• A shifting competitive environment. The small business competitive spaceis still taking shape following the financial crisis. In today’s tight credit en-vironment, business banking customers are more willing to switch primaryinstitutions, and banks that are lending are grabbing share from more con-servative peers. At the same time, as banks reshuffle and cut staff, manysmall business relationship managers (RMs) have switched institutions,often taking their customer relationships with them. The chaotic mergerand acquisition activity in late 2007 and 2008 has also led to increasedswitching propensity among customers of acquired institutions. These dis-locations in the market are creating windows of opportunity for proactivebanks, which could translate into longer-term advantage.

• Increased role of government and regulation. There is also still much uncer-tainty concerning the long-term ramifications of regulatory change for theindustry. Further disclosure and reporting requirements are likely to accom-


pany increased government intervention, which will raise banks’ cost toserve. Although the ultimate impact of increased government scrutiny is stilluncertain, banks will need to closely watch the situation for both opportuni-ties and challenges.

Winning in small business banking

While the credit crisis will leave lasting scars, some banks will emerge asclear winners in small business. To join the ranks of those winning institu-tions, banks need to quickly address and focus on four critical elements oftheir business model.

Segmentation and coverage

As a first step, banks must reexamine how they define the small businesssegment from the size of the businesses they serve to the coverage and re-sourcing models they employ. Historically, small business has often beenthe forgotten step-child, with most large and regional banks rolling the busi-ness in with retail and spending limited time and effort understanding cus-tomer needs. Moving forward, serving small business should be awell-planned, strategic decision, based on careful analysis of the customerbase, in-footprint growth opportunity, cost to serve customers, and the cul-ture of the bank.

Segmentation in small business can drive significant value, but needs to besimple and actionable. At the highest level, segmentation and sales coverage

should be based on size, as the revenues of abusiness often dictate the complexity of its bank-ing needs. For instance, smaller small businessestend to behave more like consumers, while largersmall businesses trend toward more complexproduct needs, such as cash management.

Once a bank has executed this top-level segmen-tation, it can begin to target a small number ofsweet-spot industries. The choices will vary bybank, considering footprint and risk profile, but

should be based on a thorough evaluation of what segments are most attrac-tive, given the unique profile of the bank. Characteristics such asaccount/transaction activity, product needs (credit-only versus cash manage-ment plus credit), growth potential and industry risk (expected losses, volatil-

Historically, small business has often been the forgotten

step-child, with most large andregional banks rolling the businessin with retail and spending limited

time and effort understandingcustomer needs.


ity) should all be considered. As an example, more than half of small businessprofit pool revenue is in industries with relatively lower volatility (Exhibit 2). An-other important consideration is level of deposits; deposit-rich industries areparticularly attractive in today’s environment. Through analysis and select in-dustry targeting, banks can construct a balanced customer and productportfolio, thus improving overall returns on the business.

Underwriting model

Banks must fully reexamine and rebuild their small business underwritingprocesses and models, both for cards and the broader set of lending prod-ucts. Getting the underwriting model right is a critical part of restoring confi-dence and profitability to industry.

To drive this end-to-end improvement, banks need to address three keylevers. These levers will not only improve the underlying predictive power oftheir underwriting models, but also reduce the pricing variability and leakageissues that erode bank margins.

Average annual revenue by industry and revenue bandPercent of total, $ billion

Business services

Professional services

Personal services

Health/Social services

Wholesale sales

Trans./Comms./Public Utilities

Construction

Agriculture/mining

Retail sales

Real estate services

Manufacturing

Profit Volatility1

< 40%

40 50%

> 50%

1.0 MM 10.0 MM Total0 1.0 MM

40 23 634%

2%

2%

4%

3%

10%

18%

18%

20%

9%

12%

6%

7%

15%

15%

8%

5%

9%

5%

6%

18%

6%

18%

18%

9%

6%

9%

6%

5%

16%

2%

2%

3%

1 Change in NIBT from 2009 to 2013/Average Revenue of 2009–2013

Source: McKinsey Small Business Profit Pool Model

Exhibit 2

Average volatility by small business size and industry


• Improve credit process boundaries and design. Prior to rebuilding creditmodels, banks need to take a hard look at the number and types of mod-

els and processes they are using today and wherethey are drawing the “chalk lines,” or limits, be-tween them. Depending on the volume and size ofloans processed, banks may want to employ amix of pure score, score-plus and manual creditprocesses, each with varying predictive powerand marginal cost. Deciding where and how touse models is a trade-off between efficiency and

effectiveness, balancing evaluation cost and timing against potential creditlosses and lost profitable accounts.

• Upgrade data and credit models. Small business lending models oftenhave the lowest Gini coefficient (degree of predictive power) in the bankingindustry. This can be dramatically improved through the use of enhanced,richer data sets, more frequent refreshing of the model (every two to threeyears), and the addition of a qualitative credit assessment (see sidebar).With this approach, banks can see increases of between 30 and 35 pointsin their small business Gini coefficient, which can have a sizeable bottom-line impact. For example, improving underwriting models by just one per-cent (raising the Gini coefficient by a single point) can reduce credit lossesby $3 million per year on a $10-billion portfolio (assuming a 2 percent loss

The ability to leverage proprietarycustomer data, and the analyticskills to exploit the outputs, can

give banks a competitiveadvantage over their peers.

What is a QCA?

In addition to traditional quantitative scoring models, banks can benefit from incorporating a qualitative probabilityof default (PD) rating model, QCA (qualitative credit assessment), to improve the predictive power of the process.QCAs can be complementary to statistical scoring models or can stand alone. If used correctly, they can be ex-tremely powerful, increasing the Gini coefficient of models by more than 15 to 30 percent.

A true QCA approach is a highly standardized qualitative assessment tool with between 15 and 25 questions anda clearly defined and balanced set of answer options. The answer options are designed to be objective and ob-servable, making this process very different from the ad-hoc “expert RM/underwriter” judgment used by somebanks. QCA questions are focused on real risk drivers, such as demographics, market position, company opera-tions and management, and each is assigned a weight based on its relative predictive power. The end result is aneffective and efficient PD rating tool that can significantly improve small business underwriting performance with-out significantly impacting speed or cost.


rate). Improving the Gini by 20 to 30 points can reduce credit losses by upto $100 million on a $10-billion portfolio.

When upgrading models, banks need to move beyond the traditional datasets and incorporate more creative variables, such as industry and sector-specific inputs and geographic factors, to build maximum differentiationand predictive power. For example, banks could look at recent industryfailure rates as a new model input to developing the probability of default(PD) score. On average, small businesses focused on construction hadapproximately 1.5 times greater business failure rates than those focusedon professional services (Exhibit 3). This suggests that banks that identifyhigher-risk segments and adjust their models accordingly could see lowerlosses than peers.

Additionally, banks should integrate existing customer information intotheir scoring models, including business owner personal data such asDDA history, savings account balances and credit card usage. The abilityto leverage this proprietary customer data and the analytic skills to exploitthe outputs can give banks a competitive advantage over their peers.

Indexed failure rates by industry1

Percent of overall failure rate

Wholesale

Trans./Comms/Public utilities

Construction

Retail

Manufacturing

Real estate

Agriculture and mining

Personal service

Business services

Professional services

Health and social service

Overall

100

123

119

117

102

97

88

80

80

80

67

100

1 Average of Dun & Bradstreet and U.S. Census reports

Source: Dun & Bradstreet June 2009 U.S. Business Trends report, U.S. Census Bureau 2006 Business Tabulations report, McKinsey analysis

Exhibit 3

Business failure rates by industry


• Make the right offers and reduce leakage. Even when models are correctand generate accurate PD, many banks still have challenges with pricingand offer discipline, with significant inconsistencies across products andRMs. This disparity leaves a considerable amount of money on the tableand can often quickly be improved with enhanced pricing tools and analysisand frontline incentives.

Accurate pricing requires understanding the drivers of expected loss, which isbased on the PD, expected loss given default (LGD) and estimated exposureat default. Correctly estimating LGD is especially critical in lending to smallbusinesses, as they typically have a higher PD, and inaccurate LGD esti-mates damage profitability by underpricing high risk and overpricing low risk.The recent crisis demonstrated the weaknesses in existing models, andbanks now need to revisit and refine those models. Additionally, even whenthe recommended pricing is correct, many banks have weak offer discipline,creating wide variations in profitability (Exhibit 4). While this can be addressedthrough strengthened pricing guidelines and realignment of incentives, it mayalso require a shift in mindset, in which RMs are focused on longer-term prof-itability implications, as opposed to shorter-term volume targets.

2 1 0 1 2

Average = 0.11%

Actual rate versus target rate (for signed contracts)Percent, N = 60

Average loan priced 11 basis pointsbelow target rate


Exhibit 4

Pricing discipline by relationship manager


Relationship banking

Banks must also move away from single-product customers toward a multi-product, relationship-based approach. This is a large opportunity in the smallbusiness segment, as banks can capture not just the small business ac-count, but also the business owner’s personal account and potentially evenemployee personal accounts. Business owners represent an additional 10percent of the financial services profit pool and tend to be much more afflu-ent and profitable than the average retail customer.

As we describe in “Back to the Future: Rediscovering Relationship Banking”(page 56), the relationship banking approach is about more than cross-sell; itis about serving the customer in a more holistic and coordinated manner. Su-

perior service, a high-touch customer experienceand multichannel support are all critical to a rela-tionship banking approach.

Relationship banking also allows banks to leverageproprietary data about customers to make more in-formed lending decisions. This drives customerswith good credit to do more of their lending busi-ness with the bank, as that bank will be able to uti-lize unique, customer-specific data to create abetter offer for the customer. The ability to consider

a business’s risk across both personal and professional deposit and lendingaccounts can result in a 15 to 25 percent increase in approvals, but few bankstoday have this capacity. Additionally, banks with a cross-product perspectiveon their customers can offer multi-product approvals, pre-qualifications orproduct recommendations at the same time, creating more hooks for the cus-tomer to bring further business to the bank.

Portfolio management and collections

Lastly, improving small business portfolio management and collectionsprocesses are foundational capabilities that banks cannot afford to ignore.These capabilities are critical as banks emerge from recent heavy lossesand will create a sustainable advantage when the cycle turns. Portfoliomanagement and collections should be seen as part of a disciplined ap-proach – along with underwriting and credit processes – to consistentlyreviewing and managing loan performance.

Portfolio management focuses on identifying changes in a client risk profileand proactively managing that risk to reduce potential losses. Critical activi-

The ability to consider a business’srisk across both personal

and professional deposit andlending accounts can result in a

15 to 25 percent increase inapprovals, but few banks today

have this capacity.


ties include creating models to predict changes in industry risk, developingearly warning systems that flag high-risk accounts and conducting regularaccount reviews across the entire portfolio. For example, research has shownthat when businesses are in financial distress, they are likely to increase theircredit line utilization. One large bank saw average line utilization spikes of 24percent, 34 percent and 133 percent across three different credit products inthe months leading up to customer default.

Superior collections practices can also significantly improve loss ratios insmall business lending. Small business collections are distinct from consumerand commercial collections and require a dedicated approach that leveragesboth the personal and individual-driven approach used for consumers andthe commercial skills and mindsets that allow collectors to stress-test infor-mation and make decisions on a business’s ability to pay. Best practices insmall business collections include identifying the right segmentation (basedon balance and risk), developing collector load ratios based on account com-plexity, developing clear and simple tools to guide interactions, and empow-ering the front line to offer treatments. By establishing dedicated smallbusiness delinquency and workout groups, banks can capture significantvalue that would have otherwise walked out the door.

* * *

Small businesses were hit especially hard by the financial crisis and are stillworking through the aftermath. But this critical piece of the U.S. economy ispoised for resurgence. As small businesses recover, they will look for banksto deliver credit, stability and a positive customer experience. Banks that arewilling to invest in improving core capabilities and developing clear strategiesabout what segments will be most profitable stand to gain sustainable share.


Stepping Into the Breach: How to Build Profitable MiddleMarket Share

The $50-billion U.S. middle market banking segment, comprised of compa-nies with between $10 million and $500 million in annual revenues, is under-going a dramatic competitive shift. The distressed condition of manyspecialty finance and monoline lenders is clearing wide swathes of opportu-nity and tipping the balance of power toward commercial banks. Regionalbanks have stumbled as well, creating opportunities in the broader commer-cial sector, while some megabanks have retrenched in certain geographiesand sectors. It is a great moment for gaining share in the market. Best-in-class lenders reap ROEs of 20 percent or higher. However, getting to best-in-class is not as simple as picking up where specialty lenders left off.

To step successfully into these profitable gaps in the middle market land-scape, banks need to reinvent the business model and redefine best-in-classexecution. We see nine imperatives for banks seeking an edge in this market.

Build relationships

Banks pursuing profitable middle market share must follow a path we see ascritical across the entire banking spectrum. What we are calling relationshipbanking has a basic premise: in order to attain sustainable, profitable growth,

expand relationships with your best customers.This approach, while not new, is in stark contrastto the expand-at-all-costs approach of the pastseveral years. It is also particularly relevant forcommercial banks with large national clients.These larger clients – and even some more localbusinesses – have needs that go beyond thelending products that are usually a bank’s entrée

into serving them. And while lending is critical to securing relationships in thefirst place, it is not nearly as instrumental in driving profits as other products,such as cash management services (Exhibit 1).

To step successfully into profitablegaps in the middle market

landscape, banks need to reinventthe business model and redefine

best-in-class execution.

