fostering rewarding customer relationshipsWinning banks will utilize superior skills and strategies to thrive in this languid recovery.

Customer Lifecycle: maximizing Value holistic approach to small Business Customers

Behavioral life: Predicting Customer Patterns

VOL. 1 NO. 4 2010

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VoL. 1 no. 3 | 2010

Inside:

Small Business Banking: Agenda for Relationship Growth

The Case for Building Customer Lifetime Value

The Portfolio Approach to Asset Allocation

Mass Affluent Strategy: Tilting from Investments to Payments

Prescription for Cross-Sell: Customer Lifetime Value

Transform the Branch Model — Before It’s Too Late

Feature report

New Strategies for Relationship Expansion

as retail banks fight for growth through market share gains, ex-ecutive management will need to create explicit strategies in order to to cultivate fuller customer re-lationships.

Linking Customer Behavior with Risk Management

the recent financial crisis has sparked a new level of collabo-ration between the treasury and customer oriented business lines, centered on in-depth analysis of account behavior.

Looking Beyond Products to Customer Lifetime Value

in an ongoing tight market, banks can no longer pump out an as-sortment of their very best prod-ucts and rest assured that profits will come rolling in.

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Strategic Turning Pointseldom will a single bank be able to fulfill 100% of the customer’s financial services needs, but does that mean it should settle for the current average of about 15% to 20%? it is a vexing question at a time when banks are hungry to win business in a tight market.

after two decades of trying, banks are in need of breakthrough successes in selling multiple products to each customer, as explored in this issue of the Novantas Review. our cover story, “new strategies for relationship expansion,” discusses the manage-ment challenges in coordinating major product groups for a fuller customer outreach.

in many cases, a narrow view of short-term product profitability is obstructing the larger view of total customer needs. a better approach, as detailed in “Looking Beyond Products to Customer Lifetime Value,” is to analytically consider the full range of cus-tomer possibilities over the life of the relationship, and then set a tight list of cross-sell priorities that will unlock the greatest value for the customer and provider alike.

one issue for the bank is assembling composite information. as revealed in “small Business Banking, setting the agenda for relationship growth,” half of the major banks in a recent novantas survey said they could not yet measure progress in serving the household financial needs of small business customers. overcoming such challenges will be the hallmark of winning banks in the race to more fully serve each individual, household and small business.

Steve Klinkerman Steve Klinkerman Editor-in-Chief

“Banks are in need of breakthrough successes in selling multiple products to each customer.”

Letter from the editor

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New Strategies for Relationship Expansion

typically in banking, a single institution serves no more than 15% to 20% of the customer’s total financial service needs, meaning that 80% to 85% of the relationship potential is lost to competitors. it is a persistent issue that goes to sleep during market expansions and roars back to life when the revenue tide recedes during a downturn.

this system actually can work quite well in a strong mar-ket, where surging customer demand helps to satisfy the es-sential quest for sales volume. in turn, banks see less of a need for a coordinated marketing and sales outreach and in-depth composite knowledge of customers and households.

instead of a temporary discomfort, however, relationship fragmentation now poses a sustained challenge for the bank-ing industry. revenues simply will not be rebounding to any-thing approaching pre-recession levels anytime soon. in the meantime, how can banks afford the massive duplication of expensive branch capacity that occurs when the typical cus-tomer goes to five different institutions for financial services?

we are entering an era when there will be towering pres-sure to take costs out of the branch network, not only because of recession after-shocks, but also because of an accelerating

customer migration to alternative distribution channels. Cur-rently, roughly 15 out of every 100 branches have a nega-tive operating margin nationwide, according to our research. and that ratio will jump to roughly 18% once the impact of new restrictions on checking overdraft and debit card fees is fully realized.

there is a very real risk in radical branch cost reduction. it disturbs the primary anchor for retail customer relationships and the potential for future growth. according to a recent novantas survey, for critical transactions such as opening ac-counts, a majority of consumers still prefer the branch, mak-ing deposits and resolving problems.

the higher road will be to leverage the branch network through relationship expansion, garnering new revenues by winning a greater share of the customer’s “financial wallet.”

winners in this new contest will come out permanently stronger. Banks that lose even more wallet share, by contrast, ultimately could be at risk of losing their independence — cost-cutting will not tide them over.

the question is whether or not executive management can come up with specific strategies for relationship expansion.

As retail banks fight for growth through market share gains, executive management will need explicit strategies to cultivate fuller customer relationships.

BY rick Spitler

�December 2010

Blanket, high-intensity cross-sell tends to bombard custom-ers with irrelevant offers — ineffective and also irritating. a moderately successful approach (often seen today) is selling additional products within categories, such as an additional savings account to a saving household. there is only one path to high-potential cross-sell, and that is selective selling across product categories, a strategy that can lead to an enormous boost in relationship profitability — multiples in many cases.

thus the challenge is to set clear priorities for relationship expansion, in line with customer needs and opportunity for the provider. this roadmap is critical in marshalling the re-sources of the organization for tangible revenue results.

through the lens of customer lifetime value, the institution can consider the full range of opportunities over the life of the customer relationship. from this multi-dimensional analysis, the bank can identify the select types of offers which have the highest potential with various major customer groups.

Leveraging the branch network through relationship expansion, will garner new revenues and win a greater share of the customer’s “financial wallet.”

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new strategies for relationship expansion

importantly, this type of strategy will require a higher level of cooperation among the various product units within the bank. this is precisely why executive management must play a central role. Many larger customer opportunities get overlooked when business units narrowly focus on their own products and sales goals. solid information and marketing bridges must be built to overcome this persistent tendency.

C-LEVELCHALLENGEthe value of effective cross-sell extends well beyond numeri-cal count and product margins. in-depth customers tend to stay with the bank longer and make higher use of their prod-ucts. they give the bank a higher priority in the repayment of debt. in many cases, price sensitivity falls as the focus turns to rewards, recognition and service. also, cross-sell can be far more cost-effective, compared with a product-by-product effort.

this is a case where the total value truly exceeds the sum of the parts. there is a definite “relationship premium” that is realized in effective cross-sell, in turn, this is one of the primary tools that successful banks will use in combating the ongoing revenue drought and shoring up the economics of the branch network.

from an executive management perspective, however, a renewed emphasis on cross-sell reintroduces an age-old problem — lack of coordination among the product silos. there is a strong insular tendency among the business units, which tend to be slow in referring clients to each other, and in sharing customer information.

internally, one place where the problem manifests itself is in annual planning and budgeting. typically, this exercise is heavily centered on the individual business units within the bank, with each group focusing on its own revenue and profit goals, and the resources needed to achieve them. then in cus-tomer-facing activities, the problem manifests itself in myriad individual product campaigns which focus primarily on unit sales, with little or no collective consideration of composite consumer and household needs.

to succeed in the new environment, executive manage-ment will need to ensure proactive collaboration among the product silos — a difficult and longstanding banking industry challenge that simply must be mastered. from time to time, each product area has valuable touch-points with the cus-tomer. in these fleeting moments of opportunity, an outreach is needed that (intelligently) extends beyond promoting an additional widget from within the same product family.

in considering how the business units should work to-gether to achieve the full potential with each customer, an extreme answer is to “tear down the walls” between the busi-ness units. in addition to being complicated, such aggres-sive integration risks disturbing the management integrity of critical banking activities. a major product line, such as the credit card, has its own marketing, processing and risk man-agement dynamics, which require continuous focused atten-tion. any linkages elsewhere within the bank need to be well-defined, and also well-justified from a revenue perspective.

in turn, executive management will be looking for selec-tive multi-silo initiatives that amply justify the effort that goes

“For bank executive management, the challenge is to come up with a clear set of strategies that will capture cross-sell opportunities in a focused way, meaning maximum effectiveness with customers, and minimum waste and maximum return for the institution.”

�December 2010

into them. in our work with major banking companies, we have seen a tight list of projects gaining significant traction.

• Priority cross-sell to consumer households.• Priority cross-sell to small businesses and their house-

holds.• improved credit origination decisions, risk manage-

ment and collections.• improved financial management and customer seg-

ment targeting.sharp analytical guidance will be needed in these initia-

tives. even with certain high-potential categories of cross-sell, the uptake can differ sharply among various customer groups. Currently, many banks are targeting their “best customers” for home equity loans. that will be ineffective for customers who currently are valuable on the basis of money market de-posit balances as they are liquid already and probably don’t require additional interim credit.

to avoid such traps and take maximum advantage of proactive cross-sell, the bank will have to consider critical questions about required customer information, the level of analysis that will be needed, priority applications and the various implementation factors that will be essential to suc-cess. typically, for example, we find that the bank has some work to do in unifying scattered bits of customer information into a composite picture of individuals and households.

Multi-silo projects will need to be broken into their major components and then evaluated within the context of a busi-ness plan. often, the head of retail banking will take the leadership in making this happen.

IMPLICATIONSOFCUSTOMERLIFETIMEVALUEQuite extensively in banking today, revenue progress is mea-sured in terms of product scorecards, typically centered on current-year sales volume and profitability. this nomenclature runs through a long chain of activities, including business unit planning and management; financial reporting; marketing and branch sales.

rare, however, is the institution that understands the depth of relationship with each customer and household. Pattern recognition becomes a difficult exercise if the customer re-lationship can only be partially viewed through a series of product lenses.

Customer lifetime value seeks to close this gap by con-sidering the full interaction with the customer over the life of the banking relationship. as an example of the difference this makes in decision-making, consider the current bank-ing challenge with the demand deposit account. given the successive crackdowns on overdraft and debit fees, there is a tendency to back away from checking. But this short-term

view overlooks the fact that checking’s potential CLV is still quite attractive — $3,000 to $4,000 — provided the bank can follow through with effective cross-sell of the right down-stream products.

“To succeed in the new environment, executive management will need to ensure proactive collaboration among the product silos — a difficult and longstanding banking industry challenge that simply must be mastered.”

in these and other instances, the bank will be well-re-warded for the effort it expends on relationship diagnostics and priority cross-sell. However, the benefits can only be re-alized through the direct involvement of executive manage-ment. CLV may be the ultimate interdisciplinary goal within the bank — potentially powerful yet critically dependent on coordination, cooperation, and disciplined applications.

one major executive consideration falls under the head-ing of composite customer information. as an example of the challenge, in a recent novantas survey of best practices in small business banking, fully half of the respondents said they were not yet able to track the household consumer bank-ing accounts of their small business customers. Major busi-ness lines seldom rally to close such informational gaps on their own.

a second major success factor with CLV is customer ana-lytics. to identify priority cross-sell initiatives, the bank needs to be able to sort through a large set of possible product combinations and offer sequences, and arrive at a select list of offers that will provide the highest value to both the customer and the bank. in one instance, the retail banking division of a major bank initially evaluated more than 200 cross-sell possibilities, eventually narrowing down the consid-eration set to somewhere between 12 and 15 possibilities that would capture the lion’s share of the opportunity.

a third success factor falls under the heading of imple-menting targeted marketing campaigns — following through to match the right offers with the right groups of targeted customers in the field. in the post-crisis economy, mass-market product promotions will be far less effective in the face of slack demand. fourth, within the branch network and call centers, there are interrelated staff considerations, including informational prompts, coaching and training, and sales in-centives.

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new strategies for relationship expansion

CLAIMINGMARKETSHAREas banks gear up for extended tight market conditions, the huge cost overhang of the branch network will provoke an inevitable battle for market share. the bank that best utilizes its branch sales capacity will have the best chance of retaining strengths during the revenue drought. the clear priority is doing more business with each customer.

for executive management, the challenge is to create a clear set of strategies that will capture cross-sell opportuni-ties in a focused way, meaning maximum effectiveness with customers, and minimum waste and maximum return for the institution. fortunately, this path has at least partially been

paved by advances in information tools, permitting a much more effective approach to cross-sell than what was seen when the concept first attracted widespread attention 15 to 20 years ago.

already in the industry, we are seeing instances where major regional banks have worked through some of the cross-silo information and coordination requirements and started to come to grips with some of the core issues in re-lationship expansion. simply by establishing priority cross-sell marketing initiatives, they have been able to cost-justify initial efforts to build CLV, and they anticipate further mo-mentum as the various product lines within the bank col-laborate even more strongly to serve customers fully and proactively.

in this sense, the current revenue drought actually pres-ents a defining moment for many institutions. a certain lev-el of organizational transformation will be needed to make it through the next few years, yet the winners will come out permanently stronger. By contrast, there is very real pos-sibility that banks with a “steady-as-she-goes” philosophy will lose further ground.

Rick Spitler is a Managing Partner in the New York office of Novantas LLC, a management consultancy.

“As banks gear up for extended tight market conditions, the huge cost over-hang of the branch network will provoke an inevitable battle for market share.”

�December 2010

Linking Customer Behavior with Risk Management

Traditionally within the Treasury group, efforts to anticipate customer behavior center on generalized estimates of interest rate sensitivity. But the focus is rapidly expanding following the dislocations of the recent financial market crisis.

BY Steve turner

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Linking Customer Behavior with risk Management

Beset on all sides with funding uncertainties, institutions found that they needed far more detailed information about the various categories of depositors and bor-

rowers along with how they likely would behave in various stress scenarios. this sparked a new level of collaboration between treasury and customer-oriented business lines.

the concerted effort has opened a vault of detailed cus-tomer behavioral information as well as a new frontier of bank financial management. fairly rapidly, progressive banks have discovered a suite of applications, including:

• an enhanced ability to identify customer segments for tailored treatments and pricing, based on clear definitions between core and marginal customers;

• improved hedging results, as permitted by more finely-grained funds transfer pricing and more robust asset/liability equations of anticipated customer be-havior in a variety of scenarios; and

• an expanded range of longer-term investment pos-sibilities based on a more thorough identification of assured long-lived deposits — both in stable and stressed environments — that can be used to support equally long-term investments.

these advances capitalize on the thorough study of customer account behavior. Progressive bankers specifically evaluate how accounts behave over time, rather than rely-ing on general mathematical estimates based on the portfolio average for all customers. they then develop perspectives on potential future behavior, along with anticipated consistency over time and in varying environments. Ultimately the bank is able to identify differentiated behavioral segments and take appropriate actions with each one.

Looking through the new lens of “behavioral life,” cus-tomer-facing business lines and treasury can identify a fuller range of account drivers affecting balance augmentation, diminishment, and attrition. this provides a methodical basis for identifying and treating major customer segments within the overall portfolio.

as a result, customer-facing groups have much better seg-ment-level insights on customer behavior, and treasury has a better understanding of how these customers will affect over-all balance sheet structure. along with refining bank financial management, asset/liability measurement, and regulatory compliance, such insights can be used in targeted marketing, product design and pricing.

AMATTEROFNECESSITyas is almost always the case, necessity forced many institu-tions to invest in tools and approaches that otherwise would not have been considered valuable. the recent financial cri-

sis was a catalyst for these investments, given its profound impact on bank balance sheets and funding.

at the height of the crisis, it became imperative for bank management to understand the nature as well as stability of the institution’s funding sources across the full spectrum. Management also needed a way to anticipate the likely be-havior of borrowers, particularly those with lines of credit that could be drawn upon at any time.

rate sensitivity analysis was inept to this task, given that bankers needed to understand how a variety of factors might affect funds suppliers and users. an expanded analysis had many aspects:

• first, how would depositors and other funds suppli-ers react if the bank’s financial condition visibly de-teriorated? which customers would pull their funds, and which would stay? How would these behaviors change if there was a continued slide?

• at the same time, customers were being battered by the economy. How will the institution be affected as throngs of customers lost jobs, saw their housing val-ues drop precipitously, and searched for stable places for their savings and retirement funds?

• finally, banks saw interest rates sink to troughs un-precedented in our lifetimes. absent any semblance of steady-state market conditions, the bank needed insights beyond traditional rate sensitivity analysis.

• analyses based on aggregated portfolio information could not cope with the size and speed of these cross-currents. decision-makers were stymied by limited in-formation that was confusing, relatively useless, and certainly not actionable.

this crisis provided justification for building new bridges between customer groups and treasury, given the shared ur-gent need for deep, detailed and reliable information. need-ing a way to discern between core customers and marginal customers, banks turned to detailed analysis of customer ac-count behavior. now, progressive banks are routinely using this knowledge of differentiated behavior. applications in-clude improving liquidity management and hedging in trea-sury, as well as tailored pricing and customer targeting in the customer-facing business lines.

CUSTOMERDIFFERENCESwhen customer behaviors are disaggregated, differences between customer segments become clear, both within and across product lines. it also becomes evident that these pat-tern differences can be systematically identified and then used to predict likely customer behaviors in a variety of scenarios going forward.

11December 2010

Moreover, segment behavioral differences go beyond traditional top-down views that “consumer deposits are sta-ble” and “business deposits are unstable.” Yes, there is a large pool of highly stable and predictable consumer depos-its, but even these deposits evidence decay and variability over time, and it is worthwhile to study these patterns.

the following two graphs display distinctively different customer behaviors in two products. each graph shows the history of 60 separate customer cohorts over time. that is, we tracked all of the customers who acquired each product 60 months ago, and then determined how many customers remained after each month of decay. we did the same for customers who entered the product 59 months ago, etc. the graphs then answer the question: “How many customers will retain this product after “x” number of months, and what level of confidence can be placed in this prediction?”

in figure 1, based on a disguised case study, the decay profile graph shows a 20% customer attrition rate after 12 months, with 80% of the customers remaining. it also shows little difference in pattern among the 60 cohorts. Clearly, this product has predictable and long-lived customer behaviors, and customers in this product are highly valuable.

By contrast, the account decay patterns displayed in fig-ure 2 are quite different, with highly unpredictable behaviors

that generally appear to decay much faster than the customers in figure 1. the customer group on the margin is not one that is highly desirable. their behavior is unpredictable, hence compli-cating investment and hedging decisions on the balances repre-sented by this group.

this level of detail had been previously untapped and unused at most institutions. even when considering customer interest rate sensitivity, treasury and finance groups often only go so far as to create probabilistic estimates of average balance fluctuations in response to market rate changes.

along with other metrics such as average account turnover, these insights are used to make important decisions about port-folios ranging from hundreds of millions to billions of dollars. this conventional approach is not ade-

quate for the complicated tasks of asset-liability management, hedging interest rate risk as well as preserving liquidity in a variety of scenarios. Post-crisis, it is clear that the underlying measurement accuracy of customer product portfolios within banks had not kept up with advances in the tools available to measure these portfolios. in addition, the customer context has been too narrow. the various bank regulatory agencies have taken notice of this as well. examiners have become increasingly aggressive in questioning management assump-tions as well as their accompanying contingency plans.

“Customer-facing businesses and Treasury groups will soon realize increasing benefits from sharing and using information that is core to how the other group thinks.”

a further drawback of aggregated product-level rate sen-sitivity analysis is not providing a basis for proactive customer outreach. it does not help in identifying sweet spots in prof-itable and loyal balance formation, for example, either by

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Customer Tenure (Months)Source: Novantas, LLC

Account Attrition Analysis Based on 60 Successive Monthly Origination Cohorts. With some customer groups and product sets, accounts behave quite consistently.

Fig. 1: customer account profile — predictable Behaviors

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Linking Customer Behavior with risk Management

customer segment, regional market or type of product. that deprives the bank of a basis to evaluate the larger universe of behavioral drivers that affect prime customer groups.

for a large group of customers, fluctua-tions in local housing prices and employment are the dominant influences in short-term bal-ance formation, both with deposits and short-term credit. along with quantifying the extent and overall impact of such influences, the pro-gressive institution will want to pinpoint the most- and least-susceptible sectors of various regions and customer portfolios.