47Stepping Into the Breach: How to Build Profitable Middle Market Share

To begin, banks need to make clear distinctions between how they servelocal middle market clients and large national corporate clients. A one-size-fits-all approach to relationship banking is not sustainable. Banks sufferedsteep losses in the smaller middle market segment during the crisis, oftendriven by an overreaching attempt to lend in geographies and industrieswhere they did not have sufficient experience or knowledge. For smallerclients, best-in-class banks will return their focus to their home turf, lookingto build scale on a local level with in-footprint clients. Competitive advantagein the smaller middle market segment will derive not from over-extension andvolume, but from targeted lending in areas banks know best.

For larger, national-scale clients, banks need to leverage lending interactionsinto deeper and more lasting relationships based on products and services thatare both stickier and more profitable. (Although they are demanded more bylarge corporate customers, some middle market businesses may also needspecialized finance products such as FX and interest rate derivatives.)

Redesign client coverage and account planning

Regardless of client size, an important foundation of relationship banking isseamless coverage and rigorous account planning.

43

25

32

2008 30 50 10 10

3,000

1,000800

100

Upper middle market bank relationships1

Percent of total

68 percent of middle market relationships involve credit

Average revenue per mid-market client indexed (100 = lending only)

But cash management still drives profitability

Cash management only

Credit only

Credit & cashmanagement

Percent of lending clients

Lending + cash management (or other CB products) + Investment banking

Lending + investment banking

Lending + cash management (or other corporate banking product)

Lending only

1 Survey of 1,608 U.S. corporations with annual sales over $100 MM; of these, corporations with sales from $100 MM to $500 MM considered upper middle market

Source: Phoenix-Hecht, 2008; McKinsey analysis

Exhibit 1

While credit is important to securing middle market relationships, cash management drives economics


There is great opportunity in targeting profitable industry sectors or verti-cals that are aligned with a bank’s existing capabilities and geographicfootprint. Banks should also consider which products are most profitableand build capability to serve sectors that rely heavily on those products.For example, cash management, that profitable standby, is in high demandwith professional services, retail, insurance, government and non-profitclients (Exhibit 2). Cash-centric clients spend two times more than theircredit-intensive peers and also use more products (8 for cash-centric ver-sus. 6.2 for other segments).

Understanding customer needs is also crucial for banks in designing relation-ship manager (RM) coverage. Our research has shown that larger and smallerclients value different RM attributes. As an example, smaller clients place ahigher value on product knowledge, whereas larger clients tend to value in-dustry and local market knowledge (Exhibit 3).

To capture the combined value of geographic footprint, product knowledgeand industry expertise, best-practice commercial banks support their re-

High

Low

HighLowCredit usage

Retail

Attorneys

Consulting

Technology

Insurance

Some manufacturing

Healthcare (provider/doctor groups)

Hotels

Transportation

Wholesale trade

Publishing

Agriculture

Mining

Transportation

Real estate development

Large/public companies across industries

Large government/public sector entities

Construction

Entertainment (e.g., film finance)

Restaurants

Healthcare (hospitals)

International trade

Governmentt/public sector (e.g., municipali-ties, school districts)

Financial intermediaries

Non-profit/membership organizations

Cash management usage

Cash-centric(20% of companies, 25% of profits)

Complex cash and credit needs(27% of companies, 29% of profits)

Credit-centric(44% of companies, 35% of profits)

Sophisticated opportunists(44% of companies, 35% of profits)


Exhibit 2

Industries with higher cash management use are more profitable


gional coverage with a meaningful degree of industry and product overlay.They deploy front-line teams by geography and use industry sectors orverticals to cover specialized sectors. Across regions, generalist RMs arethe primary customer contacts, working closely with product specialistswho provide targeted support. Industry verticals have dedicated expertRMs and support teams.

Beyond coverage, it is very important to develop and institutionalize anaccount planning process that prioritizes customers in each target groupand results in a holistic approach to customer-level profitability. A rigor-ous planning process starts with the selection of potential clients andthe scheduling of meetings. Next, a relationship manager should con-duct a needs assessment for identified clients by each product and pre-pare action plans, finalized with a direct manager and productspecialists. With action plans complete, next steps should be definedthrough activity plans that create a visible interface and a transparentschedule for participants in the account plan. Finally, reporting mecha-

5

7

17

24

48Knowledge ofcredit needs

Product specialist

Industry knowledge

Local knowledge

Other 8

23

22

17

32

9

22

16

17

35

5

33

29

8

25

4

29

29

4

35

$2 – 5M $5 - 25M $25 - 100M $100 - 500M $500M – 2B

Most important attributes of relationship managerPercent of respondents by revenues

Source: McKinsey Corporate Banking Survey, March 2009 (based on 400+ responses from McKinsey’s proprietary panel)

Exhibit 3

Large and small middle market customers value different areas of expertise


nisms should be established to follow up on, track and review results ofaction plans before closing.

Capitalize on disruption in the monoline space

Many players in sub-segments of the commercial space, such as monolines,are experiencing severe disruption. Savvy financial institutions will step inand take share by meeting pent-up credit demand. For example, at onelarge regional bank, current cross-sell rates for lease products to middlemarket and corporate banking customers were 3 to 7 percent, compared to10 to 30 percent for a best-in-class institution. This leaves significant oppor-tunity for deeper product penetration (Exhibit 4). In particular, the vendorchannel represents an attractive growth opportunity for well-capitalizedbanks due to competitor dislocation and certain captive finance companiesscaling back their presence.

Enhance product offerings

To take full advantage of market opportunities, banks need to honestly assesstheir product capabilities, identify gaps based on the needs of client seg-ments, and develop competitive offerings.

For example, a bank could develop a standardized cash management productfor the low-end middle market or a suite of derivatives, FX and other special-ized finance products for larger firms.

However, banks will need to go a step further and improve the functionalityand efficiency of delivery for the product suite, which could mean upgradingsystems, platform integration and reporting. The key drivers of customer satis-faction are access to systems, delivery of information, reliability of systems, ef-fective issue-tracking and rapid resolution.

Revamp end-to-end underwriting and credit adjudication

Weaknesses in commercial lending and underwriting processes have con-tributed to both significant levels of customer dissatisfaction and unprece-dented losses. This dissatisfaction can be addressed though the adoption oftwo important principles:

• Functional excellence reduces excessive touch points, unclear accountabil-ity, over-stressed roles and sub-optimal spans of control by creating spe-cialized roles for each component of the credit process (e.g., client service,transaction management, credit and portfolio management).


• Expert choreography improves process efficiency by eliminating waittime, reducing unnecessary duplication of work due to lack of expert co-ordination; defining clear, differentiated “flight paths” based on dealcomplexity (e.g., auto-decisioning for select customers); and creatingprocess champions.

Streamlining credit delivery can lead to a 30 to 50 percent increase in produc-tivity. At one U.S. regional bank, an analysis revealed that almost 75 percentof an 11-day approval process was spent on hold time. Reducing even a per-centage of such delays, which are partially caused by approvers working onhigher-priority items, would speed delivery and leave clients more satisfied.

Reduce risk-weighted asset leakage

The current regulatory environment, in combination with limitations in balancesheet capacity, make it more important than ever for banks to reduce capital

15 30

7

15 30

5

10 20

3

Division

Small business

Middle market

Corporate

Factors impacting cross-sell Value potential

Current cross-sell rates of lease products into banking customers Percent

Representative bank cross-sell rates by division compared to competitor benchmarks

Representative bank

Best in class

Small businesses likely to have one primary banking relationship

Highest propensity to lease (80%)

Relatively more difficult to penetrate due to high volume of potential customers

Smaller number of customers/RMs make identifying customers for cross sell easier

High propensity to lease (70 80%)

Relatively easy to cross sell if credit relationship in place

Most price sensitive

Large corporate customers have multiple, diversified relationships, and are most likely to lease with one of their banks

$15 million for each additional percentage point increase in cross sell




Exhibit 4

There is significant opportunity to grow lease cross-sell into existing customer base


wastage. Our experience shows that risk-weighted asset (RWA) optimizationcan reduce leakage by 15 to 25 percent and increase revenues by 8 to 12percent in the relevant books of business.

There are four major sources of capital wastage. The first are internal mod-els that calculate capital requirements based on regulatory approaches thatdo not maximize capital efficiency. Second are poor credit processes –lacking state-of-the-art monitoring and workouts – that lead to higher regu-latory risk parameters and capital requirements. The third source is prob-lems in collateral management: lack of updated collateral values and errorsin timeliness and booking of credit lines and collateral. Finally, data qualityissues directly translate into higher capital requirements; for instance, regu-lators may impose additional capital requirements for low data quality.

These problems can be addressed with a capital-optimized business modelbuilt around six actions:

Stemming the tsunami of commercial loan losses

Default trends in commercial loan portfolios typically lag consumer loans by 12 to 18 months and are emerging as thenext major casualty of the global credit crisis. Banks that are already reeling from a liquidity and capital crunch willlikely face high default volumes and major losses in their commercial portfolios through 2010. The signs pointing tothis tsunami of losses are clear. Delinquency and charge-off levels in commercial real estate (CRE) and commercialand industrial loans (C&I) are four to eight times higher than historical averages; at some banks they are even worse.The Federal Reserve’s stress tests in March and April 2009 projected losses over the next two years, under adverseeconomic scenarios, at 10.6 percent of CRE outstanding and 5.8 percent of C&I. This translates to $600 billion for the19 banks tested. Over the next four years, we expect combined losses in these two areas to be in the range of $500billion to $1.2 trillion, depending on the severity of economic scenario.

Many institutions are unprepared to deal with this level of losses, having allowed their loss mitigation capabilities to atro-phy. The situation calls for immediate action. Banks must redesign commercial loss mitigation structures and support-ing mechanisms and use proven and effective best practices. Banks need to catch problems early instead of waiting forthem to trickle down. They need to assign their best people to workouts rather than reserving them for business growthinitiatives, and sharpen the accountability and transparency of loss mitigation efforts. Additionally, compensation philos-ophy should be based on well-defined targets, rather than vague or broad top-down targets. Finally, banks need effec-tive reporting on both activities and outcomes so early interventions can succeed.

Best-in-class banks can reduce commercial loan losses by 10 to 15 percent by following through on three imperatives:

• Strengthen early-warning mechanisms. The key to successful loss mitigation is identifying and working on at-riskloans early. Failure to do so ensures that many loans will be dead on arrival at the loss mitigation group. Early de-


• Establish clear rules regulating client acquisition to avoid exposure toclients likely to be unprofitable, given operating and capital costs.

• Provide commercial guidelines and tools that direct the front line towardhighest RWA-return products and maximizing collateral without jeopardiz-ing RWA return.

• Instill risk-adjusted pricing, e.g., through a regulatory capital-compliantrisk-adjusted pricing tool per client and transaction, and introduce a seg-ment-specific pricing process.

• Offer clients solutions for improving their financial profile and thereby theircredit rating.

• Set up market placement enablers through product, system and organiza-tional features to selectively leverage possible market placement opportu-nities (e.g., syndication, securitization).

tection triggers allow banks to quickly identify and prioritize high-risk loans, based on the external economic outlookand metrics specific to the debtor. Banks should also identify high-risk portfolio areas and sectors and develop spe-cific action plans for them.

• Install world-class workout and restructuring processes. To effectively manage large volumes, institutions must ensurethat their processes and procedures are scalable, structured and consistent. This requires clear decision rules toquickly move high-priority loans from the business to the loss mitigation group. Workout groups need checklists forfile preparation and execution. Leaders must also ensure that different groups adopt the same practices and monitoreach group’s activities to identify outliers with low recovery rates or high average resolution times. And once thesegroups are spotted, the root causes of these problems must be addressed; for example, leaders must understandeach group’s criteria for selecting workout strategies.

• Enhance organizational capacity, structure, reporting and capabilities. The average caseload per loan workout officerhas increased by a factor of three to five. Banks must increase their capacity and ensure that they distribute the work-load equitably. To manage the complexity and severity of the loan losses, they can create groups that deal with differentsizes of loans and staff them with loan officers with the necessary skill sets (including skills from different sectors, e.g.,CRE, structured finance and retail). These employees also need the right tools, so they can select strategies that maxi-mize value, set priorities and monitor recoveries and costs. To improve performance management, banks should de-velop key performance indicators and link compensation incentives (and future employment) to value creation. Finally,given the heightened demand for transparency – from internal and external stakeholders – banks should develop struc-tured, consistent and action-oriented reporting dashboards on portfolio trends, efficiency and effectiveness.


• Optimize product mix and design by using more capital-efficientproduct types for both short- and long-term financing that deliversimilar value to clients (e.g., overdraft instead of short-term struc-tured solutions).

Broaden and intensify portfolio management

In the wake of the financial crisis, management of risk in the loan portfoliohas taken on heightened importance. Banks must develop more rigorousportfolio management processes to track aggregate exposures by com-pany, sector, region and industry. They must instill processes in their riskparadigm and scenario analysis to test implications on various events anddevelop contingency plans to respond to different scenarios.

Further, banks must identify and monitor high-risk client segments andaccounts, based, for example, on the likelihood of events that couldimpact the industry and cause the client to fall into delinquency, suchas production disruptions, demand fall-offs and supplier or key cus-tomer bankruptcies.

Furthermore, loan portfolio management should inform and drive proactiveactions. As an example, banks should identify single-product relationshipsand work to either deepen the relationship or end it, if there are no signs ofcross-sell efforts succeeding.

Strengthen loss mitigation

Loss mitigation capabilities atrophied over the course of the last boomcycle and must be transformed. Delinquencies and charge-offs have in-creased six to eight times in commercial real estate and commercial andindustrial loans, across segments, creating a drag on capital and earnings.

There are three areas where banks need to focus: early warning; workoutand restructuring processes, and organization/capability incentives andtools. (See “Stemming the tsunami of commercial loan losses,” page 52.)

Unleash talent

Performance management in commercial banks needs improvement.Much ink has been spent describing how incentives have led to behav-ior adverse to the interests of banks and their shareholders. A goodexample is relationship managers who are incented to sell loans by vol-ume, without consideration or accountability for the long-term prof-itability or health of the loan. A less egregious, but still important


example is that relationship managers are not incented strongly enoughfor cross-selling.

Banks need a complete redesign of incentive plans across the enterprise:for the front line, product specialists, loss mitigation and support functions.Both quantitative and qualitative aspects need to be considered. Pay pack-ages must account for profit, health and volume of products sold and over-all client profitability.

* * *

There is clear opportunity for banks seeking a stronger foothold in the prof-itable middle market. Distressed and dislocated players are leaving a wideopen field, but simply stepping into the breach would be a mistake. Winnersin the space will be those institutions that reinvent their business model notonly to grab share, but to build sustainable, profitable relationships.


Back to the Future:Rediscovering RelationshipBanking

The financial crisis and ensuing recession, coupled with regulatory changesrelated to fee income, have exerted enormous pressure on U.S. retail banksto develop profitable growth engines. Instead of relying on mergers, de novoexpansion and underwriting, banks must now derive greater value from ex-isting customers. There are three primary ways this will happen: by drivingproduct sales and fee income through up-selling and cross-selling; increas-ing retention of high-value customers; and mitigating losses with specificrisk strategies based on the entire customer relationship. In short, banksmust successfully take on the relationship banking challenge.

Such success has been elusive. Perhaps the biggest indicator of theshortfall is that the average cross-sell metric for the banks in our researchstands at a relatively low 4.6 product categories per household, against atheoretical maximum of 13 (Exhibit 1). Furthermore, more than 70 percentof the cross-sell total occurs at account opening, implying that the lifetimevalue of a consumer often remains untapped (Exhibit 2, page 58). In addi-tion, only a few U.S. banks have taken initial steps toward developing afull customer relationship view – let alone incorporated it into their sales,service and risk strategies.

Our work suggests that banks have been slow to adopt a relationship ap-proach because of their siloed nature. Most banks serve their customersthrough product-focused channels, oriented only to whether the customerneeds a specific product. These efforts generally meet with limited success ingenerating either sales or greater customer satisfaction. Similarly, efforts toserve customers across product lines are often hampered by an inability toview the entire customer relationship or by systems that cannot service multi-ple products.

Banks must address the full range of customer needs across all financial prod-ucts at all touch points. Only in this way will they reap the rewards of increasedcross-selling, enhanced risk decision-making and customer retention.

57Back to the Future: Rediscovering Relationship Banking

Challenges

Five obstacles have accounted for the lackluster results in banking cross-sellperformance to date:

• Cross-selling in a silo. Sales forces generally do not have the ability or in-centive to offer a broad range of products. For example, few banks’ mort-gage channels offer customers a checking account, even duringrefinancing, although the eventual value from a checking account can farexceed the value from the refinancing. This is due either to a lack of en-ablement (e.g., awareness, training or tools) or incentives.

• The operational challenge. Operationally integrating a single cross-sellcampaign is difficult. U.S. banks have historically grown through acquisi-tions. Business units cobbled together often share different systems, op-erational platforms and processes. The result is that few banks can trulyoffer the full product suite at account opening, where, as previously men-tioned, 70 percent of cross-selling occurs. Similarly, few banks can view acustomer’s full range of products and total household profitability whenmaking subsequent sales or servicing decisions.

3.9

4.6

5.1

2.9

3.4

3.6

1.2

1.6

+31% +25%

0.6

+138%

DDA relatedNon-DDArelatedTotal CRI2

Low bank

Average3

High bank

Number of product/service categories per DDA household1

1 13 Product categories: DDA-related (DDA, debit card, direct deposit, online banking, bill pay, overdraft) and non-DDA-related (savings, MMA, CD, mortgage, home equity, credit card, investment account)

2 CRI: Client relationship index, a measure of the average number of product categories penetrated per DDA household

3 Average across all banks in survey; sample average product penetrations were used in 4 cases when a bank did not report data for 1 of the 13 products/services

Source: 2008 McKinsey Cross-Sell Benchmarking Survey

Exhibit 1

Cross-sell effectiveness varies across banks


• Siloed support functions. Support functions such as risk, marketing or datasupport align to business units. This structure works well when banks needto make product decisions in silos. However, as customers aggregate theirrelationships, the arrangement no longer serves the bank well. For exam-ple, many banks cannot assess a customer’s real holistic risk profile or seesales opportunities based on gaps in what the customer has because theyare constrained in knitting together data across the businesses.

• Disconnected channels. Different businesses often own different channels,which are typically not interconnected in a customer-friendly manner. As aresult, at many banks, the branch may not fully service loan products(e.g., questions to a personal banker about credit cards require callinginto a card call center).

• Reliance on new customer driven growth. Credit-driven growth in the run-up to the financial crisis resulted in a surge in new customer acquisitions.Cross-sell naturally became less important than selling the first product toa new customer. In the wake of the recession, this scenario is changing,as new acquisitions have dropped sharply.

Products per new retail household by time since first account opened1

Percent of steady state value average across all participant banks and branches

100

777372

30 days 60 days 180 days Steady state2

1 Includes all new personal/retail household (not just DDA HH) originated within the branch network during the first two months of the annual data sample analyzed (Jan-Dec 2007); for purposes of this metric, direct deposit, online banking, bill pay, and overdraft were not counted as product accounts. Other personal loans were added as a product account

2 Average product accounts per retail household as of December 2007

Source: 2008 McKinsey Cross-Sell Benchmarking Survey

Exhibit 2

Account-opening is the single most important time for cross-sell


Real relationship banking

Only by addressing these challenges will banks build deeper relationshipswith customers and increase cross-sell. Relationship banking will succeedonly when customers feel that they are dealing with a single bank and notseparate businesses. Customers must also see real value in the model; forexample, their bank provides better advice based on a more complete viewof their financial picture, or better prices based on the relationship’s value, ormore convenient service. To achieve this, banks must present themselves asa single entity across multiple channels and have a single view of the cus-tomer across the different products he or she uses. Finally, banks shouldfocus on customers who offer the highest long-term relationship value. All ofthese imperatives have profound implications for sales, risk and operations.

The rewards for banks that can crack the relationship banking nut are signifi-cant. Deepening relationships with existing customers clearly make for attrac-tive economics. We have found, for example, that customers with twoproducts are disproportionately more valuable in terms of revenue than thecombination of two similar customers (each of whom own one of the prod-ucts). This relationship multiplier – driven by higher balances and usage – canaccount for up to a 25 percent increase in revenues. There are also signifi-cant retention benefits depending on segment.

Risk benefits also accrue from relationship banking. Our analysis has showna 10 to 25 percent lower risk from customers that have deeper, multi-productrelationships with a bank. And integrating operations to deliver a seamlesscustomer experience can result in further savings of between 5 and 15 per-cent in the areas addressed. Typical drivers of these savings are better orga-nizatonal spans and layers, fewer broken transactions, pooling benefits,de-duplication of platform or functions and, most importantly, sharing of bestpractices across the consolidated groups.

A systematic approach

Taken together, these benefits can significantly boost the profitability of abank. To achieve these results, banks need to take a systematic approachthat addresses the friction points outlined above:

• Product design: To bundle or not to bundle products has been an intensedebate in the industry. Our research suggests that bundles can help drivehigher cross-sell performance to some extent, but contrary to conventionalwisdom, their impact is truly felt in non-demand deposit account (DDA)


products rather than in DDA-related products. There is 9 percent highercross-sell rate in non-DDA products among banks that bundle. (The lack ofDDA impact may stem from sales forces offering DDA-related products aspart of the customer discussion, regardless of whether they are bundled ornot, and not doing so for non-DDA products, which then require activebundling.)

More broadly, U.S. retail banks have only recently started thinking aboutother innovations in product design that could encourage deeper relation-ships. For example, most bundles are fairly rigid combinations; banksshould offer more flexible options through dynamic pricing, features orservices. Banks could also bundle across product categories at the valueproposition level. For example, Manulife offers a combined deposit andcredit account. As Canada’s first flexible mortgage account, it combines amortgage with checking and savings, using the net balance to calculate

Three models: A global perspective on relationship banking

We looked at banks in the U.S., Canada, Europe, South America and Asia to understand the state of relationshipbanking and found that banks on this journey fall along a spectrum into three models:

Phase 1: Sporadic cross-sell with some consolidated servicing assets

Several U.S. banks fall into this group. Phase 1 banks typically have cross-sell programs that are carried out in-silo (e.g., bundles that are limited to the deposit suite). Most have started on the journey towards consolidatingservicing assets, but have done so primarily as a cost-saving move (e.g., using a single off-shoring vendor). Agood example of this is a single call center technology platform that makes it easier to route calls across skillsets. Another is the move towards an integrated data architecture.

This basic capability level makes sense for most banks. Consolidated servicing assets can be refocused frombeing simply cost-saving efforts to revenue-enhancing efforts (e.g., an enterprise call center is better placed toadopt relationship servicing).

Phase 2: Enhanced “moment of truth” support

These banks are delivering the right operational, organizational and risk tools to the front line at account opening,onboarding and problem resolution. Defining features include: operational integration of the account-openingprocess (e.g., product selector tools, product configurators, integrated loan applications, coordinated risk view orsingle score, pre-qualifications across products); the ability to welcome and fulfill customers across product silos(e.g., coordinated welcome call, single cross-sell group doing follow-up, joint fulfillment, single statement); and


the client’s interest – which positions the account to serve as the client’sprimary current account. Bundling does not need to be just product related– banks can bundle over time, allowing customers discounts for loyaltyachievement across products, or bundle across people, offering rewards,services or discounts for family participation.

The goal should be to craft the bundle based on customer needs. Whilecompanies in other industries have taken this to heart, only a select fewbanks offer products that can be configured based on customer prefer-ence. Too much flexibility can be confusing for customers and salespeople(not to mention expensive to implement), and too little results in inactiveproducts or higher loss rates. But linking bundle design tightly to needs as-sessment helps overcome this. To do this, banks need to dramatically in-crease their emphasis on the frequency and quality of customer needsassessment. Our research found that only 40 percent of branches conduct

integrated call center abilities to solve multi-product problems (e.g., cross-trained agents for high-value cus-tomers, one 800 number).

Some banks in the U.S. and others in Canada, South America and Europe are Phase 2 banks. One Spanishbank can calculate and incent their front line on household profitability, allowing them to make the relative trade-offs across products much easier to resolve.

Phase 2 is easier for smaller banks to pull off in entirety. Regional banks, closer to their customers than nationalplayers, but still large enough to bring relevant scale to bear (e.g., in their call center operations and productrange), may be best positioned. Larger banks with massive product silos will likely find relationship bankingharder to execute due to ingrained organizational and operational legacies. For them, the answer could lie infinding the deepest pain points that inhibit building relationships with the most-valued clients and surgically fixingthem, rather than implementing broader relationship initiatives.

Phase 3: Technology enabled

Phase 3 banks are truly the next generation of relationship banking and use a heavy dose of technology to en-able features such as: multichannel functionality that enables customers to apply for any bank product using amobile phone; video conferencing that allows call center agents to join a customer’s browsing session; ATMpayments for products across the spectrum (including investments); and dynamic household-profitability-baseddecisions that drive service levels in channels.


a structured needs assessment the first time a customer enters the branch.

• Relationship sales: Banks configure and train sales forces in a generallysiloed manner, specializing by product. This means that customers inter-ested in other products have to be referred to other channels or salesforces, a process that results in high leakage or customer dissatisfaction(e.g., from re-submitting basic information).

A relationship sales approach would differ in several ways. First, a cus-tomer’s file is reviewed across products to determine gaps. This approachrequires deep data-mining and validation. Second, high-potential targetsare approached in a coordinated manner across products by a quarter-back who always remains the common touch point. Third, formalizedteams across business units (e.g., small business, retail and mortgage)must coordinate to address customers’ needs across unit boundaries.This helps create a name-face recognition between team members, mini-mizing referral leakage and ensuring that follow-ups are conducted (Ex-

Banks miss valuable opportunities to discuss new products at follow-up conversations

Number of branches by onboarding behavior observed1

Percent

Follow-up contributes to cross-selling success

Product categories per DDA household1

Percent

4.50

5.12

+14%17

8

100

71

4

Personalized dialogue and did discuss new products

TotalPersonalized dialogue but did not discuss new products

No follow up

Formulaicfollow up2

Any follow up call (29%)

No follow up call (71%)

1 Calculated based on 24 responses from Wave 1 mystery shopping

2 “Formulaic follow-up” characterized as short, scripted conversation with no personalization

Source: Mystery shopping; 2008 McKinsey Cross-Sell Benchmarking Survey

Exhibit 3

New account follow-up drives stronger cross-sell performance


hibit 3). Fourth, periodic customer relationship reviews assess additionalsales potential (e.g., reduce leakage) across all products and businessunits. Finally, retention programs are structured in a cross-product manner(e.g., a decline in DDA balances for a customer who also has a credit cardtriggers an alert in both business units).

This work is not easy, especially when targeting mass customers (as op-posed to high-net-worth customers) with limited sales capacity. Indeed,we have found that up to 40 percent of a bank’s mass customer base canbe unprofitable. The important point therefore is to select customers whohave high potential relationship value. Identifiers such as direct deposit oronline bill pay sign-ups often flag this relationship potential, as do otherpragmatic approaches to segmentation. Focusing on the truly valuable re-lationships and de-emphasizing less valuable relationships can help withcapacity issues.