ENHANCEDMETHODOLOGyaccount behavior stands largely neglected as a source of customer insight in many ar-eas of banking, despite the rich information it offers. in many instances, management sim-ply does not perceive a tangible benefit that sufficiently exceeds the effort and expense of mining the data. also, there is a lot of uncer-tainty about analytical technique — every ma-jor bank has stories about chasing down trails that ultimately led nowhere.

Behavioral account analysis, however, stands on a solid foundation that has been built in areas outside of traditional banking. for decades in the credit card industry, for exam-ple, management has closely tracked each successive wave of new card originations, monitoring factors such as bal-ance formation and repayment patterns over the life of each account. along with emerging trends, card issuers study the dispersion of results within each “vintage,” using the find-ings to optimize current relationships and refine new waves of offers.

in banking, the analysis of the behavioral life of accounts begins with the monthly tracking of each new wave of ac-counts for a particular product. each new “cohort” is tracked over the complete life of the accounts that it contains. from there, as a monthly time series is built, it is time for pattern recognition, including trends and the dispersion of results.

our research indicates that the findings are not only strongly predictive, but also quite valuable in engaging with different customer segments. this analysis provides a key in-dicator for issues requiring deeper investigation. what are the salient characteristics of the high-tenure group? what market factors most strongly correlate with changes in their account behavior?

Knowledge from such segment-based cohort investiga-

tions then becomes a basis for a variety of decisions and activities beyond basic internal financial management.

• hedging: what are the strongest non-rate drivers of balance diminishment and attrition? what are the implications for preserving liquidity and margins in a variety of market scenarios? what proactive steps would be appropriate in interacting with customers in unstable segments?

• pricing: Based on direct and systematic observation of account behavior over time, which customer groups are comparatively less sensitive to price? which cus-tomer groups are the most sensitive? How should that information be factored into new offers?

• targeted marketing: what are the priority customer segments for various types of offers, and what prod-uct positioning will best resonate?

• product design: what product features do the best job of encouraging customer tenure and profitable account behavior, and which might actually be coun-terproductive?

RELATIONSHIPCREDITwhile management quite properly wants to know the prior-ity applications coming out of account behavioral analysis,

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Fig. 2: customer account profile — Volatile Behaviors

Account Attrition Analysis Based on 60 Successive Monthly Origination Cohorts. With some customer groups and product sets, accounts behave quite inconsistently.

Source: Novantas, LLC

1�December 2010

the immediate answer may well differ among institutions, and in any case probably will not come clear prior to a preliminary analysis. although the techniques used in be-havioral life analysis have been around for some time, the ways that these analyses are being applied along with the insights they generate, are new. Many institutions actually have little idea of the patterns that they likely will encoun-ter. there will be a learning curve, and for some, maybe even a shock curve.

generally, however, there are three immediate benefits that bank financial managers and business lines should be working to capture through account behavioral analysis in 2011 and 2012:

1) the first priority is to improve the internal calibration of deposits and loans. this includes a better under-standing of customer account behavioral life and interest sensitivity, and the dispersion of behaviors in various scenarios.

2) second, business lines will be employing these approaches to produce much more finely-grained measurements than those usually used by treasury in the funds transfer pricing system. where treasury will customarily receive anywhere from six to 12 segments for setting funds transfer pricing rates, the business lines may have 60 or 70 separate marketing segments to work with. this granular information is being used by the business lines to identify and pursue high-value customer segments; adjust pricing strategies; and to guide and evaluate the performance of relationship managers.

3) third, treasury is building better hedge structures — and doing so with greater confidence, knowing the realistic boundaries within which loan and deposit behaviors will likely fluctuate. Product behaviors are being incorporated into asset/liability models, creating a clear picture of the hedging risks built up in the portfolio.

we are at the onset of what will likely be an extended era when customer-facing businesses and treasury groups will realize increasing benefits from sharing and using information that is core to how the other group thinks.

Progressive treasury groups will build increasingly ac-curate asset/liability measurement models using deep cus-tomer insights. Meanwhile, customer-facing business lines will combine new understandings of customer behavior to-

gether with improved valuation techniques from treasury. results will be used both to build and to market products with focused identification of target customers. together, treasury and the business lines will incorporate customer account behavioral insights into robust funds transfer pric-ing systems, based on improved measurements of interest sensitivity and liquidity behavior.

Bankers who have employed these approaches have consistently been overwhelmed by the amount of informa-tion that has been forthcoming. Many are building second-generation infrastructures to better utilize this information in financial and business line management. the bankers that have made this transition are quickly progressing to greater levels of insight and effective action that will give them a significant advantage over competitors who are not developing these tools.

Steve Turner is a Partner in the New York office of Novantas LLC, a management consultancy.

“Along with refining bank financial management, asset/liability measurement, and regulatory compliance, such insights can be used in targeted marketing, product design and pricing.”

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Looking Beyond Products To Customer Lifetime ValueBY Sherief MeleiS

Ever since large-scale banks began surfacing more than four decades ago, the manage-ment division of labor has centered on products and channels. Each product team primarily focuses on meeting its individual profit goal for the year, with far less emphasis on building the overall profitability of each customer relationship over time.

this system actually can work quite well in a strong market, where surging customer demand helps to satisfy the essential quest for sales volume. in turn, banks see less of a need for a coordinated marketing and sales outreach and in-depth composite knowledge of customers and households.

But times have changed. there is a revenue drought in retail banking, provoked by a triple whammy of slack de-mand, a flat rate environment and a legislatively-induced fee revenue crunch. institutions can no longer pump out an as-sortment of their very best products and wait for profits to come rolling in.

instead, growth will critically depend on claiming a larger share of a shrunken revenue stream. relationship acquisition will remain important, but ultimately relationship expansion will win the day, with much greater emphasis on established customers. that means winning more of the business frag-mented among multiple providers. the next few years are shaping up as a wallet-by-wallet battle for market share. win-ners will be the ones that more fully serve each customer.

to succeed in this quest, banks will need to look beyond individual products to the total customer relationship. along with more carefully considering the full range of customer needs, banks will need a more robust frame of reference to manage and measure their progress. Customer Lifetime Value (CLV) is this frame of reference.

along with considering the big picture of customer needs, CLV examines how various individual products mesh with each other to encourage cross-sell and build long-term rela-tionship profitability. it also explicitly recognizes the “hidden value” in deep customer relationships, including the potential for lowered credit risk, longer account tenure and higher us-age and improved pricing, and factors this into decisions.

today, a bank provides only 15% to 20% of the total fi-nancial service needs of a given retail household, meaning that 80% to 85% of the opportunity is often divided among competitors. winning banks will shift those odds in their fa-vor, and Customer Lifetime Value is one of the major tools they will use to do it.

1�December 2010

SELECTIVEAPPROACHwhy isn’t the answer to the banking revenue challenge, a blanket, high-intensity cross-sell? for one thing, the level of receptivity for various product offers differs sharply among customer groups. equally skewed is the value realized by the provider, depending on the specific transactions and behav-iors of a given customer or household.

thus, selectivity is of critical importance in profitable re-lationship expansion. only by considering the total customer relationship can banks identify the right high-value offers for the right set of customers. targeted cross-sell of home equity loans, for example, can trounce a typical mass-market cam-paign for the same product.

in the same vein, it is important to look at the full life of the customer relationship, and not just the current-year profit picture for individual products. By motivating customers to actively use their debit cards for example, the bank may see a substantial improvement in customer loyalty, and even re-duced credit losses on loan products (as the more involved customer feels a greater sense of repayment obligation).

there are several components of an action plan based on Customer Lifetime Value. Most immediately, these in-clude: 1) recognizing the “hidden value” in deep customer relationships; 2) identifying the customer behaviors and product combinations that really matter (from a total CLV perspective); and 3) setting immediate priorities, based on knowledge of the total customer relationship. Longer term, CLV can be incorporated into a variety of customer-facing activities and decisions in the organization.

hidden value. in building the specific business case for relationship expansion, it is important to look beyond the obvious fact that providing two profitable products to the customer is better than just one. Powerful additional benefits include:

• Lowered credit risk, given that institutions with deeper ties to consumers are likely to be placed higher in the repayment hierarchy;

• Longer life and higher usage, given the extra sticki-ness that is observed when customers commit more of their finances and transaction stream to a bank;

“Relationship acquisition will remain important, but ultimately relationship expansion will win the day, with much greater emphasis on established customers.”

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Looking Beyond Products to Customer Lifetime Value

• Higher pricing power, reflecting an attitudinal shift that occurs as in-depth customers place more empha-sis on intangibles such as rewards, recognition and service.

our research indicates that, the average lifetime value of a consumer banking customer ranges between $2,000 and $4,000. for a small business banking relationship, the CLV total can approach $10,000 (especially when the bank is able to serve both the enterprise and the household financial needs of the proprietor).

while the total value can be significant, it is not self-op-timizing. the individual drivers of CLV must be studied and nurtured in a systematic manner.

“Acquisition will remain important, but ultimately relationship expansion will win the day, with much greater emphasis on established customers.”

SySTEMATICSEARCHto set a solid foundation for cross-sell, activities must be iden-tified and prioritized within the context of customer needs and receptivity, along with variations in economic potential. Banks will need answers to the following questions:

What is the best first product? the longstanding answer has been the checking account, but at a time of reduced account turnover and fee revenue potential, banks need to expand their thinking. for example, other valuable points of entry to a profitable customer relationship include the credit card or the money market deposit account.

What is the subsequent “path to profitability”? after a new customer comes to the bank for example, cultivating an active payment relationship particularly with online bill pay and active debit, has proven to be a critical driver of CLV. another valuable follow-on is the home equity line of credit.

it can be enormously helpful to serve the customer in mul-tiple product categories. in the best circumstances, expand-ing the retail customer relationship across deposits, loans and investments can propel a more than five-fold boost in Customer Lifetime Value.