• Service to sales: Each service interaction with the bank is an opportunityto sell, and each sale should really be about serving the customer with aproduct. Our benchmarking shows that best-in-class banks sell 4 to 8products per 100 calls through the call center. To offer the right productwithout referring the customer, an agent needs a broad knowledge of theproduct set. One regional bank has cross-trained 10 percent of its agentsacross nearly all the deposit and loan products it offers.

• Relationship risk: Banks should take a cross-product view of the customerwhen calculating risk. If they neglect to do this, they can misprice the truerisk, which can result in lower approval rates for good risks and also limitsbanks’ ability to offer multi-product approvals or qualifications at account

opening. An integrated view of risk, incorporatingdeposit and loan information, supports featuressuch as a single risk score, joint decision-makingand pre-qualification at account opening.

Banks therefore need to incorporate the relation-ship view into their pricing and decision-makingalgorithms, using all internal information (across

deposits, loans, wealth management) and external information (from bu-reaus, promotion or distribution partners – where regulations permit in-formation-sharing). They also need to develop the capability tounderwrite products jointly in order to support bundled selling, as well asrelationship collections capabilities to make collections more effective

Each service interaction with the bank is an opportunity to sell,

and each sale should really be about serving the customer

with a product.


and ensure that the right approach is adopted for higher-value relation-ship customers.

• Relationship servicing: Ninety days after the average customer opens anaccount, banks’ cross-sell drops off sharply and the rest of a customer’stenure with the bank accounts for only 30 percent of the total products heor she buys. This large opportunity remains untapped due to two factors.First, banks typically service most of their retail customers in the sameway without regard to their relationship value. Indeed, as we noted earlier,at one bank over 40 percent of the customer base was unprofitable on afully allocated basis, while the small proportion of truly valuable relation-

ship customers accounted for more than 80 per-cent of the bank’s profit. Second, servicing assetsand processes are fragmented into product silos,leading to lost opportunities to deliver on the rela-tionship promise. For example, valuable cus-tomers often need to call multiple servicenumbers for products they were sold in a bundle.

Banks need to be able to recognize and servetheir customers based on their relationship value,delivering superior cross-product service to themore valuable customers and channeling less-

valuable customers to self-serve options. This focus on customers withtrue relationship value should enable better cross-sell and retention,while reducing costs. The call center is the main venue for realizing thisopportunity – customers with high relationship value should experienceshorter service queues, receive service from more skilled agents, or beeligible for special offers. The same agents would also be superior atservice-to-sales techniques.

Relationship sales, risk and servicing efforts must be supported with organi-zational changes along the following lines:

• Product-line ownership: Consolidating organizational ownership for prod-ucts that customers typically buy jointly facilitates the development ofwell-integrated bundles and channel strategies. Several U.S. regionalbanks have recently consolidated lending business ownership.

• Operational sites: Consolidating servicing assets is difficult without a sin-gle leader. One bank that wanted to integrate its call center onto a singleplatform first appointed a shared service owner to oversee its operation.

At one bank over 40 percent of the customer base was

unprofitable on a fully allocated basis, while the small

proportion of truly valuablerelationship customers

accounted for more than 80percent of the bank’s profit.


• Risk and marketing analytics: An integrated risk or analytics function thatspans businesses can help better coordinate customer data analysis andrisk assessment across products.

Organizational silos can be broken down in different ways: through organiza-tional moves (e.g., a single-channel leader), through incentives or throughworkflow. This can be the trickiest part of any relationship banking strategyand must be carefully tailored to the individual bank, personalities and cus-tomer preferences.

* * *

The ideal of relationship banking has always been a sound one. It makesgood sense for banks to deliver a unified experience to their customers andto cultivate loyalty from those customers that are most profitable. What hasoften been missing, however, are the sales, risk, operational and organiza-tional capabilities to support this vision. Given today’s pressures on profits,the time is ripe for banks to get relationship banking right.


Big Fish in Small Ponds: Why Regional Banks NeedCritical Mass

The United States has long had one of the world’s most fragmented retailbanking markets. More recently, however, assets and customers have be-come ever more concentrated in four national “megabanks.” Together, theseinstitutions dwarf their regional competitors and pose a formidable competi-tive threat. Despite their size and scale disadvantages, however, regionalbanks have an opportunity to fight and win against these giants. To do so,they need to concentrate their energy on their local markets and focus onbuilding what we call local scale.

Understanding the concept of local scale and aligning strategy accordinglycould give regional banks a substantial boost not just in the battle for de-posits, but also in performance across the board. It will, of course, amount tolittle if they cannot also excel in execution. The big banks may haveeconomies of scale on their side, but a targeted strategy, combined with alocal market approach, will enable regional banks to flourish.

Local matters

If banking was just a numbers game, then virtually everyone on the fieldwould be heading back to the showers. The four megabanks – Bank ofAmerica, Citibank, JPMorgan Chase and Wells Fargo – collectively have 25

percent more branches than the top 10 publicallytraded regional banks combined and 80 percentmore assets.

In fact, among them, the megabanks hold ap-proximately three-quarters of U.S. retail bankingassets and control 40 percent of deposits. This isstill less concentrated than in the U.K., for exam-ple, where the five biggest banks account for

close to 90 percent of the assets and 57 percent of deposits. Nonetheless,considering that there are 16,000 depositary institutions in the United States,

The big banks may haveeconomies of scale on their side,but a targeted strategy, combinedwith a local market approach, willenable regional banks to flourish.

67Big Fish in Small Ponds: Why Regional Banks Need Critical Mass

four banks holding 40 percent of deposits reveals the extent of the concen-tration. Even the smallest of these four, Wells Fargo, has $1.3 trillion in as-sets, 4.5 times more than PNC, the next-largest institution (Exhibit 1).

New kids on every block

The consolidation in the banking sector and the rapid evolution of these na-tional megabanks has shaken up almost every geographic market in thecountry. Regional banks have reason to be concerned, as they suddenly findthemselves competing head-on with one or more banking giants in almostevery market within their footprint. Seven of the 10 largest regional bankscompete with a megabank in at least 85 percent of their markets, with Sun-Trust and Capital One, for example, encountering the megabanks acrossmore than 95 percent of their footprints.1 Many regional banks may see thisas a daunting proposition. After all, the big banks have enormous nationalmarketing budgets, can lure the brightest talent, and should be able to passon to customers the benefits of their scale in operations.

Top U.S. publicly traded banks and thrifts by assets$ billions; 2Q 2010

M&TKeyBankWellsFargo

CitiChaseBank ofAmerica

Sun-Trust

5,2305,860 1,010 6,157 2,350 2,530 980 1,315

Number of branches1

Megabanks Top 10 regional banks

1,690 1,660 1,280 950 131640

Percent of footprint that overlaps with superbanks

67 92 98 9689 83 90 89 10083

PNCU.S.Bank

CapitalOne

FifthThird

RegionsBB&T Hudson City

6894283

1,226

1,9382,014

2,364

171262 197112135155 61

1 Branch and footprint data based on 2Q 2009 numbers Note: Excludes asset servicing/asset management banks (BNY Mellon, Northern Trust, State Street, etc.) Source: McKinsey analysis, SNL Financial

Exhibit 1

Four banks dominate the retail banking landscape

1 Geographic markets in the analysis were usually at the county level or metropolitan statistical areas depending on the population density.


Regional bank fears are compounded when one realizes that where themegabanks compete, they generally become the dominant player. WellsFargo, for example, ranks in the top three for branch share in 85 percent ofits markets, while Bank of America and Chase manage this feat in around 75percent of their markets. By contrast, most regional banks muster a top-three spot in just 40 to 60 percent of their markets.

Despite the onslaught from the big banks, McKinsey research shows that theregional banking model remains robust. However, regional banks must be verydisciplined both in managing their footprint and ensuring superior execution, ifthey are to thrive. Regional banks can excel by delivering a “best of bothworlds” strategy, which requires the bank to be deeply embedded in its localcommunities in order to deliver more personalized service (similar to commu-nity banks), while also providing the full product and service suite at a similarprice-point to the megabanks. On average, 70 percent of a regional banks’profits derive from what are essentially local revenue streams: retail accountsand local and regional businesses. In other words, the more “regional” they canbe, the more they appeal to their most critical customer base.

Managing the S-curve

In order for a best-of-both-worlds strategy to be effective and for regionalbanks to have the opportunity to bring these local skills to bear, they mustfirst build critical mass in their core markets. Without critical mass, regional

banks will struggle against their larger competi-tors, continually lagging in deposit share and re-maining an also-ran in the market.

Critical mass, in this context, is based on the rela-tionship between the share of branches and theshare of deposits in any given market. Plotting

branch share against deposit share for all banks in a market inevitably showsthat the greater the branch share, the greater the deposit share, but the real-ity is more nuanced. We analyzed over 250 major counties in the UnitedStates and found that an S-curve relationship exists in over 80 percent. Wedefine critical mass as the area on the local market S-curve where a certainlevel of branch share begins to yield disproportionate returns in terms of de-posit share (Exhibit 2).

Although S-curves can vary in shape and slope, the underlying structure ofmost curves is similar to that shown in the exhibit. When a bank has low

Regional banks must be verydisciplined both in managing their

footprint and ensuring superiorexecution, if they are to thrive.


branch share in a given market, it is likely to see lower marginal returns andpunch below its weight in regards to deposit share. When it has reached mo-mentum branch share (the left-hand border of critical mass), it can enjoy in-creasing marginal returns. As a bank reaches the inflection point on the curvewhere the rate of deposit share growth begins to slow, it is likely to be a lead-ing player in that market. Eventually, the rate of deposit share growth beginsto slow as expansion continues and a bank reaches saturation point. At satu-ration point, no matter how many more branches a bank adds, the impact onits share of deposits will be very small.

Achieving critical mass requires understanding the shape of local market S-curves (which will vary depending on market demographics and the competi-tive landscape) and strategically focusing branch investments in marketswhere critical mass can reasonably be obtained. Our research shows that, onaverage, regional banks can reach critical mass by achieving at least 6 to 8percent branch share, which could be as low as four branches in FairfieldCounty, Ohio, or as high as forty branches in Palm Beach County, Florida.

Market S-curvePercent

Depositshare

Branch share

Moderate marginal returns(subscale)

High marginal returns Low marginal returns

Momentum branch share

Inflectionbranch share

Saturatingbranch share

Banks have moderate marginal returns (deposit share) on their branch investment

Banks reach critical mass in branch share, with increasing marginal returns that peak at the inflection

Banks have low and decreasing marginal returns on branch investment

Source: McKinsey analysis, SNL

Exhibit 2

At critical mass, banks reap disproportionate returns


The S-curve of any given market will evolve over time. Not surprisingly,larger and more attractive markets have seen greater competition in recentyears, resulting in a flattening of the S-curve. This flatter S-curve makes ittougher for a bank to capture disproportionate returns; that is, it takes morebranches to achieve a smaller increase in deposit share. For example, in2003, New York County had 450 bank branches, and a bank reaching satu-ration point could expect to hold around 45 percent of deposits. Fast for-ward to 2008, the county had more than 40 percent more branches, and abank reaching saturation point could expect only 30 percent deposit share(Exhibit 3).

Additionally, changes in market landscape (e.g., through M&A), demograph-ics or customer behavior can also have an impact on the shape of the S-curve. For example, a large acquisition can lead to the combined entity farexceeding saturation share in a market and thus distorting the S-curve. Thecurve will usually revert to a more standard (and statistically significant) shapewithin one to two years, as the new entity stabilizes and the market adjusts.

0

5

10

15

20

25

30

50

0 5 10 15 20 25 30

Chase

Citi

HSBC

Deposit share

Branch share

Saturation point1

Branch and deposit market share by bankPercent, 2003 2008

2003

47%46%

33%–16%

30%

2005

2007

2008

1 Saturation point is the maximum deposit share a bank can expect to get in this market by increasing its branch share.

Source: 2008 McKinsey Branch Benchmark; SNL 2008

Exhibit 3

A case example: New York County’s flattening S-curve


Interestingly, the growth of online and direct banking has not had a substan-tial effect on S-curve dynamics. Research shows that although the youngergeneration is less likely to visit a branch to research a new product, 80 per-cent of 18- to 30-year-olds still prefer to visit a branch to open a new ac-count. This share increases by age group, suggesting that branches andphysical presence will continue to play a key role in bank success.

Tempting as it might be simply to map every market and attack those wherea bank has yet to reach critical mass, this is clearly a flawed approach for re-

gional banks. Spreading investments too thinlyacross the footprint is always going to presentenormous management and balance sheet prob-lems and increases the chances of continuing toplay second fiddle to the entrenched megabanks.Success will not come from casting the net toowidely, or from targeting seemingly lucrative butcompetitive markets, where a bank has a minimal

presence. Instead, regional banks should focus their resources on a set ofcore, strategic markets that offer the biggest potential for improvement, inorder to achieve local scale.

Perhaps the most compelling argument in favor of cementing a regionalfocus and critical mass in a series of core markets comes from our analysisof regional banks’ performance against megabanks. When the regional playerhad a branch share that was at or above the saturation point for the market,it outperformed the megabank by approximately 5 percentage points in termsof deposit share, even when the megabank, itself, was also at saturationpoint. Both banks were among the market leaders, but the regional bank wasoutcompeting a theoretically more efficient rival. Although a number of execu-tion-related factors likely contribute to this performance, the analysis showsthat once a regional bank achieves local market scale, it is no longer at a dis-advantage to a megabank, despite the latter’s greater access to marketingand resource dollars. We are not arguing that branch investment alone is suf-ficient for sustainable success, but the analysis implies it is a necessary con-dition – and one that regional banks need to recognize as they plan theirinvestment strategies.