What about targeting and sequencing of offers? as the bank improves its analytical understanding of customers, then it can begin to refine offers for major customer groups, and focus on selectively presenting various offers where they will do the most good. as an example of how conventional

practice falls short, targeting the home equity product to all of the “best customers” (a fairly standard technique at big banks) is ineffective for customers who primarily are valu-able in terms of high MMda balances — they have liquid resources and likely don’t need credit.

in many cases, banks have opportunities to improve their anticipatory sales strategies, based on an understanding of customer stage of life, major life events, and an analytical un-derstanding of likely cross-sell progressions from one product family to another. along with being financially constructive, this sort of proactive outreach brings authenticity to a rela-tionship orientation.

What are the core enablers of cross-sell and clV? trans-action intensity can make a big difference in CLV, not only with the primary checking account, but also with the credit card account. the biggest driver of high CLV continues to be capturing the primary payment relationship, including direct deposit, online bill pay, and active debit card usage.

POTENTIALAPPLICATIONSas leading banks work through these questions, they are us-ing the findings for various important applications, such as: marketing and promotions; relationship packaging and pric-ing; relationship credit; organizational incentive design; and sales processes and targeting.

marketing and promotion. especially in an uneven econ-omy, it is critical to concentrate scarce marketing resources where they will do the most good. CLV insights help the bank rise above individual business lines and consider the total potential for value creation among prime customer groups. as an example of how this helps, consider the question of customer promotional incentives, such as a $150 “bonus” on account opening. such an outlay can be a bargain if it helps to acquire a $4,000+ CLV customer, as is possible within certain customer segments. in this and a myriad of other instances, CLV is the compass that winning banks will use to set priorities for customer acquisition and relationship expansion.

relationship packaging and pricing. Banks have only taken baby steps in developing relationship-based products and pricing strategies, with many institutions automatically slapping discounts on multi-product offers — not always nec-essary and not always in line with customer expectations for rewards, recognition and service.

for a more rational and productive approach, the bank first needs to understand the value produced by the sale of different product combinations — critical in determining how much can be shared back with customers in the form of discounts, rewards, etc. the bank also needs to understand

1�December 2010

what “currency” customers really value. this includes price levers (both rates and fees), and non-price features such as rewards, premium service as well as enhanced functional-ity (combined statements; auto-transfers between accounts; payments services and information; etc). Understanding both sides of this equation will enable banks to offer rela-tionship pricing and other kinds of benefits that optimize value both for the customer and for the institution.

relationship credit. in more than a few instances, the progressive bank should be able to underwrite credit that other providers cannot, simply by virtue of the superior in-formation access provided by in-depth customers (this gets back to the importance of capturing the core payments account). also, the bank that is able to look at the total customer relationship has an improved opportunity to spot unfolding household credit distress and work with custom-ers before situations spin out of control.

“Along with more carefully considering the full range of customer needs, banks will need a more robust frame of reference to manage and measure their progress.”

incentive design. refining sales incentives is an ongoing challenge in the branch. Volume-based performance metrics often back fire which encourage representatives to go to extremes in originating accounts that have little or no po-tential. through CLV, the bank can re-orient sales incentives around the opportunities that matter most, in terms of acquir-ing and expanding profitable customer relationships.

sales process and targeting. CLV helps to narrow down the cross-sell menu to a short list of targeted offers that will generate the greatest value for the bank and customers alike. By understanding each “path to profitability,” banks can identify the highest-value “next product” at each stage of the customer relationship lifecycle. and because of the thoughtful construction that goes into these offers, they pro-vide a valuable context for staff training, coaching and sales management.

early sucess of this effort lies in targeted initiatives that, through intelligent marketing, allow the bank to get more mileage out of the current product set — without a lot of re-invention. for example, one major regional bank was able to lift its home equity cross-sell effectiveness by more than 15% by establishing a multi-faceted relationship filter that al-

lowed it to focus on a prime subset of the most eligible and potentially receptive customers within the retail bank.

FOLLOwINGTHROUGHobviously, CLV enables a distinctly different approach than what was seen 15 to 20 years ago, when cross-sale first gained widespread industry attention. early attempts were more of a product-push exercise, with lots of time wasted on low-value or implausible offers, and less consideration given to underlying customer needs.

But various kinds of preparation will be needed inside the institution. the marketing team will need to develop robust models that will accurately measure the total lifetime value of every customer, and communicate this information in a way that is clear and credible with other constituen-cies within the bank. individual product teams will need to collaborate with distribution if the bank is to succeed with centrally-designed cross-sell offers that branch and call cen-ter reps can sell within a relationship context.

executive management will need to bring these groups together in a focused way that unlocks opportunity with minimum strife and wasted effort. one issue, for example, is that individual product silos typically have their own per-formance goals which discourage feature or pricing trad-eoffs while successful with customers, might cut the profit-ability of an individual product line. institutions will need to establish mechanisms allowing for transfer pricing between product groups (for example, with relationship pricing). to be clear, this is not a call to immediately reorganize banks around customer segments. However, there is a pressing need for an informational overlay that will allow banks to effectively pursue customer-focused initiatives within the current product/channel hierarchy.

some banks are already solving the management and operational problems to make this happen. others have a long way to go and they will be at an increasingly com-petitive disadvantage, as they work to solve this problem. while some level of substantial effort is required to expand relationships and CLV, it is not clear that banks have an-other choice, given the prospects for a continuing revenue drought. Banks simply must find a way to generate more value from their established customers.

Sherief Meleis is a Partner in the New York office of Novantas LLC, a management consultancy.

1�

Small Business Banking: Agenda For Relationship Growth

such instances were less of an issue during the boom years. Banks saw less need for a highly orchestrated small business strategy in an era when double-digit growth was the norm for loans, deposits and fee revenues.

But the picture certainly is different now. while the small business customer segment has held up better than many oth-er banking books of business, the recession has taken its toll. there is a significantly smaller pool of credit-worthy enter-prises with an appetite for borrowing. and the fed’s new reg Q, deregulating the payment of interest on business deposits, could eventually impact margins in that business as well.

the upshot is that for the next few years, banks will be facing intense competition for a tightened pool of small busi-ness customers, especially high-value relationships that gen-erate the lion’s share of sector revenues. in-depth strategies that formerly may have been viewed as “nice to have” now will be essential in the relentless quest to gain profitable mar-ket share.

small business bankers will need to look at the whole customer relationship, both business and household, and systematically identify profitable cross-sell opportunities in line

with priority customer needs. targeted marketing to the right clients and prospects will be essential, with less emphasis on mass-market product promotion. then there is an entire chain of decisions in refining the array of sales resources, placing sales personnel in the right local markets, and providing sales expertise appropriate to the opportunity. four concepts will be central in these growth initiatives:

1) “sweet spot” capacity configuration, which concen-trates sales resources in the local markets with the highest potential demand from both customers and prospects.

2) customer lifetime Value, which analytically consid-ers the full range of client opportunities, not just the current-year profitability of individual products.

3) refining the specialist equation, providing the right level and type of sales expertise in the branch and in the field.

4) Branch sales optimization, a continuing challenge for many banks.

recent novantas research indicates that the small busi-ness banking relationship can potentially generate from five

Even in the best of times, small business banking has not always been pursued with a co-hesive focus at many institutions. In a recent survey of major U.S. banks, for example, half said they were not yet able to internally measure progress in serving the financial needs of the small business owner’s household.

BY leS dinkin

1�December 2010

to 10 times the value of the average re-tail banking relationship. in many cases, banks have come nowhere close to real-izing this potential, instead standing by while up to 80% of the client’s business is divided among competitors. winning banks will create deep relationships with high-potential customers over the next few years.

CUSTOMERVIEwPOINTin considering whether or not to expand the banking relationship, small business-es customers tend to rely on a simple but powerful set of experiential criteria. first, they often act on the basis of a positive experience with the current banking ar-rangement, however simple it may be. second, they often are persuaded on the basis of added convenience and the prospect of freeing up more time to fo-cus on running the business. third, they may seek more leverage in the banking relationship, such as improved pricing, higher levels of service, or various types of rewards and recognition.

these requirements often present is-sues for banks, even before getting to the basic questions about products and services. Many small business customers

feel they are not being served with the proper level of exper-tise. Convenience can be undermined as customers rotate be-tween branch managers, branch counter representatives and field specialists, searching for responsive service. and rare is the bank that consciously puts together relationship value propositions that encourage multi-product purchases.

there is also a need for more proactive customer manage-ment. representatives tend to focus on individual products, and only on an episodic basis, with little or no systematic intelligence from the parent bank as to which offers might

elicit the highest likely customer receptivity while generating the highest value for the bank. in such circumstances, it is easy to see how opportunities can slip through the cracks. in a complex branch network that is largely preoccupied with serving retail consumers, only a small amount of staff effort is devoted to tailoring the small business customer experience. Bankers do the best they can and may even begin to assume that nothing better is even possible. Meanwhile, most plat-form sales representatives do not feel competent or confident in conversations with small business customers.

“Representatives tend to focus on individual products, and only on an episodic basis, with little or no systematic intelligence from the parent bank as to which offers might elicit the highest likely customer receptivity while generating the highest value for the bank. ”

�0

small Business Banking: agenda for relationship growth

Before embarking on new sales growth strategies, it is important to acknowledge a major organizational challenge that directly contributes to many of these performance short-comings. that challenge is coordination between business units. at most banks, what we have today is a loose assem-blage of customer-facing activities. Various branch bankers and specialists operate on different incentives, report to dif-ferent managers and business units and even use different market and customer information.

such management fragmentation can work against per-formance improvement initiatives. that is why organizations that are serious about improving small business banking must first unify the leadership of the function.

in our experience, the small business unit performs more strongly when solidly parked within the retail line of business, with leadership that closely interacts with the retail team to co-ordinate initiatives through the branch system. alternatively, it should operate as a standalone line of business, supported by strong partnerships with the retail and branch network groups and a mutually rewarding goal and incentive system.