Winning across the board

As banks reach critical mass in a market, they not only attract disproportion-ately more deposits, they are also able to generate superior benefits across a

Success will not come fromcasting the net too wide, nor fromtargeting seemingly lucrative but

competitive markets where a bankhas minimal presence.


number of critical measures of bank performance – including non-DDA cross-sell, product mix, employee and branch productivity, risk and pricing. Addi-tionally, building local scale does not just affect the bank’s consumerfranchise, it is also heavily correlated with small-business, mid-market andcommercial penetration.

Revenue and productivity

Combining the S-curve analysis with McKinsey’s proprietary branch bench-marking survey shows that building critical mass can have significant impacton a bank’s revenue and productivity (beyond just DDA). If we look at cross-sell rates, there is a striking correlation between the cross-sell rate of non-de-posit products and the percent of markets where the bank is in the top threefor branch share. This suggests that as banks gain deposit share, they alsoimprove their ability to cross-sell non-DDA products.

This relationship may seem obvious, but it demonstrates the importance ofbranch presence in building multi-product relationships and increasing cus-tomer loyalty. One might think this relationship is driven purely by bank-spe-cific execution, but even for a single bank, cross-sell rates are higher inmarkets where the bank has a top-three position, versus markets where it isnot a leading player (i.e., number six or lower). This suggests that improving

cross-selling requires not only a targeted sales pro-gram and strong front-line execution, but also criti-cal mass in branch share.

Additionally, leaders with critical mass – that is, witha top-three position in a majority of markets (exactfigures will vary according to the market) – alsohave a more attractive mix of deposit products than“laggards” (defined as banks ranking fifth or lowerin branch share). While leaders generate less than30 percent of new deposit sales from free DDA

products, these low-margin products account for 25 percent more new unitsales at the laggards. This leads not only to lower revenues for the bank, butalso lowers customer loyalty and reduces cross-sell opportunities, as freechecking customers tend to have lower balances and higher switching rates.Leaders also sell a greater percentage of the more lucrative savings products(e.g., savings accounts, MMDAs, CDs).

Finally, one of the most pronounced performance differences between lead-ers and laggards is in productivity, both at the individual and the branch level.

As banks reach critical mass in a market, they not only attractdisproportionately more deposits,

they are also able to generatesuperior benefits across a

number of critical measures ofbank performance.


In our sample, sales of deposit products per FTE were 43 percent higher forthe leading banks, and deposit product sales per branch were a staggering109 percent higher. This suggests that leading banks are either able to at-

tract more affluent customers, grab a greatershare of a customer’s deposit wallet, attracthigher-skilled staff, offer better rates, or, morelikely, some combination of all of these. Althoughsome of this difference is probably driven by exe-cution, the sample considered 40 distinct coun-ties, with a number of different banks representingleaders and laggards across those counties.Given the wide variation in market performance

and operating styles across these banks, it is fair to conclude that criticalmass played a significant role in the productivity variation.

Pricing and risk

In addition to revenue and productivity improvements, McKinsey researchsuggests that banks with critical mass may also see improvements in pricingand risk. For example, a bank can price more competitively in markets whereit has a leading position than in those markets where it does not. Lookingspecifically at various money market products, the rates were, on average,10 to 20 basis points higher in markets where the bank did not have criticalmass than in those where it did. This difference translated into a $120,000annual pricing opportunity per branch, or a $6 million opportunity, assuming50 branches in the market. This analysis implies that as a bank builds pres-ence and scale, it no longer needs to compete as aggressively on price.

Preliminary analysis also suggests that building critical mass can help banksachieve a superior risk selection. For a large regional bank, mortgage delin-quency rates were over 500 bp higher than the top three banks in marketswhere the bank could not muster better than a top five ranking. This is partlybecause the leading banks have a better choice of applicants and can moreeasily pick the best risks. In addition, a regional bank with a strong presenceshould have better local knowledge of risks than a bank with a far smallerfootprint in that market.

Small business and middle market

Building local market critical mass can also have a significant impact onthe success of a bank’s small business and middle market banking fran-

In addition to revenue andproductivity improvements,

McKinsey research suggests thatbanks with critical mass

may also see improvements inpricing and risk.


chises. There is a strong correlation between branch critical mass and busi-ness customer penetration, clearly suggesting that a bank will have greatersuccess – in both small business and middle market – in locations where ithas invested in building a significant retail infrastructure (Exhibit 4). This mightseem obvious, but it contradicts the strategies that many regional bankshave recently pursued: aggressively investing in middle market capabilities inlocations where they have limited physical scale. Middle-market customer re-lationship managers rarely sit in branches, so the assumption has been thatbranch presence was not critical for success.

This analysis suggests that small business and middle market customersvalue local presence as much as retail consumers do and, therefore, re-gional banks should have a coordinated strategy across their local busi-nesses (i.e., retail, small business and middle market). These businessesare usually separate entities with distinct growth plans, so this will requiremore coordination and collaboration across the bank.

0

5

10

15

20

25

30

35

40

45

50

55

60

0 10 20 30 40 50 60 70 80 90 100

Share of branches in counties where 1, 2 or 3 position

0

5

10

15

20

25

30

35

40

45

0 10 20 30 40 50 60 70 80 90 100

Share of branches in counties where 1, 2 or 3 position

Geographic region/market for sample bank

R2 = 79% R2 = 70%

Small business penetration/market sharePercent

Middle market penetration1

Percent

1 As defined by primary relationships

Source: 2008 McKinsey Branch Benchmark; SNL 2008

Exhibit 4

There is a strong correlation between branch critical mass and small business/middle market penetration


What now for regional banks?

It is clear that there are major advantages to being a bigger fish in a smallerpond, despite many banks’ attempts to expand into larger and seeminglyricher waters. Indeed, the point is more relevant now than ever before, as re-cent events have made the seas rougher and the competition tougher.

This insight leads to four major implications for regional banks – each ofwhich should be adapted to a bank’s strategy and position.

First, banks that have extended themselves into new regions or marketsshould rethink their footprint strategy. As previously mentioned, we esti-

mate that a bank must build at least 3 to 5 per-cent branch share in any market to begin toattract a disproportionate level of deposits andposition itself to be a leader in that market. Mostregional banks are already in several marketswhere they are not leaders and therefore needto prioritize investments in locations where theycan reasonably reach critical mass. Being luredinto, or continuing to invest in, supposedly at-

tractive high-traffic markets that require a huge roll-out of new branches(e.g., more than 20) may turn out to be futile.

Second, as M&A activity heats up in retail banking it will be important for ac-quirers to consider the impact of potential purchases on their local scale.Banks should actively seek to acquire smaller banks/branches in attractivemarkets where they are currently below scale, especially in today’s invest-ment-constrained environment. For example, when M&T Bank bought Provi-dent Bankshares Corporation in May 2009, it picked up 135 new branches,90 percent of which overlapped with M&T’s pre-acquisition footprint. These ad-ditional branches quickly increased M&T’s branch share in these markets bymore than 85 percent and had an immediate positive impact on M&T’s posi-tion on the market S-curves.

Third, regional banks need to take full advantage of their best-of-both-worlds strategy and invest in local specialization and a personalized cus-tomer experience. Building critical mass will ensure that regional banks cancompete with the megabanks, but local specialization will enable them towin. Unfortunately, over the past few years, many regional banks were cap-tivated with the idea of becoming national players and moved the other way– trying to gain national scale and losing their local touch. Our experience

Most regional banks are already in several markets wherethey are not leaders and thereforeneed to prioritize investments in

locations where they canreasonably reach critical mass.


suggests this is the wrong approach. Regional banks should look to theircommunity banking roots when addressing customer-facing activities. Ofcourse, we understand that banks must still operate in standardized ways,with full compliance and efficient processes, but local branches need to begiven some entrepreneurial freedom, with the ability to react and adapt tolocal market needs.

Finally, as banks begin to look to local market S-curves to help drive invest-ment decisions, they should also consider opportunities to move up to theS-curve (as well as to the right) (Exhibit 5). Many banks have a large num-ber of markets (40 to 60 percent is typical) where they are below the S-curve, implying that they are not getting their fair share of deposits basedon branch share. This gap is due to poor bank/branch execution in thosemarkets and suggests banks are not fully capitalizing on their branch infra-structure. Although addressing the execution deficiency can be as simpleas adding resources or changing operating hours, it more often requires

Invest in new branches in markets where the bank is near the steep part of the S curve, moving into the area of critical mass (starting point can be below or above S curve)

In markets where the bank is below the S curve, move up to the S curve (i.e., capture “fair share”)

Deposit sharePercent

Branch sharePercent

Predictednew position

Bank currentposition

Add a small number of branches, with increasing marginal returns

Deposit sharePercent

Branch sharePercent

Predictednew position

Bank current position

Improvements in execution can increase deposit share with no additional

A: Build critical mass B: Improve execution

Source: 2008 McKinsey Branch Benchmark, SNL

Exhibit 5

Using the S-curve to support strategy


significant shifts in the mindsets and behaviors of the front line, which canbe a challenging endeavor.

* * *

For regional banks, achieving critical mass across the majority of a bank’sfootprint should be a long-term objective that drives investment and acquisi-tion decisions for years to come. The benefits are significant, both in terms ofindividual branch performance and the bank’s ability to compete in a givenmarket. In the interim, we believe there is significant value to ensuring a bankgets its fair share of sales relative to its branch presence, in addition to in-creasing branch share and achieving critical mass. This requires banks toidentify markets where branches are underperforming and to focus on moretraditional execution levers such as performance management and salesforce effectiveness to raise their game. Pursuing this parallel approach ofmoving both up and across the S-curve will create growth and profitability forregional banks.


Improving Branch PerformanceIn Retail Banking

Despite the evolution and added convenience of alternative channels, thebranch network continues to be the heart of most retail banks. Many cus-tomers still harbor strong preferences for the personal interaction that onlybranches provide. Even remote users want to know that they can taketheir more complex transactions to a local branch. With retail banks facinga range of pressures and pursuing growth through deposits, it is more im-portant than ever for them to get the most out of their branch invest-ments. Our ongoing analysis of branch networks across the United Statesreveals exactly where these networks are falling short and how banks canmake improvements.

A vital link for banks

Personal interaction and service rank highly in the consumer decisionprocess about where to bank. While alternative banking channels deliveradded convenience, it is branch offices that customers turn to when theyseek assistance with non-routine financial needs and where prospects go tolearn about and open accounts. Banks have acknowledged this by continu-ing – until recently – to invest heavily in growing their branch networks.

Today’s economic environment places significant pressure on operating costsacross most industries, and for retail banking a substantial portion (60 to 70percent) of these costs are centered in branch networks. Recent and ex-pected regulatory changes will put additional pressure on profitability. Sowhile the branch is still a core asset and a vital link to customers, banks willneed to take a hard look at their branch networks to ensure that their contin-ued investment results in strong returns.

Room for improvement

The results of our recent branch benchmarking surveys clearly reveal thatthe branch networks of many U.S. retail banks have been operating wellbelow their full market potential. Through executive interviews, data col-lected across a range of banks (most recently, 8 of the top 10, represent-

79Improving Branch Performance In Retail Banking

ing 21,000 branches) and market types, and in-depth analysis comparingsales productivity, we discovered that banks can earn considerably higherreturns on what typically is their largest resource investment. To ensurebranch performance was compared on a level playing field, we developeda proprietary Market Adjusted Performance Index (MAPI), which incorpo-rates differences in wealth, demographic and competitive factors acrossbranch trade areas. The following are a few areas where we found signifi-cant shortcomings:

• Disparities in sales productivity: There are significant differences in salesproductivity among branches, both within a given bank’s network andamong banks themselves. High-performing banks frequently are three tofour times more productive than low-performing ones, as measured by unitssold per full-time salesperson (Exhibit 1). Even adjusting for market type andopportunity differences, the disparities remain substantial within bank net-works. The bank network that performed best in personal DDA accountsshows a wide range of branch sales productivity that is remarkably similarto the lowest-performing bank network (Exhibit 2, page 80). These findings

0A B C D E F G H I J K L M

50

100

150

200

Higher-performing banks Lower-performing banks

Branch median to 85th percentile

Branch median to 15th percentile

Branch average

Study average

Source: 2008 McKinsey Branch Benchmark survey

Exhibit 1

Branch sales productivity varies significantly among banks

Personal DDA units sold per FTE, by bank


suggest that significant value can be reclaimed by raising sales productivityin underperforming branches to levels consistent with market potential.

• Metrics not reflecting market differences: Banks frequently rely on ab-solute metrics that do not reflect market opportunity differences which areoften substantial. Instead, they should normalize performance objectivesfor branches and individual bankers based on the opportunity within theirtrading areas, recognizing that sales potential varies according to the de-mographics, wealth and competitive structure of each micro-market. Ad-justing for these marketplace variables enables branch networkmanagement, as well as branch managers and their staffs, to better un-derstand the extent to which branches may be over- or under-performing.

• Overemphasis on units sold: Although total balances are a key driver ofrevenues, banks frequently define sales goals in units, such as the numberof DDAs acquired, and downplay factors such as high average balancesand the sales potential for other products. In fact, our findings reveal thatbranch trade areas with strong potential for DDA unit sales have only aweak correlation with those showing strong potential for acquiring high-

Bank A(low performer for personal DDA)

Bank B(high performer for personal DDA)

1.0 2.20.0 1.0 2.20.0

Branch performance relative to sales potential for personal DDA accounts

Underperforming branches

Overperforming branches

Note: MAPI (Market-Adjusted Performance Index) of 1 indicates actual sales = potential.

Source: 2008 McKinsey Branch Benchmarking survey

Exhibit 2

Branch sales productivity varies widely regardless of network performance


balance DDAs and for selling other products. More broadly, we note anongoing misalignment between activities that actually create long-termvalue for branch networks and the activities network management tendsto routinely stress.

• Over-branching in top-tier markets: The marginal rate of return for increas-ing branches in a given market follows the familiar S-curve, where thebank’s share of deposits for the respective market increases with eachbranch added until the network effect eventually starts to diminish. Branchsaturation of top markets, combined with slower deposit growth, has putincreased pressure on branch economics – a change that has becomepronounced in the largest metropolitan statistical areas. Meanwhile, sec-ond- and third-tier markets have shown relatively stronger growth. Over-branching has also started to flatten the optimal branch density curve formany markets, thereby lowering the optimal deposit share for banks withthe greatest number of branches in those markets.

• Suboptimal local market density: In contrast to over-branching, we alsofound many markets where banks continue to operate with inefficientbranching levels. An earlier McKinsey analysis of branch performance inmore than 100 markets between 2003 and 2007 revealed that, on aver-age, banks begin to accrue disproportionately higher shares of depositsonce they attain approximately eight percent branch density. This repre-sents the initial inflection point in the S-curve noted earlier. Remarkably,

however, we found banks operating manybranches in markets with suboptimal branch den-sity. National banks had 16 percent of theirbranches in markets where they had suboptimaldensity, whereas smaller, regional banks had al-most 50 percent of their branches in marketswhere they had suboptimal density. Low-perform-

ing branches suppress overall network performance and reduce return oninvested capacity. While market entry necessarily involves an initial periodlow performance, successful network development strategies center onquickly attaining optimal branch density levels in all markets entered. (See“Big Fish in Small Ponds: Why Regional Banks Need Critical Mass,” page66, for more on this topic.)

• Inappropriate resource allocation: Branch staffing is often based solely ontransaction volume, with little apparent consideration of local market op-

Low-performing branchessuppress overall network

performance and reduce return oninvested capacity.


portunity. This ensures customer service consistency across branches,but also starves branches in higher opportunity areas where increasingsales staff would boost branch performance. Importantly, resource alloca-tion that ignores local market opportunity can leave such opportunitieswide open to competitors and prospective market entrants. Our studyfound that, unlike low-performing banks, those that lead in sales produc-tivity typically maintain staffing levels 30 to 70 percent higher in their high-opportunity branches than in their low-opportunity branches – even afteradjusting for transaction volume (Exhibit 3).

Making the branch network pay

The findings discussed above suggest several steps banks can take to signif-icantly improve performance:

1. Pursue markets based on opportunity and ability to achieve optimal den-sity. For banks that have not yet done so, it is important to begin by devel-oping a clear understanding of both existing and target markets, keeping in

Indexed increase in median branch FTEs based on transaction volume and market opportunityNumber

416 395 502

281 263 270

219 220 213

176 168 169

145 152 150

409

289

222

175

126

432

281

232

182

100

320 338 375

253 263 273

213 216 237

172 179 186

170 149 175

310

244

206

174

144

291

231

191

150

100

Laggard bank Leading bank

Market opportunity for branch Market opportunity for branch

Low Medhigh

Med Medlow

High Low Medhigh

Med Medlow

High

Low

Medlow

Med

Medhigh

High

Transaction volume

Low

Medlow

Med

Medhigh

High

Transaction volume

Staffing increases with both transaction volume and opportunity

Staffing only increases based on transaction volume

Source: 2008 McKinsey Branch Benchmarking survey

Exhibit 3

High-performing banks staff branches according to both market opportunity and transaction volume


mind that markets change – sometimes radically – over time, so data devel-oped five years ago might no longer be accurate. Demographics, competi-tion and economic conditions change continually and in the process canquickly render specific markets more or less attractive. Armed with a clearknowledge of the prevailing nature of the bank’s markets, managementshould prioritize them based on their respective attractiveness, branch den-sity and competitive set.

As discussed earlier, branch performance peaks when branch densityreaches the optimal level for a particular market. It is therefore essential at

this point to assess the current branch densitylevel relative to the optimal range for each mar-ket and carefully consider the bank’s ability toattain that range. Because opening and closingbranches is typically a complex and costlyprocess, various factors can limit the ability toattain optimal branch density. Where circum-stances make it extraordinarily difficult to

achieve this goal, it may be prudent to withdraw from that market. Branchoversaturation should also be avoided.

Existing presence in low-opportunity markets also deserves consideration. Ifbranch density is still well below optimal levels in these markets, improvingperformance might require exiting the market altogether or minimizing costs,such as staff and marketing expenses.

2. Align sales and service capacity with market opportunity. The sales capacityof branches should reflect current market opportunity within branch tradingareas. Because market opportunities continually shift, staffing levels need tokeep pace and ensure optimal performance. Reassessing sales capacity on abranch basis and reallocating it according to marketplace changes is bestdone on a regular schedule.

In allocating branch resources, it is also important to remember that some ac-tivities and processes add significantly more value than others. Those that addlittle value probably warrant careful reconsideration with the aim of reducingservice demand and capacity requirements to the extent possible without hin-dering performance in other areas.

Realigning branch resources according to local market opportunity levels andservice requirements also enables network management to identify areas ofover- and understaffing and thereby adjust overall network staffing to current

Maintaining a lean organization is always key to

maintaining peak performance; it is especially important during

economic downturns.


needs. Maintaining a lean organization is always key to maintaining peak per-formance; it is especially important during economic downturns.

3. Manage according to branch peer groups and reward performance basedon market-adjusted metrics. Most mid-size and large banks operate in multi-ple, highly diverse markets, but assigning the same goals to downtown met-ropolitan branches and their suburban counterparts, or even to downtown orsuburban branches in vastly different metropolitan areas, usually is short-sighted. To be meaningful, goals should be consistent with prevailing condi-tions and opportunities in the branch’s trading area.

A very helpful approach is to segment branches into peer groups based ontrade area similarities. Doing so allows more meaningful normalization ofstandards and objectives and helps reveal a network’s true performance win-ners and losers.

Peer grouping of branches is also a highly useful tool for creating incentiveplans that are consistent with local market opportunities. Plans that rewardperformance levels that are perceived to be unattainable in the employee’slocal market do little to motivate performance; conversely, easily attainableperformance levels typically reward mediocre performance. Both objectivesand incentives, then, should reflect the branch’s local market opportunity.

Looked at a more broadly, banks should motivate and reward sales produc-tivity and other market-driven performance measures according to marketopportunity levels. Regional and local market managers generally face dis-parate market conditions, so a single set of incentives, recognition plans,training programs and sales guidelines will inevitably influence field managerperformance differently in each market. Market and region-adjusted targetsare important tools in any effort to enhance branch network performance.

* * *

Customers increasingly demand multichannel access, but it would be a mis-take for banks to lose focus on the branch. It is still the heart of the retailbanking experience. In today’s environment, banks need to make informedand systematic decisions on where to pursue scale, how to strike the rightsales and service capacity balance, and how to set goals and reward per-formance. If they do so, the heart of retail banking will keep beating strongly.

85Banking on Multichannel

Banking on Multichannel

Technology continues to rapidly change the way consumers behave and in-teract. Virtual channels are becoming more relevant, with the increasing pen-etration of high-speed Internet connectivity and Web-enabled mobile devicesallowing consumers to spend more time online. Bank customers will not onlycontinue to use a mix of channels, but will use non-branch channels for in-creasingly complex banking transactions

While retail branches remain a core banking channel, research shows thatcustomer traffic is in some cases flat or declining, as customers come torely more heavily on direct channels. In fact, online banking and call cen-ters account for 55 percent of transactions today (Exhibit 1, page 86).This shift can be a positive development for banks, but they must beready to provide customers with a rich set of capabilities and a seamlessexperience across all channels. Successful execution of such a strategyhas tangible economic rewards, but requires the right set of investmentsand development of new capabilities.

Given the overuse of the term multichannel over last decade, it is importantto establish what we mean when we use it. True multichannel banking pro-vides a rich set of products and services to customers in a seamless and al-ways available fashion across all channels. Seamless here indicates thatacross channels customers have a consistent experience, can see the fullview of their relationship, can shift at will (e.g., mobile to online), and can pickup an interaction where they left off (e.g., part-way through the application fora product). Multichannel banks also provide the appropriate levels of support(e.g., online channel supported by click to chat/call available 24x7) to let cus-tomers select their channel of choice based on usage context (e.g., on wayto work, at home on computer after dinner) at any time of day and completea satisfactory interaction. Banks that build multichannel capabilities that meetthese criteria will enjoy rich economic rewards over the next decade.

Tangible economic rewards

Leading multichannel banks are already capturing benefits. Perhaps the mostobvious is improved cross-selling to existing customers. Every interaction inany channel – including common service requests – can be a potential sales


opportunity when appropriate. An integrated cross-sell engine can identifycustomer needs and help capture instant sales (e.g., offer and close on per-sonal loans at an ATM) or generate warm leads.

Multichannel banking can also improve conversion rates. Frustrated cus-tomers often give up on trying to complete transactions online when they findthe process too difficult. A strong multichannel offering is attuned to thesemoments and proactively offers assistance (e.g., live online chat pop-upswhen customers spend too much time on one page). These actions reduceabandonment rates for sales transactions significantly.

The enhanced functionality and experience that define multichannel bankingcan help increase customer lifetime value and reduce churn rate. Innovativetools and products such as bill-pay features, person-to-person transfers and

14.6 14.9 15.1 15.1 15.1

14.4 14.7 14.7 14.8 14.8

15.9 17.0 17.8 18.5 19.3

19.7

23.326.8

30.033.3

ATM

Branch

Call center

Online

2012E2011E2010E2009E2008

12.6

4.3

0.2

0.4

Transactions Billions

CAGR (08-12)Percent

Source: Tower Group; McKinsey analysis

Exhibit 1

Direct channels are growing more quickly than traditional channels


money management tools are all ways to provide a more compelling experi-ence that builds customer loyalty and value for the bank.

Finally, a well-developed multichannel offering can strengthen a bank’s overallbrand promise, whether it be convenience, customer service or low fees, andlay a foundation for satisfying customer expectations and further cross-selland up-sell offers.

The economic benefits of these various opportunities can be substantial; twolarge regional banks found more than $250 million in incremental revenue byproviding improved functionality within non-branch channels and a consistentmultichannel experience.

There are also clear cost-saving implications in successfully implementingmultichannel banking. By providing improved self-servicing capabilities, retail

Multichannel in other industries

Over the past decade, several prominent brick-and-mortar retailers have focused on delivering a seamless andconsistent customer experience across channels. Companies such as Banana Republic and Best Buy offer cus-tomers the flexibility to research products, make purchases and conduct service transactions easily across theretail store, Web and call center. Some, such as J. Crew and LL Bean, have created a multichannel offering froma traditional direct mail and call center business.

Each retailer has focused on different aspects of the multichannel experience. For example, Banana Republicprovides a consistent customer experience by using all channels to improve customer service (e.g., allowingcustomers to return products online or in stores and to address service issues through any channel). In addition,the company provides a single customer service phone number for issues across all channels, and call centerreps have detailed information about each customer’s activity in other channels. Finally, Banana Republic sharescustomer data across channels to enable a high level of service and targeted sales offers.

Best Buy lets customers researching and purchasing products online see whether local stores have the productin stock. The customer can then opt to have the product shipped to their home or placed on hold for pick-up atthe nearest store. Best Buy also uses customer insights from transactions in data-rich channels to inform mer-chandising and promotions in another.

Even retailers at the leading edge of the multichannel customer experience acknowledge that they have along way to go. Customers are becoming more demanding and expect a consistent experience across allchannels for both sales and service transactions. Given that it can take years to develop a differentiatedmultichannel strategy, firms need to invest in new technologies and incorporate the multichannel experi-ence in their core value proposition.


banks can reduce the overall expense base while providing customers withthe same (or a higher) level of service for common transaction requests.Banks can reduce the volume of balance inquiries, stop-payment requests,account information updates and other common transactions to higher-costchannels by ensuring that lower-cost (i.e., direct) channels can handle theserequests, are easy to use and reliable.

In the same way, a customer’s non-transactional needs can be answeredthrough self-discovery tools (e.g., mortgage price) and advice, allowing thesales force to focus efforts on more complex transactions and cross-selling.

Finally, by developing a robust Internet offering, retail banks can realize signif-icant savings in the area of customer acquisition. Benchmarks suggest thatthe all-in cost to acquire new accounts through the Web can be between 15and 45 percent lower than through the branch or call center (Exhibit 2).

The journey to best in class

Achieving the full benefits of multichannel is not an overnight project. Formost banks, this will take years, not months. The alignment of systems and

Call center/phone

250

Branch/store

328

Internet 143

-43%

193

179

121

-32%

100

115

55

-45%

287

318

225

-22%

220

265

191

-13%

Savings account

Credit card Mortgage

Homeequity loan

Checking account

Average cost of acquisition for select consumer banking products, per new account

Source: February 2008 U.S., Canada, and U.K. eBusiness, channel and product manager online survey

Exhibit 2

The all-in cost to acquire new accounts through the Internet channel is 15% to 45% lower than the branch or call center


data across channels takes time and, as we have noted, considerable IT ex-pense. But these investments are a prerequisite to providing a consistentcustomer experience.