THEPRINCIPLEOFPRIORITIzATIONin considering specific performance initiatives, it is important to avoid the trap of “across-the-board improvement.” the opportunities in small business are decidedly unequal among local markets; customer segments and receptivity; and in terms of value creation. in such circumstances, it is critical to deploy scarce developmental resources where they will have the most impact. this is the context for the following four recommendations:

1) “sweet spot” capacity configuration. Many banks still try for an even allocation of small business banking sales

personnel and resources across the branch network. But this practice is routinely undermined by the realities of skewed local market opportunity. in fact, our research in retail bank-ing shows that up to two-thirds of the revenue potential can be concentrated in just one-third of the network geographic footprint.

through systematic analysis, progressive banks can iden-tify priority markets in which to concentrate the small busi-ness effort. typically they seek a “density factor”— high local concentrations of targeted, high-potential customers matched with a robust local branch network presence. detailed exami-nations of market opportunity and sales headroom can be conducted all the way down to the level of “micro-markets” that encompass multiple neighborhoods.

once priority local markets are identified, the bank has a roadmap for deploying marketing resources and field spe-cialists — and for establishing local sales goals. Markets with above-average potential should have above-average targets.

2) customer lifetime Value. Most major banks still operate as a collection of product units, with each division tightly focused on its own current-year profit. this narrow orientation is especially detrimental in small business banking, where customers offer the double potential of business patronage and retail household patronage.

a better approach is to consider the full range of cus-tomer opportunities over the life of the relationship, and then establish cross-sell priorities in line with customer needs and potential value for the provider. this is the goal of Customer Lifetime Value analysis.

Many banks are handicapped in CLV analysis because they have not yet combined business and household infor-

�1December 2010

mation for small business customers. this composite picture, assembled from information scattered across the bank, is critical in identifying high-value target customers and specific cross-sell opportunities.

3) specialist equation. Many banks are forfeiting sales opportunities by relying primarily on branch managers — generalists, by definition — to handle small business sales. this is at odds with a growing customer desire for a more specialized level of banking expertise, and also at odds with the reality of platform staff capabilities.

in other cases, banks do assemble a respectable team of small business branch and field specialists, but then there is a struggle to gain full traction. Bankers are spread thinly when they should be concentrated in priority markets. they often operate without good customer information and lead genera-tion lists. efforts are often only loosely coordinated with the branch managers, who remain prominent in customer acqui-sition and service.

“The small business unit performs more strongly when solidly parked within the retail line of business, with leadership that closely interacts with the retail team to coordinate initiatives through the branch system.”

often, local market representatives are left to their own devices in deciding which customer or prospect to call on next. in some micro-markets, the sales team should be largely focused on customer acquisition; in other markets the pri-ority should be expanding share of wallet with established customers.

it is difficult to sort through these questions without accu-rate guidance on market potential and customer needs. this is why it is so important to analyze the network, the customer base and local market opportunity. once priorities become clear, there is a much stronger basis for identifying the type and level of sales resources needed, where they should be deployed and how tightly they should be managed.

4) Branch sales optimization. recent research indicates that small business customers and their households account for 40% to 50% of the annual revenue at many branches. Yet survey respondents said branch representatives rarely spend more than 10% to 15% of their time serving small business clients — consumer transactions get all of the attention. addi-tional challenges include high annual branch staff turnover,

sales incentives that are skewed to widgets (without specific small business sales goals) and inadequate information on composite business/household needs.

Vague “process improvement” campaigns are not the answer. to sort through these important questions, the bank needs to clarify what it is trying to accomplish.

we believe that the overarching priority should be serv-ing the full range of small business owner needs, both for the enterprise and for the household. through CLV analysis, it is possible to systematically identify the small business sales and service priorities across the franchise. this insight be-comes the basis for effective revisions to all aspects of the small business sales model, ranging from overall design to everyday processes.

THEROADAHEADfor perhaps several more years, banks will be facing a con-tinuing revenue drought in small business banking, driven by a quadruple whammy of slack demand, a flat rate environ-ment, a legislatively-induced fee revenue crunch and reg Q-driven margin compression. Most banks can no longer pump out an assortment of their very best products and rest assured that customers and profits will continue to come rolling in.

instead, growth increasingly will hinge on gaining profit-able market share at the expense of other institutions. Players will win by deepening the relationship with each individual customer, both established and new to the bank.

small business banking offers virtually the highest poten-tial payoff from this effort compared with many other areas of the institution. to achieve this, a systematic effort will be needed, centered on total customer needs as opposed to in-dividual products.

some important groundwork will be required to set the stage for profitable small business relationship expansion. it is unavoidable. Yet we see significant, tangible financial re-wards for a priority-based transformation of small business banking, both in the near- and long-term.

alert banks will leverage their hard-won branch pres-ence by using customer and market insights to claim profit-able relationship wallet share currently lost to competitors. Banks at the losing end of that equation will be even more disadvantaged in the continuing revenue drought.

Les Dinkin is a Partner in the New York office of Novantas LLC, a management consultacy.

�� as seen in BAI Banking Strategies

The Case For Building Customer Lifetime Value

it seems odd in an age of information, but most banks don’t yet have a good grasp of the composite needs of individuals and households. this analytical gap is a hangover from for-mer strong economic cycles, when surging customer demand helped to satisfy the essential quest for sales volume.

now, however, there is a pressing need to serve each customer as fully and proactively as possible. rather than freeing the product groups to focus strictly on their own cur-rent-year profits, progressive banks are learning to base marketing decisions on the more comprehensive measure of Customer Lifetime Value (CLV).

along with more carefully considering the full range of customer needs, CLV provides a more robust frame of refer-ence to manage and measure progress. specifically, CLV considers how various individual products mesh with each other to encourage cross-sell and build long-term relation-ship profitability. it also explicitly recognizes the “hidden value” in deep customer relationships, including the poten-tial for reduced credit risk; longer account tenure and higher product usage; and improved pricing power.

as an example of CLV in action, consider the current banking challenge with the demand deposit account. given the successive crackdowns on overdraft and debit fees, there is a tendency to back away from checking. But this short-term view overlooks the fact that checking’s potential CLV is still quite attractive at “$3,000 to $4,000” provided the bank can follow through with effective cross-sell of the right down-stream products.

Most immediately, an action plan based on Customer Lifetime Value includes: 1) quantifying the “hidden value” in deep customer relationships; 2) identifying the customer behaviors and product combinations that really matter (from a total CLV perspective) and 3) setting priority marketing initiatives based on knowledge of the total customer relation-ship. Longer term, CLV can be incorporated into a variety of customer-facing activities and decisions in the organization.

CROSS-SELLPRIORITIESto set a solid foundation for cross-sell, activities must be identified and prioritized within the context of customer needs

At a time of revenue drought in retail banking, there is tremendous pressure to ramp up sales within the individual product units. Yet many banks are sacrificing significant opportunity by failing to look beyond products to the total customer relationship.

BY Sherief MeleiS

��December 2010

and receptivity, along with variations in economic potential. the “best first product,” for example, long has been viewed as the checking account. But there are other valuable points of entry to a profitable customer relationship, including the credit card and the money market deposit account.

as leading banks work through these questions, they are using the findings for a number of important applications. one immediate priority is targeted marketing: matching the right offers with right customers. another is relationship pack-aging and pricing: incenting customers to acquire multiple products at the points of sale. other applications include credit decisioning (taking fuller advantage of household in-formation in loan origination and risk management); organi-zational incentive design; and managing the branch and call center sales process.

the urgency of such initiatives is heightened by the fragmented state of customer relationships in retail banking, in which a single provider typically serves no more than 20% of a household’s financial needs. a side effect of this is extreme duplication of expensive branch networks. in the current tight market, winning banks will avoid slash-and-burn cost cuts by focusing on profitable relationship expansion, as guided by Customer Lifetime Value and the larger frame of reference it permits. others will lose market share, creat-ing more pressure for deep capacity cuts that could lead to even more problems down the road.

Sherief Meleis is a Partner in the New York office of Novantas LLC, a management consultancy.

“Along with more carefully considering the full range of customer needs, Customer Lifetime Value provides a more robust frame of reference to manage and measure progress.”

�� as seen in Bank Accounting and Finance

The Portfolio Approach To Asset Allocation

the problem, however, is that critical portfolio performance issues can be overlooked in the drive to max out each dis-crete line of business. too little consideration is given to the sympathetic risk exposure of various lending categories, and often there are pronounced skews in the risk/return profile of various asset categories.

in such circumstances, there is a heightened risk that ex-ecutive management will wind up dissatisfied with the collec-tive performance of the lending units. Business line decisions based on margin and volume often compromise the overall loan portfolio, in terms of diversification and risk-adjusted re-turns. and this flaw typically worsens over the lending cycle as fast-growing asset categories overtake the portfolio mix.

Coming out of the biggest financial crisis since the great depression, banks have every reason to strengthen the frame-work for asset allocation, a critical exercise in shaping the market outreach and overall risk posture. indeed, the weak-nesses of conventional tools and approaches were clearly exposed during the crisis:

• in many cases, budgets and loan growth objectives

were set without examining the overall portfolio implications. institutions often under-priced for risk, which had the effect of exaggerating growth in high-er-risk loan categories and among less creditworthy borrowers.

• risk models were based on a limited range of re-cent results achieved in a period of strong economic growth, without appropriately reflecting the implica-tions of prior or potential future down periods, con-tributing to a false sense of security.

• Potential high-stress market scenarios were rarely considered, and even when they were, institutions typically did not consider how risk correlations can morph in a crisis (i.e., the risk covariance between home equity and credit card lending leaps from, say, 30% in steady-state conditions to 70% in a market collapse).

• decisions and results were not evaluated within the larger context of peer group performance. in some cases, it takes only a glance to see that a bank’s

As banks move beyond the worst of the recent U.S. financial crisis, management teams are turning more attention to the question of loan growth. And, true to form, most are largely relying on goals and measurements pertaining to individual lending categories, everything from commercial realty to retail credit cards.

BY AnnettA cortez And Wei ke, phd

��December 2010

risk-adjusted performance is out of line with optimum results seen elsewhere in the industry.

given the grievous consequences of these practices dur-ing the recent downturn, it is clear that asset allocation mat-ters, and is not a simple exercise where the business activ-ity with the highest current returns gets the most available balance sheet space. in particular, executive management needs a systematic way to rise above the political and fi-nancial dynamics of the various business lines, and continu-ously evaluate and refine risk-adjusted performance across the institution.