The journey to excellence in multichannel has three major stages (Exhibit 3):

• In-channel excellence across the major customer touch points. The firststep is for banks to meet minimum industry standards for common end-to-end sales and service transactions for each channel – ATM, branch,call center, Web and mobile.

• Consistency across channels. Banks then need to standardize informationand align systems across channels, and develop uniform look and feel,branding and messaging (e.g., product information, disclosures andterms, product pricing and offers).

• Seamless multichannel integration. The next stage centers on enablingcustomer transactions across channels. Customers should be able to“click to call” from the bank’s Web site; and Web kiosks should be avail-able in the branch. Customers should be able to start a sales or service

Channel of choice

Achieve in channel excellence for all channels (industry standards for branch, ATM, online and phone)

Enable end to end transactions in customer’s channel of choice

Consistency acrosschannels

Standardize information and align systems across channels

Provide consistent customer experience across channels (e.g., consistent branding and messaging)

Seamless multichannel integration

Enable multichannel transactions (e.g., “click to call” from Web site, Web kiosks in branch)

Additional revenue enhancement through cross channel sales, lead escalation

Higher customer satisfaction due to broad channel usage


Exhibit 3

Journey to multichannel excellence in retail banking


transaction in one channel and complete it easily in another. If a cus-tomer filling out an online credit card application has some questions, heor she should be able to dial the call center and have the representativeview the application and help finish it. Finally, banks can influence be-havior to use certain channels for specific customer segments or typesof transactions (e.g., online for check reordering, branch for jumbo mort-gage applications).

Some leading global banks have already achieved key elements of a seam-less multichannel integration through consistent investment and a test-and-

The “IT” side of multichannel banking

Providing customers with a multichannel experience – and capturing the benefits – requires a targeted set of infor-mation technology-enabled capabilities. The broad aim of these capabilities is to provide the bank with a seamlessview of the customer; without this view, the bank cannot provide the seamless experience to the customer. Theprimary capabilities required are:

• Consistent customer data. All channels should have a common, consistent set of customer data. This isachieved through use of a single customer data warehouse and repository for product information. For in-stance, there should be a single content management system, and data should be integrated across channels,business units and products.

• Comprehensive view of the customer. To enable multichannel consistency, bank staff in all channels must havea comprehensive view of the customer. They should be able to track customer interactions across all channels.Call center and branch staff should have access to customers’ activity on the bank’s Web site, and should beable to make the same offers to customers that they have seen online.

• Targeted customer messaging. A single, common marketing engine provides targeted and consistent customermessages across channels. This prevents frustrating disjointed or repeated messages coming to customersfrom different channels.

• Capturing customer information. A common application engine across products and channels will ensure thatall channels are requesting and capturing the same customer information. This results in less work for cus-tomers, and minimizes complications for the bank when customers start an application in one channel butcomplete it in another.

• Single pricing engine. Banks must ensure that price quotes to a customer are consistent across channels.While many banks say they have such a common pricing engine, the reality is that customers often receive dif-ferent rate quotes when pricing a single loan through the branch, call center and online channels. The causesof this disconnect are often the pricing engine, content management system or latency issues in transmittingprice information from the engine to the customer.


learn approach over the last five years. Customers are presented with con-sistent product offers and pricing across channels, and call center andbranch reps can see all interactions – regardless of channel – that a cus-tomer has had with the bank. For example, a call center rep would knowwhat Web pages a customer has viewed, and what transactions a cus-tomer typically uses an ATM for. Customer information is integrated acrosschannels, which gives the bank a single view.

Wide-ranging implications

Building consistent cross-channel capabilities and customer experience canhave broad implications for retail banks. There are often considerable IT in-vestments required to enhance and connect various channels. There is theshift to a sales focus for the call centers and online channels, which cur-rently are often more focused on service transactions. Additional areaswhere banks will have to manage change include:

• Shift in role of the branch network: The retail branch network serves asthe primary sales channel for many banks. A multichannel approachwill begin to shift this balance, with the branch network likely to experi-ence a reduction in customer traffic and account sales volumes of 10percent or more, as a portion of the total transaction volume moves todirect channels.

• Creating multichannel owners: Banks need to establish clear owners re-sponsible for defining and delivering the overall multichannel customerexperience. These owners need to have influence to ensure the coher-ence of customer experience desired for each product and channel. Amultichannel approach requires an enterprise-wide vision and objectivesrather than the customary silo approach.

• Sustained, integrated cross-channel investment: Banks should establisha funding mechanism to ensure that investments can be made acrosschannels and products. For example, the functionality required for multi-channel mortgage sales transactions is similar to that required for creditcards and other credit products. Banks should be able to leverage in-vestments across products and channels. Banks will need to review thecompetitive landscape and conduct test-and-learn efforts on an annualbasis to ensure that investment in each channel maintains parity withpeers. Any upgrades and investments made in one channel will need tobe integrated within the context of multichannel strategy.


• Refinement to the current operating model: Banks need to strategicallyleverage scale across channels. Each channel has to be more tightly inte-grated and share capabilities not only across lines of business within achannel, but also across channels. For example, a single application en-gine could be utilized for the credit card product as well as for the coredeposit and loan products across online, phone and ATM channels. Mak-ing these changes can lead to structural cost reductions of 10 to 15 per-cent of total non-branch channel cost.

• Modifications to the performance measurement and incentive systems:Implementing a true multichannel offering will force banks to refine thecurrent performance measurement and incentive systems, which are oftenset around sales targets through a specific channel. Each channel willneed to have product-level sales and servicing targets, but line of busi-ness employees need to work toward driving customer interest in thebank’s products regardless of which channel is used to complete thetransaction. These metrics have to be incorporated into incentive systemsfor product and channel teams.

• Integrated insights from rich customer data: As multichannel capabilitiesare deployed, it is important for banks to track customer interactionswithin and across channels. They need to understand how and why cus-tomers are interacting through particular channels. The informationgleaned from such a focus can be enlightening: for instance, are cus-tomers migrating to one channel because their needs are not being metby another? The top customer service requests received by the call centershould create the development agenda for building new Internet self-ser-vicing capabilities and improving awareness of existing features.

* * *

The arguments for providing customers with seamless access across multiplechannels are numerous and compelling. Most banks are already offeringsome level of access through all the customer touch points, and multichannelwill soon be ubiquitous. However, the banks that reap the full revenue andcost benefit of this approach will be those that have done the thoroughgroundwork, made the right upfront investments and developed capabilitiesand mindsets to support it.

93The Evolving Consumer: Implications for Retail Banks

The Evolving Consumer:Implications for Retail Banks

The financial crisis and recession have altered consumer banking behaviorsand attitudes toward their financial security. While it is not clear if thesechanges will be lasting, it is nonetheless crucial for banks to develop thestrategies and skills to serve evolving consumers. Current trends indicate thatthe customary means by which banks grow profits and attract new cus-tomers will no longer suffice.

There is, of course, no single “new” consumer. Within the banking populacethere are divergent behaviors along financial and generational lines. However,there are common threads. To guide banks in meeting changing consumerneeds, we have drawn four broad themes from our extensive research:

• Consumers are likely to continue spending less and paying down debt,changing the dynamics of retail banking profits.

• Consumers view the investment market with skepticism, and reveal agrowing aversion to personal risk, with strong implications for bankingproducts.

• Older consumers are more anxious about – and thus more ready to ad-dress – the state of their retirement savings.

• Consumers are becoming more empowered in their financial decisionsthrough social media and online tools, and banks will need new strategiesto engage and win them.

The post-crisis financial consumer

U.S. consumers came out of the financial crisis with a broadly more conserva-tive and realistic attitude toward their finances. This is reflected in what they dowith their money, and how they view the future both for themselves and theeconomy as a whole. They are also increasingly likely now to form their opin-ions and make decisions based on input from friends and social networks.

While there are no simple silver-bullet solutions to serving today’s consumers,understanding the following themes will help retail banks reorient their approach.


1. Consumers are spending less and paying down debt

Consumer sentiment about the overall economy remains low, with morethan 64 percent of consumers believing that the economic downturn willlast at least another year (Exhibit 1). And while there is a growing senseamong consumers that the downturn has hit bottom in terms of its severity,they are still spending less and deleveraging. Early in 2009 our researchfound that up to 90 percent of consumers had curtailed spending. Almosttwo years later 61 percent are still doing so.1 Our most recent surveys alsoshow an increase in the percentage of consumers planning to pay downdebt at a greater rate (Exhibit 2).

The increase in fiscal conservatism is reflected in a range of metrics. In thethird quarter of 2009 more than half of consumers surveyed indicated thatthey no longer wanted to purchase many goods and services that they hadpreviously been purchasing. (More worryingly, some consumers included in-vestments in retirement among their cuts in spending.)

In your opinion, how long will the current economic downturn last?Percent of respondents

More than 5 years

More than 3 years but less than 5

More than 2 years but less than 3

More than 1 year but less than 2

Around 1 year

Around 6 months

Less than 3 months

8 10

18 17

38 39

7

10

17

30

25 22

24

10

211

55

5 6

January 2010June 2009March 2009Consumer expectations of the duration of the recession have only modestly improved from early 2009.

Source: McKinsey US Payments Map 2008-2013, release Q4-09

Exhibit 1

Consumers remain pessimistic on the economic outlook

1 McKinsey Financial Institutions Consumer Insights Survey, January 2010


The net result for banks is a decline in lending balances and interest revenue,and a shift in the customary sources of profits.

Implications

• With pressure on margins and a shift in traditional profit pools, banks willneed to become much clearer about understanding the lifetime value ofcustomers, and the incremental cost of acquiring and sustaining relation-ships with them. A more fine-tuned examination of the long-term ROI of ahigh-value customer can show that the return is not as high as expected.Conversely, consumers undervalued by a bank can develop into loyal andprofitable customers. The implications of this longer-term ROI focus extendacross the value chain, and are particularly relevant to marketing decisions,where heavy investments in a particular channel may not be cost-effectivewhen measured against the long-term value of the targeted consumers.

• Banks should also develop finer stratification of customer segments, goingbeyond financial factors to include behavior. Simple but effective ways todifferentiate could include customized Web landing pages, more effective

6.44.9

6.27.1

2.7

5.3

3.8 4.53.3 3.4 4.03.4

Mortgage Secondmortgageor HomeEquity loan

Auto loan Personalloan

Short termloan

Educationloan

Intend to open orincrease balance

Intend to close orreduce balance

Net score -1.3+0.7-3.8-1.7-1.1-3.0

Which of the following best applies to you for each of the following loan or credit products? Percent of respondents

Source: McKinsey Financial Institutions Consumer Insights Survey, Jan 2010

Exhibit 2

Consumers are still planning to reduce debt


subdivision of call center representatives to focus on valued customers,and personalized service on remote channels.

• Banks can also take an explicit lead in creating products that foster and re-ward more disciplined consumer borrowing. For example, in late 2009 JP-Morgan Chase launched “Chase Blueprint,” a set of tools that givescardholders more control over their spending and their debt. Under thenew program, cardholders have the option of choosing which types of pur-chases they want to pay off in full to avoid interest charges, and whichones they want to pay off over time.

2. Continued aversion to market risk

Consumers continue to be guarded in their views on the stock market. Theseviews, however, are not uniform. Belief in the stock market’s resilience does im-prove with age and with income (Exhibit 3). This may be because some olderconsumers have lived through the ups and downs of the market. And onlythose above 45 have witnessed positive total real returns from investments inthe stock market on average (including dividends). Another group that is more

What do you expect returns on the stock market to be over the next 30 years?Percent of mass market segment respondents1

38

31

60

28

43

25

34

26

15

36 45 years old 46 55 years old 56 64 years old

Positive (>5%)

Neutral (0 5%)

Negative (<0%)

1 Mass market defined as income between $25K and $50K

Source: McKinsey Consumer Survey, March, 2009

Exhibit 3

85% of younger consumers do not expect stock market returns above inflation over the next 30 years


optimistic about stock market returns is the affluent: the more money a con-sumer has, the more hopeful they are concerning the stock market.

There is a broad shift away from risky investments to safer investments. Thepercentage of people who intend to increase their investments in “safer in-vestments” such as deposit accounts and money market funds is far higherthan the proportion who intend to increase investments in stocks and mutualfunds. We expect holdings in FDIC-insured products to grow at three timesthe rate of investments in non-insured accounts.

Our customer experience research also suggests a shift in the drivers of con-sumer satisfaction in banking. In 2009, trust became the primary factor in de-termining satisfaction among those we surveyed, replacing branch service,which was the leading satisfaction driver in prior years.

Implications

• Increased conservatism among mass market consumers should promptbanks to focus on low-risk deposit and savings accounts that offer con-sistent, modest returns. Consumers will favor proactive, end-date man-aged investments with liquidity at lower fees.

• Banks should also move to meet increased consumer appetite for afford-able guaranteed products. The challenge, however, is that consumers donot have a clear understanding of these products.

• As risk appetite diverges along generational, educational and income-re-lated lines, banks must develop ways to identify and align customers tothe appropriate portfolio. Banks may also shift how they communicatewith different consumers segments to address new anxieties. (For exam-ple, in insurance, Geico put horn-rimmed glasses on its geckomascot/spokesperson in an advertising campaign reassuring mass con-sumers of Geico’s longstanding financial stability and trustworthiness.)

3. The retirement security awakening

The financial crisis has shocked many consumers, especially older con-sumers and less financially sophisticated consumers, into the belated realiza-tion that they will not have enough to retire on. If this new awareness is notquite a silver lining to the crisis, it is a positive development that consumersare more ready to address the problem. And the problem is acute: our retire-ment research suggests that the average American working household willlack 37 percent of the income it will need for a safe and dignified retirement.


The fact is that widespread reductions in household spending have notclosed the retirement gap for most. After years of low savings rates, few re-port even basic levels of household liquidity, and many have a long way to goto reach that level.

Implications

• There will be clear opportunity for banks as consumers turn to financial in-stitutions for advice on bridging the gap between what they have andwhat they need to retire securely. While trust in banks has fallen overallsince the crisis, they (along with credit unions) are more trusted than allother financial institutions (Exhibit 4). Banks should build on this trust tohelp transition their customers securely toward a more solvent retirement.Those that deliver simple and consistent retirement advice are most likelyto build and maintain consumer trust and capture this opportunity.

• With growing awareness of retirement shortfalls, and with more than one-third of households lacking access to workplace retirement plans, there willbe new appetite among consumers for retirement products. Specifically,such products would include outcome-oriented solutions protecting againstmarket volatility risk (e.g., inflation- or principal-protected) and income-guar-

“How much do you trust the following entities with your money?” Percent of respondents1

Age group

18 34

35 54

Over 55

19252117

414

31363425

228

25352923

3016

Financialplanner or registered FA

Publicly tradedinsurance company

Full servicebrokerage firm

Mutual fundcompany

Credit unionBank

Younger consumers trust banks while older consumers trust credit unions most

Younger consumers exhibit ~10% smaller trust deficit than their older counterparts

Second most trustworthy

Most trustworthy

1 Top-3 box responses (“trustworthy”) less Bottom-3 box responses (“not trustworthy”)

Source: McKinsey Financial Institutions Consumer Insights Survey, September 2009

Exhibit 4

Banks are more trusted than other financial institutions, especially among younger consumers


anteed solutions to provide stable retirement funds. Banks should work tochannel recent deposit flows into longer-term retirement-oriented solutions(e.g., index-linked CDs or fund products with very simple guarantees).

4. The empowered consumer

Consumers are taking more active roles in gathering information and makingchoices about their financial life. This trend is firmly in line with broader retailinfluences, in which technology empowers consumers to gather and ex-change information, compare products and prices, and share opinions andexperiences.

Our research mapping the consumer decision journey (or purchaseprocess) across a number of sectors suggests that social media is playing a

large role in this empowerment, enabling con-sumers to shape their own and others’ choicesto an unprecedented degree. For example, whenpurchasing auto insurance, consumers considerword of mouth advice to be twice as influential inevaluating different options as either traditionaladvertising or agent interactions.

The emergence of sites such as Mint andWesabe, which aggregate a customer’s accounts

with different financial institutions and leverage a broad view of consumers’financial life to make product recommendations, is threatening to put moredistance between banks and customers.

Implications

• With a more finely tuned set of tools and advice at their fingertips, con-sumers can increasingly base choices more directly on the merits of eachbanking product. Thus, the pressure on banks to differentiate their offer-ings, or find new means of maintaining loyalty, will grow.

• Empowered consumers will have more freedom to define for themselveswhat a bank actually is. Banks will need to respond by establishing new,cost-effective service models to meet changing consumer expectationsand drive loyalty.

• The growing propensity of consumers to turn to family, peers and online so-cial networks for financial advice will entail a sea change in how banks mar-ket. The power of the bank brand will be susceptible to a broader range of

Consumers have in many ways been shocked into a more

conservative, careful approach tohandling their money, and are more

apt – and empowered – to makeindependent financial decisions.


counter-influences. The best response to this fact is not to simply investmore in traditional branding methods: the most successful players will de-velop explicit strategies for systematically harnessing social media, includ-ing potentially launching formal word of mouth lead generation programs asP&G has successfully done in the consumer packaged goods market.

• Financial institutions must actively consider how they can win consumerattention and expand their consideration set. Visa’s Facebook page for itsSignature Card, which alerts “friends” on the site about perks and events,is an example.

* * *

Consumers have come out of the financial crisis with changed priorities. Theyhave in many ways been shocked into a more conservative, careful approachto handling their money, and are more apt – and empowered – to make inde-pendent financial decisions. The implications for banks are widespread, andwill have a direct impact on how they succeed, or fail. Retail banks shouldact now to develop the products, services and channels to serve the needsof their evolving customers.

101Profiting Through Simplification

Profiting Through Simplification

Coping with unnecessary complexity has become one of senior bank man-agement’s most difficult – but also most imperative – challenges. The re-wards, however, are considerable. Simplifying product, channels, process,technology and organizational structure can significantly improve perform-ance and customer satisfaction. In an environment in which banks are seek-ing to reconnect with valued customers, these are important goals.

Taking a systematic approach can not only help reduce complexity, but instill an ongoing mindset that prevents unnecessary complexity fromsprouting back.

Coping with a complex web

Complexity pervades retail banks like a vine creeping into every organiza-tional crevice. We need not look far to locate the roots of the problem.Throughout the last decade, banks pursued market share and profits largelyby adding products and services – from mortgages and home equity loans tocredit cards and money market funds. Each new offering required new sup-port systems, sophisticated technology, distribution plans, policies, guide-lines, training and marketing – all of which proved fertile ground for theinvasive growth of complexity. Mergers and acquisitions compounded theproblem as bankers struggled to prune and consolidate products, programs,systems, branch networks and staffing, efforts that were often complicatedby the need to retain customers. Little wonder, therefore, that banks haveevolved into highly complex enterprises, often comprising weakly linked net-works of functional, product and geographic silos that, taken together, canbe difficult for bankers and customers alike to fully comprehend.

Complexity is often, of course, necessary. Customized private client reporting,for example, is a necessarily complicated endeavor. However, there are manycases in which complexity is a by-product with no clear purpose. With growingcompetition for deposits and revenues, banks will need to cut costs while re-taining customers and deepening relationships. They can reduce costs throughaggressive pruning of complicated products and processes as well as staff po-sitions that contribute little added value. Customers are unwilling to pay for un-warranted complexity and often it is therefore not essential to long-term viability.


Five major factors drive complexity:

• Product portfolio. Years of operating in a product-centric mode have ledto a plethora of products, variations, special offerings and exceptions thatrequire systems, guidelines, policies, training and ongoing support regard-less of the value they currently add to the organization.

• Distribution channels. Technological advances continue to enable newand more convenient channels, leading customers to gradually abandonless convenient alternatives.

• Processes. As products and channels expand, so do processes and oftenduplication of processes, as in coordinating origination processes acrossproduct groups. Complexity can stem from unnecessary process steps,from duplicative work and from unneeded handoffs.

• Technology. Banks depend heavily on technology systems often com-prised of multiple platforms and linkages. These typically require extensivetraining, frequent costly updating, high security and 24-hour support.

• Organizational structure. As banks pursue new growth organizationalstructures become more intricate, with product, back office, channel, ITand other teams frequently involved in cross-matrix interactions.

As these key drivers illustrate, complexity is an organization-wide problem.Consequently, a change in one area generally requires changes in some or allof the others. Tackling the problem demands a systematic approach.

A systematic approach to simplification

Controlling complexity must be an institution-wide effort that has the full sup-port of senior management. Uncertainty about how and where to begin suchan extensive task undoubtedly has led most banks to largely evade it. How-ever, a comprehensive and systematic approach will result in gradual ongoingimprovement in customer satisfaction and bottom-line performance. Threefundamental steps are critical for success: establishing a complexity baseline,designing a customer-centric program plan, then diligently implementing theplan and inculcating a simplification mindset.

• Establish a complexity baseline. This vital first step – often overlooked –provides a solid foundation on which to build a program that will actuallybe capable of rooting out pointless complexity. Identifying and applyinga series of relevant metrics across the areas that drive most complexitycan help reveal where it is most pervasive, and how it may also be driv-


ing unneeded complexity in other areas. When creating a baseline, it isalso important to estimate the relative cost and difficulty of simplificationin those areas where it is needed. This baseline information will provide afooting for identifying hot spots and prioritizing simplification tasksacross the organization.

• Design a customer-centric plan. The most effective approach is often onewhich takes a customer-centric focus. This means starting with the prod-uct portfolio, then moving on to address distribution channels andprocesses, and lastly operations and technology. Products, versions andexceptions tend to proliferate over time with little attention paid to discon-tinuing weak performers. Is offering 25 types of credit cards, for example,really important to maintaining the current customer base? Reducing thenumber of card types would simplify marketing and back-office opera-tions, and would lead to bottom-line contributions from each. To gain aclear perspective on which products are truly driving profitability, andwhich are driving only more complexity, we suggest banks develop a gridwhich measures products by both level (high vs. low) and kind (good vs.bad) of complexity (Exhibit 1).

Size of bubble indicates number of accounts

70% products with high and bad complexity

BadLow High

Good

Kind of complexity(product margin)

Level of complexity(Number of products in same segment, if product is actively offered, number of exceptions)

Products to keep

Products to migrate/standardize

Note: Product portfolio assessed based on bank’s strategy regarding products and complexity KPIs


Exhibit 1

Assessing product portfolio complexity


Banks should also consider whether the use of all channels for all prod-ucts and services is necessary. Discontinuing channels that are seldomused for a particular products or services can bring immediate gains insimplicity (Exhibit 2). Similarly, processes often have unnecessary steps,duplicated efforts and relatively pointless handoffs to certain areas ordepartments; weeding out this type of complexity will streamlineprocesses, and thereby save both time – including the customer’s – andexpense (Exhibit 3).

Simplification in the product, channel and process areas will underscorerelated opportunities in the bank’s technological and organizational infra-structures. Experienced IT managers know that platform redundancies,frequent systems updating, ongoing technical training and system in-compatibility issues often add needless complications and expense tobank technology systems. Moreover, organizations frequently grow newlimbs in these core areas to accommodate additions in products, chan-nels and processes. Uprooting unwanted complexity in technologicaland organizational infrastructures is therefore usually much easier aftereliminating it in other areas.

Percentage of transactions

Cost per transaction







75%

$0.7

80%

$0.7

75%

$0.7

65%

$0.7

Main key performance indicators Internet

20%

$1

5%

$1

0%

$1

5%

$1

VRU

0%

$2

0%

$2

0%

$2

0%

$2

Mail

5%

$20

5%

$20

0%

$20

0%

$20

Call center

0%

$50

10%

$50

25%

$50

30%

$50

Branches

Product 1

Product 2

Product 3

Product 4

Products/channels to consider discontinuing

Low HighLevel of complexity

Note: Level of complexity was based on variability of channels (e.g., number of channels used) and cost of channel used


Exhibit 2

Evaluating complexity/cost of distribution channels


• Implement and sustain simplification. With a clearer view of the bank’s un-necessary complexity, management can prioritize simplification efforts, es-tablish budget allocations, assign task responsibilities and evaluate progress.

Unless there is a sustained effort to curb its re-growth, unwarranted com-plexity will rapidly grow back and erase hard-won simplicity. Successtherefore demands an ongoing institution-wide effort to prevent the addi-tion of unnecessary processes and systems. Senior leadership can assignownership of simplification efforts, set management objectives and budg-ets, and develop tools to track improvements. These steps are critical toensure simplification will remain a priority.

* * *

Bank managers know that complexity can impede both organizational per-formance and customer satisfaction. By adopting a holistic perspective ofcomplexity’s five leading drivers, financial institutions can give customersthe banking experience they want while also simplifying processes, chan-nels and products.

Throughput time (days)

Number of exception cases







Increase STP rate mainly by process (not IT) changes (e.g., allow fewer exceptions in forms)

10

30,000

5

45,000

20

60,000

5

100,000

Performance indicators

Account openings

Activities

Complexity level

1

70,000

1

50,000

8

100,000

53

300,000

Transactions

N/A

6

60,000

1

60,000

N/A

Periodic transactions

6,000

3,000

30,000

45,000

Administrative

Product 1

Product 2

Product 3

Product 4

Low

Medium

High Source: McKinsey analysis

Exhibit 3

Measuring complexity of key processes by product

About McKinsey & Company

McKinsey & Company is a management consulting firm that helps many of theworld’s leading corporations and organizations address their strategic chal-lenges, from reorganizing for long-term growth to improving business perform-ance and maximizing profitability. For more than 80 years, the firm’s primaryobjective has been to serve as an organization’s most trusted external advisoron critical issues facing senior management. With consultants in more than 40countries around the globe, McKinsey advises clients on strategic, operational,organizational and technological issues.

McKinsey’s Consumer & Small Business Banking Practice serves leadingNorth American banks on issues of strategy and growth, operations and tech-nology, marketing and sales, organizational effectiveness, risk managementand corporate finance. Our partners and consultants provide expert perspec-tives on a range of topics including corporate strategy, business model re-design, product and market strategy, distribution and channel management,the impact of financial services regulation and performance improvement.

The following McKinsey consultants and experts contributed to this compendium:

Whit Alexander

Philip Bruno

Robert Byrne

Liam Caffrey

PrasenjitChakravarti

David Chubak

Marco De Freitas

Benjamin Ellis

Daina Graybosch

Tommy Jacobs

Piotr Kaminski

Rami Karjian

Akshay Kapoor

Catharine Kelly

Nick Malik

Robert Mau

James McKay

Howard Moseson

Sudip Mukherjee

Fritz Nauck

Sandra Nudelman

Marukel Nunez

Pradip Patiath

John Patience

Greg Phalin

Leonardo Rinaldi

Pablo Simone

Vik Sohoni

Dorian Stone

Sarah Strauss

Ameesh Vakharia

Tim Welsh

Nick Malik

Director

(212) 446-8530

nick [email protected]

Christopher Leech

Director

(412) 804-2718

chris [email protected]

Contact

For more information, contact:

Marukel Nunez

Principal

(212) 446-7632

marukel [email protected]

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