CLEARGUIDANCEin the realm of risk-adjusted performance, there is a widely-held belief that it is simply impossible to detect potential is-sues in the midst of a market expansion. only when a slow-down hits, the theory goes, can management truly pinpoint the weaknesses in its growth strategy. and of course, by then it is too late.

we disagree with that assertion. going back to mid-2007 for example, when the dow Jones industrial average was still ranging well above 13,000, a variety of banking performance issues were evident — not having to do with mortgage securitization — based on data that was publicly available at the time.

one visible issue prior to the market downturn was a skew in composite performance. By plotting observed varia-tions in risk/reward along a continuum, it is possible to con-struct an “efficient frontier” of risk-adjusted returns, providing a benchmark by which individual results can be evaluated. figure 1, shows how the retail loan portfolios of 17 major U.s. banking companies stacked up in mid-2007 (roughly similar patterns would have been evident in mid- to late 2006 as well, based on data available at that time). three major types of issues spring from this type of analysis:

1) adequacy of returns. in some cases, institutions were underwriting solidly overall, but realizing only mini-mal comparative yields. this has a number of impli-cations, including a slim margin cushion in the event of market turbulence and probable misallocations of capital into business lines where margin was sacri-ficed for growth.

2) outsized risk exposure. among other institutions, portfolios were exhibiting outsized volatility in the face of average to below-average returns. one of the institutions in this group later succumbed to a fed-erally assisted merger; another has yet to emerge from an extraordinarily long and deep trough in per-formance and trading value.

3) sustainability of returns. at least through mid-year 2007, some institutions appeared to be successful, stretching out along the risk continuum to capture superior returns. But banking history is loaded with examples of high-flying portfolios and institutions that subsequently lost altitude, often quite suddenly. it is well worthwhile to verify the foundations of current success. what sectors of the portfolio are driving this performance? is there a critical dependence on a few business lines? do “strengths” rest on rapid growth in new areas? even if a deeper look is reassuring, does the market understand the sustainable foundations of the high-risk portfolio?

to test whether this type of analysis resonates with the investor view of the banking industry, we looked at how es-timated retail portfolio returns for each bank varied from the optimum as suggested by the efficient frontier. Comparing the two-year change in this metric (2007 to 2009) with the two-year change in market trading value, we saw a 43% statistical correlation. that is a high figure in financial market statistics, in which the investor frame of reference changes constantly amidst a sea of emerging information. it naturally follows that many investors, whether consciously or instinc-tively, are evaluating banks through a peer-based examina-tion of risk-adjusted portfolio returns.

DEEPDIVEas senior management becomes more sensitized to the risk/return profile of the institution, it has the opportunity to delve into the specific drivers of that profile, in terms of business line performance, setting the stage for course corrections.

Ultimately, each bank should systematically conduct a pe-riodic two-fold evaluation of portfolio efficiency. this includes measuring the risk/return profile relative to peer institutions, and also looking at the internal consistency of the portfolio, as reflected in the degree to which various asset categories divert from the efficient frontier.

simply looking at the degree to which yield in various asset categories fell short of the optimum feasible level as indicated by volatility, there were enormous differences among the banks in our performance study. within a range that assigned a score of “0” to a statistically perfect score and a “10” to the widest possible variance from the efficient frontier, several banks had a composite variance score of less than 1 (weighted by asset concentration), while several others ranged from 6 all the way to 9. also, extreme heterogeneity of volatility-adjusted asset category performance in mid-2007 was clearly associated with subsequent performance distress.

��

the Portfolio approach to asset allocation

there are clear differences, in the gravity and type of questions confronting Bank “a” versus Bank “B” (figure 2). one case appears laced with distress; the other seems more a matter of paying attention to outliers. Both profiles are based on data that was publicly available in 2007.

Bank a. for starters, Bank a was taking far more risk to achieve comparable levels of return with Bank B. to achieve a roughly 6% return in home equity lending, for example, Bank a was incurring more than seven times the volatility in that line of business, compared with Bank B.

then, looking strictly inside the retail portfolio, there was an overall pattern of declining returns relative to risk — the opposite from the norm. in terms of risk/return performance consistency among asset categories, Bank a had a compos-ite variance score of 9 (10 being the worst on a 10-point scale).

faced with an overall underwriting challenge, Bank a should have been looking at asset concentrations; areas where growth should be stopped; risk defenses should be bolstered; and pricing could be strengthened. specifically,

Bank a had one of the highest portfolio concentrations of home equity loans (22%) among the study group, with the highest comparative volatility in this asset category and the next-to-lowest yield. it was also over-weighted in residential mortgage loans (61%), with above-average volatility and below-average yield.

Bank B. while Bank B could take comfort in an overall cohesive risk/return profile (a phenomenally low composite variance score of 0.2, with 0 being the best on a 10-point scale), it still had extreme results in certain asset categories, warranting executive management attention. in particular, the credit card portfolio, while extraordinarily stable, seemed to be going nowhere in generating returns.

Meanwhile, the small business portfolio was operating way out on the risk spectrum, raising questions about sus-tainability of current results; whether to continue expanding in that area; and ultimately the outlook for borrowers in that market sector. at mid-year 2007, Bank B had the highest retail portfolio concentration of small business loans (22%), compared with an average of 15% within the study group.

AveragePortfolio-AdjustedReturn (2)

Average Portfolio Risk, as Reflected in Volatility of Return (3)

5%

6%

7%

8%

9%

0% 1% 2% 3% 4% 5%

Sustainable? Understoodby the market?

Outsized riskexposure?

AdequateReturns?

Fig. 1: comparison of major u.s. Bank retail loan portfolios, midyear 2007

Risk/return characteristics of 18 major U.S. banks, compared with the efficient frontier as suggested by modern portfolio theory (1).

1) The efficient frontier portrays the best available trade-offs between risk and return, given the individual and joint variability of assets in a portfolio. 2) Average portfolio-adjusted return is based on a time-series analysis of the weighted average of all quarterly asset-level returns (interest income less net charge-offs)

in the portfolio, with a stronger weight assignement to more recent results. 3) Average portfolio risk is based on an average volatility time series analysis of all quarterly asset-level returns in the portfolio, weighed by their respective balances. The

calculation examines how quarterly asset returns vary in relation to each other, in accordance with mean-variance portolio theory, with emphasis on recent results.

Source: Novantas, LLC

��December 2010

although these examples were selected to provide a sharp contrast, all 17 banks in the study had at least a few yellow flags in mid-2007 and many had multiple red flags. within individual loan categories, outliers in the risk/return continuum often were accompanied by exaggerated portfolio concentrations. these scenarios were correlated with the larg-est subsequent declines in trading value.

DECISIONCONTExTsome executives take the fatalistic stance that portfolios take on something akin to unalterable momentum, and they therefore do not tackle problems that they can’t address suf-ficiently in advance, believing that these issues do not have a significant impact. others are resolute in their decision that certain lending activities are non-negotiable, essential to ser-vicing customer needs and upholding the brand promise.

such comments typically emanate from bankers who are unfamiliar with the portfolio approach to asset allocation. across the industry, in fact, most major banks are neither ac-tive nor even conversant on this topic. insurance companies have done a far better job of capitalizing on this approach. By contrast, the banking industry typically only goes so far as to manage business lines with a heightened sensitivity to risk-adjusted returns. this is certainly a big step in the right direction, but it still falls short of true portfolio optimization.

to move down this path, banking executives will need to see specific pragmatic applications. there are three major areas where asset allocation methodologies can be used to improve critical executive management decisions:

risk/reward equation. one application is analytically identifying ways to improve the risk/reward equation by adjusting aspects and proportions of various risk/return ele-

0% 1% 2% 3% 4% 0% 1% 2% 3% 4%0% 0%

2%

4%

6%

8%

10%

12%

2%

4%

6%

8%

10%

12%

Risk (3) Risk (3)

Retu

rn (2

)

OtherConsumer

Typical

ResidentialMortgage Credit

Card OverallPortfolio

SmallBusiness

HomeEquity

Actual

Other Consumer

ResidentialMortgage

CreditCard

HomeEquity

OverallPortfolio

SmallBusiness

Bank A Bank B

Source: Novantas, LLC

Risk/return characteristics of Bank A vs. Bank B, compared with the efficient frontier as suggested by modern portfolio theory (1).

1) The efficient frontier portrays the best available trade-offs between risk and return, given the individual and joint variability of assets in a portfolio. 2) Average portfolio-adjusted return is based on a time-series analysis of the weighted average of all quarterly asset-level returns (interest income less net charge-offs)

in the portfolio, with a stronger weight assignement to more recent results. 3) Average portfolio risk is based on an average volatility time series analysis of all quarterly asset-level returns in the portfolio, weighed by their respective balances. The

calculation examines how quarterly asset returns vary in relation to each other, in accordance with mean-variance portolio theory, with emphasis on recent results.

Fig. 2: comparison of two regional retail loan portfolios, midyear 2007

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ments, such as product categories, geographies and credit tiers.

one bank found a way to improve overall-risk adjusted returns by executing judicious changes in its business line growth priorities over the course of three years. this can be achieved by easing back on certain business lines with high correlation in volatility (greater than 90%), and en-ergizing other lending categories that can uphold returns while providing greater risk diversification (correlation of 40% to 70%).

Diagnostics. another application is pinpointing asset categories in need of extra management attention, either to improve risk-adjusted performance or to evaluate for di-vestiture or strategic expansion.

at one regional banking company, results from a port-folio analysis provided additional support for a senior man-agement decision to exit a major lending category. this was a case in which exclusion provided a tangible lift to risk-adjusted returns. additionally, management identified other lending categories that could be re-emphasized to uphold overall balance growth.

m&a strategy. a third application lies with mergers and acquisitions. Hypothetical combined portfolios should be evaluated on the basis of the interrelated performance char-acteristics of major asset categories. Banks can can also evaluate the tradeoffs between emphasizing core internal growth or external combinations.

one institution discovered that it already was approach-ing a “sweet spot” in terms of optimal asset diversification and risk-adjusted returns, implying that in order to reach the next level of growth, it would likely need to look beyond the company for potential acquisitions.

such pragmatic techniques help banks to stay focused on the big picture of robust portfolio diversification and risk-adjusted performance, as opposed to a diffused effort concentrating on individual trees in the forest.

COREPRINCIPLESactive portfolio management is a way of life, for successful practitioners. senior management should evaluate not only individual business lines but also how the mix characteristics of the loan portfolio affect overall risk-adjusted returns.

the goal here is to develop an analytical context that will help identify the optimal portfolio mix for any given level of risk; accurately assess the current position of the institution relative to the optimal; and identify specific asset allocation tradeoffs that the institution can use to improve overall performance. we see three core principles involved in translating these concepts into action:

1) asset allocation must be managed as a dynamic process, one that utilizes a portfolio view of diver-sification and that reflects ever-changing risks and returns in the markets in which the bank functions. it is not an automatic thermostat that the user can “set and forget.”

2) Corporate decision models must account for the ways that risk actually evolves. specifically, this means that traditional economic capital models need to be retooled to reflect the potential for rap-idly changing risk correlations, both within various asset categories and among various business line portfolios, as well as the dramatic leaps in risk volatility that can occur in stressed market condi-tions. this need alone will spawn a new generation of models that are no longer tied to the limits of smooth statistical functions.

3) risk must be measured as a series of interrelated functions, where changes in one risk silo, have im-plications for how the risks in other silos, are cali-brated. going forward, institutions must keep sight of this critical perspective throughout the business cycle, and not get lulled into the trap of fine-tuning scattered details in peak market conditions.

“Executive management will need a central analytical team tasked with continuously updating the bank’s risk/return profile, with specific implications for lines of business.“

MANAGEMENTIMPLICATIONSBanks will need to make several major adjustments to em-bed these core principles into the organization.

one priority is revising executive management orienta-tion and some of the process in business line planning and performance evaluation. often, lending categories operate largely as entities unto themselves within major banks. this results in a more splintered and tactical management plan-ning process that focuses primarily on individual line of business performance year-to-year.

Certainly, it is appropriate to set careful targets; identify how they will be achieved in terms of volume and margin; consider the capital needed to support growth; and con-sider overall returns relative to risk. the trap lies in not con-sidering the conjoint risk of various business lines, and how

the Portfolio approach to asset allocation

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“Prescient banks will be able to establish a more robust context for key decisions about loan portfolio composition, and they will be much better equipped to monitor and anticipate risk-adjusted performance.”

diversification, or lack thereof, can impact performance over the full business cycle.

Ultimately, the bank will aim for a diversification-adjust-ed economic capital allocation. the contribution of each business unit should be evaluated not only by individual risk, but also by the degree to which it either strengthens or weakens the overall profile of the portfolio, relative to the diversification-adjusted return on capital.

a second priority is to approach portfolio-style asset allocation with the full analytical rigor that it deserves. Con-ventional risk assumptions made at the top of the market, only encourage counterproductive expansion, rather than functioning as a curb. in the aftermath of this crisis, one of the larger priorities in bank risk management is to reca-librate risk metrics to better assess exposure over the full credit cycle, not just in comparison with recent results.

as first demonstrated by Professor Harry Markowitz of the University of Chicago, certain patterns emerge once a portfolio is arrayed by risk versus expected return, such that current and considered configurations can be compared with an “efficient frontier” that represents the best of what potentially can be accomplished at each level of risk. the catch, however, is that the quality of the underlying assumptions and inputs ultimately makes or breaks the value of this type of analysis.

in using quantitative decision models, the institution will not only need accurate retrospectives on risk, but also ro-bust forecasts. in particular, risk measures must incorporate a full view of so-called “tail risk” (risk events with statistical-ly remote probability but potential devastating impact) to provide the most value in helping to strike optimal tradeoffs in portfolio composition.

this requires a more in-depth exploration of potential catastrophic scenarios, which can be underplayed in tra-ditional statistical models that tend to assign infinitesimal probabilities to such outcomes. for many portfolios, tail risk is the defining difference in performance over the life of the credit cycle; buried for years during benign conditions, but lethal in stress scenarios.

executive management will need a central analytical team tasked with continuously updating the bank’s risk/re-turn profile, with specific implications for lines of business. analytical techniques need to be applied consistently, with tight limits on the kinds of special exceptions that individual business units may lobby for. these findings then need to

be introduced into continuous management activities, with clear backing from executive management.

INFLECTIONPOINTUnbelievable though it may seem, given the depth of the crisis that the banking industry has gone through, renewed growth is already a rising priority and will gain more momentum going into 2011.

standing at the post-crisis ground floor, banks are reassessing strategies and portfolios, hoping to build a solid foundation for future expansion. However, if this is done only through a narrow examination of individual business lines, there is a distinct risk that new cracks and flaws will quickly creep into the foundation.

the institution’s aggregate risk exposure must be measured in a way that reflects the interrelated manner in which credit, market and operational risks surface in stress scenarios. events can trigger a chain of increasingly severe aftershocks as one risk crosses into another. an example is credit problems causing reputational concerns in the market, which then result in a liquidity squeeze.

through the discerning use of new risk measurement tools that compensate for the weaknesses identified in the current crisis, prescient banks will be able to establish a much more robust context for key decisions about loan portfolio composition, and they will be much better able to monitor and anticipate risk-adjusted performance. we believe that this approach is destined to become a long-term senior management tool that will be used throughout the credit cycle.

Annetta Cortez is a Partner and Wei Ke is a Manager in the New York office of Novantas LLC, a management consultancy.

The enormity of customer need is underscored by survey responses indicating that two of every five mass affluent households expect to outlive their retirement resources.

�1December 2010

Mass Affluent Strategy: Tilting from Investments to Payments

a continuing banking aspiration in wealth management is to reach through the branch network to tap the vast under-served market of mass affluent customers. the goal is to sharply increase the sale of investment products and gain market share in a field that long has been dominated by brokerage and investment companies.

it has been a long hard road, with few success stories. But major banks cling to the belief that their vast regional branch networks will finally gain traction with investment products and advisory services. the apparent success of the former wachovia Corp., for example, is often cited as a model of what other banks would like to achieve.

for many players, however, the time has come for a ma-jor course correction. as underscored by a recent national survey by novantas and informa research services, the banking industry has gone nowhere in building its image with investors. overall, only 12% of consumers prefer to keep their investments with a bank. it is time to recognize that most banks will never significantly penetrate the invest-ments industry.

instead, for many banks, the better path will be to double down on a central strength — payments. only a select few players will be able to substantially increase their role in help-ing people to build investment wealth during their working years, and those that do will focus on upper-echelon seg-ments. for mass affluent households, by contrast, there is plenty of room for banks to play a larger role in helping with budgeting and cash management needs, especially in retirement.

the enormity of customer need is underscored by sur-vey responses indicating that two of every five mass affluent households expect to outlive their retirement resources. More than a third of this group will outlive their personal resources by up to a decade. in such pressing circumstances, there are two areas where banks can play a major role in serving mass affluent customers.

one is household budgeting and cash management: pro-viding the information, tools, advice and products that will help with the careful management of resources and expenses in pre- and post-retirement years.

Bank investment products may never gain momentum with mass affluent customers. Yet this group has other major retirement needs that fall right into the strike zone for banks.

BY WAYne cutler

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the other is what might be termed staged disbursement: converting investment assets into monthly cash streams that can be used to supplement retirement budgets, while ensur-ing that unused funds continue to grow.

Banks shouldn’t be particularly surprised to learn that they do not have a clear field. Brokerage and investment companies are eager to build and retain household bal-ances as families shift investments to vehicles more suitable for use in meeting near-term retirement spending needs. thus while banks currently occupy the high ground in pay-ments, they need to take action now to defend their strong position.

MASSAFFLUENTSEGMENTthe mass affluent customer segment typically is defined as those households having between $100,000 and $500,000 of “investable wealth,” exclusive of formal retire-ment accounts, insurance policies and home equity.

“Turning to management implications, we are at the onset of an era in which bank internal organization increasingly will be based on customer segment, as opposed to individual products and distribution channels.“

the attraction of this group reflects the huge resource pool that it controls — roughly $13 trillion of retirement as-sets and nearly $7 trillion of other investments as of sep-tember 2010. all told, the combined $20 trillion represents an estimated 47% of all U.s. household retirement and investment wealth. one drawback in serving this group, however, is that balances are splintered across nearly 24 million households, meaning that while the collective op-portunity is huge, it can be a modest proposition on a case-by-case basis.

Many mass affluent customers are not getting the ad-vice they need to anticipate and fulfill their financial needs in retirement. this group has either been over-served by the branches, which primarily focus on selling basic savings products, or under-served by registered investment advi-sors, who sell slightly more advanced long-term investment products, such as fixed and variable rate annuities.

while the common banking wisdom favors “staying the course,” increasingly the whole mass affluent strategy seems defunct. all the fuss over distribution overlooks a

much larger problem for banks, which is a profound lack of brand resonance in the area of investments. in the recent novantas-informa national survey, for example, two-thirds of mass affluent respondents said they prefer not to keep investments with banks, and another 23% said they would do so only selectively.

some banks have tried to jump-start their wealth strate-gies by acquiring or allying with brokerage and investment firms. the goal is to leverage the valuable brand names, customer connections, distribution networks and skill sets that such firms can provide. even this is not a sure proposi-tion, as prior acquirers have learned.

for most banks, branch-delivered wealth management for the mass affluent is a losing proposition and should be recognized as such. the tide is not going to turn. at this critical juncture, however, banks should not let their fixation on investment products cause them to lose sight of larger mass affluent customer needs.

the importance of developing new banking products and services for this segment is underscored by the fact that over the next five years alone (2011-2015), roughly 1.8 million mass affluent households are expected to enter retirement. this group will carry roughly $550 billion of investment assets into retirement — along with substantial additional resources in structured retirement products and other savings. People in this group on average can expect to spend roughly 17 years in retirement and will have an ongoing need to withdraw funds to manage expenses.

the institutions that win the opportunity to manage this payment flow for retirees will generate substantial revenues from keeping idle balances in low interest-bearing accounts, and from providing payment services. and the opportunity will grow as additional waves of baby boomers retire.

PRODUCTANDSERVICEINNOVATIONalthough it is not always recognized, banks already play a prominent role in the retirement market. as detailed in our research, mass affluent customers as of september 2010 had approximately $11 trillion dollars of retirement-earmarked funds parked in “shadow retirement investments”— every-day banking products such as checking and savings ac-counts, and certificates of deposit.

there will be a continuing customer orientation toward banking products, both in preparation for retirement and as receptacles for investment resources as they are drawn down for use in meeting near-term household financial needs. But this entrée cannot be taken for granted. win-ning banks must go beyond the passive supply of basic products and become active partners in helping customers

Mass affluent: tilting from investments to Payments

��December 2010

to cope with their financial circumstances and achieve their objectives.

Budget management. as underscored by the novan-tas-informa survey, mass affluent households tend to be less confident about their retirement plans. roughly one third say they will retire later than planned, and many believe they will outlive their resources. one implication is that mil-lions of mass affluent households will have a permanent need to manage their monthly and annual budgets quite carefully, not only during retirement but during their re-maining working years as well.

to meet this emerging need, early innovators are de-ploying online toolkits that attempt to provide a complete household financial dashboard. in some cases, providers are seeking fee revenue generation; in other cases these packages are being fleshed out to capture cross-sell pos-sibilities that surface as households clarify their positions and make consequent savings and borrowing decisions. Current examples are as follows:

• as provided free of charge by Bank of america Corporation, the “My Portfolio” online planning tool allows the user to develop a consolidated view of asset and debt accounts, including accounts not held at Bank of america. along with calculating household net worth, the tool allows users to view account details, create budgets and analyze spend-ing and savings patterns. there is both a consumer version and a small business version.

• at mint.com, customers can download informa-tion on balances and transactions, and do so by category, and they can elect to receive daily au-tomatic updates. a charting function allows users to easily create graphical representations of spend-ing, income, balances and net worth. the site also makes personalized recommendations on financial products (and generates revenue for the provider through lead generation).

• at mvelopes.com, customers can view real-time in-formation on all of their accounts and balances, set budgets, and analyze spending in detail. Mvelopes charges a $190 fee for a two-year plan; $130 for a one-year plan; and $40 for a quarterly plan.

we fully expect to see a proliferation of competitive of-ferings over the next few years. and we believe that bank-

branded services will have an intrinsic brand advantage in attracting customers and inspiring user trust and confi-dence.

staged disbursement. in retirement planning, advis-ers and customers pay a lot of attention to future payout dates, specific points in time when accumulated wealth is transferred out of long-term investment vehicles and be-comes available to meet current spending needs. while such events may mark the end of one type of longstanding financial services relationship, they also can mark the be-ginning of new relationships.

specifically, most retirement households reach a stage when they primarily want their financial products to gener-ate steady monthly income — stringing out remaining bal-ances as long as possible to cover living expenses. in turn, this creates a multi-year need for a different category of retirement products centered on the staged disbursement of investment assets. Current examples are as follows:

• as provided by fidelity investments, “income re-placement funds” are specifically designed to facil-itate the disbursement of retirement savings. funds provide professional management of assets and the amount and timing of withdrawals. Customers can specify the length of period over which funds will be liquidated. typically, monthly payments are intended to keep pace with inflation, while the re-maining portfolio continues to grow in support of future monthly spending needs.

• offered by northwestern Mutual financial net-work, the “deferred Variable annuity” allows assets to accumulate tax-free, and will only start disburse-ment at a future date set by the customer.

as is obvious with these two examples, some non-banks already are alert to the opportunities in the staged disburse-ment retirement product space. our research indicates that this is a huge and growing market. along with re-packag-ing and more aggressive marketing of current products, banks need to innovate in this space if they are to avoid having investment and brokerage companies siphon away valuable balances and customer service opportunities.

SETTINGPRIORITIESLooking out over the next few years, banks have a lot of work to do in re-tooling wealth strategies. Questions about

“For mass affluent households, by contrast, there is plenty of room for banks to play a larger role in helping with budgeting and cash management needs, especially in retirement.”

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products and distribution are taking center stage at a time when many institutions need to take a fresh look at emerg-ing customer needs.

Customer research is the essential first step. Many banks need to learn far more about the composition of current balances, in terms of retirement-earmarked household re-sources held in everyday products. they also need well-con-sidered estimates of “share of wallet” and the extent of total household wealth. as progressive banks begin to close this knowledge gap, they are gaining a far better grasp of the total customer opportunity (“why take action”) and clarify-ing priority customers (“where to take action”).

“Bank-branded services will have an intrinsic brand advantage in attracting customers as well as inspiring their trust and confidence.”

the question then turns to research-based innovation. what are the future needs of mass affluent customers, es-pecially in budgeting and staged disbursement? Consid-erations include the basic value proposition (fee revenue generation; cross-sell), product design and bundling, pack-aging, competitive differentiation and targeted marketing. this is a team developmental effort centered on establishing a new banking center of gravity in serving the mass affluent customer segment.

another priority is refining distribution strategy. the cost basis of branch distribution remains high. and customers are increasingly receptive to electronic alternatives. one possibility is a “virtual hub-and-spoke” delivery strategy that feeds referrals to efficient central teams of credentialed in-vestment professionals. such teams are already being used to supplement branch networks, and they can be effective in supporting call center and online channels as well, espe-cially for the less profitable mass affluent segment.

despite setbacks with investment products, there is also much more that can be done at the ground level within branches. today in many branches, for example, there is a high concentration of single-product customer relationships centered on certificates of deposit earmarked for retire-ment. By repackaging Cd products and restructuring the sales dialogue and staff incentives, progressive banks are strengthening the relationship context with mass affluent customers, improving cross-sell and customer retention.

SEGMENT-BASEDMANAGEMENTturning to management implications, we are at the onset of an era in which bank internal organization increasingly will be based on customer segment, as opposed to indi-vidual products and distribution channels. this approach will be needed to unlock emerging opportunities with the mass affluent customer segment.

one east Coast bank created a standing committee, composed of bank and wealth managers, that was charged with creating a joint marketing agenda, including customer programs and goals for both bank and wealth products. this was a shared agenda on which both the bank and wealth teams would be measured. this committee now meets quarterly to review progress and make course cor-rections as necessary, and the initiative is supported by a central marketing group that designs the products and produces the customer calling lists and programs.

importantly, such coordinated efforts need to be based on a view of the emerging market, and not limited to better execution of current strategies and tactics — many of which have come up short and probably will continue to do so. as the novantas-informa study indicates, investment products may never deliver hoped-for momentum with mass affluent customers. Yet this customer group has important categories of retirement needs that fall right into the strike zone for banks. Banks that follow through on this opportunity will gain significant long-term competitive advantages in serving the mass affluent customer segment.

Wayne Cutler is a Partner in the New York office of Novantas LLC, a management consultancy.

Mass affluent: tilting from investments to Payments

��December 2010as seen in American Banker

Prescription for Cross-Sell: Customer Lifetime Value

there are enormous opportunities for winners in this quest. today’s cus-tomer relationship “depth gauge” remains stubbornly lodged at less than 20% at most banks. in other words, for any given individual or household served by the institution, typically more than 80% of the finan-cial services needs are met by com-petitors. Changing this ratio by even a small amount across the customer base can have a huge financial up-side.

one of the challenges banks face, is the vast shortage of insight surrounding the economics of cus-tomer relationships. Currently, many retail banks are intent on re-tooling the checking business following the governmental crackdown on over-draft and debit card fees. But this tight product focus tends to ignore

Retail banks are facing a revenue drought, a slack loan demand, a flat rate environment and dwindling fee revenues in the face of new laws and regulations. We have found that often, the best hope for growth is to serve established customers more fully — essentially a person-by-person campaign to gain “share of wallet.”

BY Sherief MeleiS

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the bigger picture of customer needs, and the lifetime eco-nomic potential of meeting them.

it is within this context that progressive banks are expand-ing the cross-sell viewfinder. rather than simply looking at the current-year profit potential of individual products, they are considering the full span of the customer relationship, from beginning to end. what are the top items of mutual benefit to the customer and the bank?

as an example of how customer lifetime value (CLV) makes a difference in decision-making, consider all of the re-cent controversy surrounding the checking account. there’s a widespread effort to “repair” free checking by attaching monthly service fees, to ease the profit drain from lost over-draft fee revenue. this approach can be short-sighted, how-ever, in cases where free checking succeeds in attracting robust accounts with high cross-sell potential. with a poten-tial CLV of between $3,000 and $5,000, for example, high-value customers will more than reward the bank for provid-ing free checking as they use additional banking products.

to capitalize on such insights, it is helpful to begin with a three-step plan. this includes: 1) recognizing the “hidden value” in deep customer relationships; 2) sorting through the maze of customer behaviors and product possibilities to find the select combinations with the highest CLV potential; and 3) setting marketing, product and sales priorities that will energize cross-sell and relationship expansion in the field.

hidden value. the value of cross-sell often is evaluated product-by-product, when in fact the benefits go much further. in-depth customers tend to stay with the bank longer; make greater use of their products; and tend to pose a lower risk of default. in many cases, price sensitivity falls as the focus turns to rewards, recognition and service. also, cross-sell can make far more effective use of staff and corporate resources, compared with a product-by-product effort. it is important to recognize these factors in considering the value of deeper customer relationships.

customer analytics. to identify priority cross-sell oppor-tunities, the bank needs to be able to sort through a large set of possible product combinations and offer sequences, arriving at a select list of offers that will provide the highest mutual benefit to the customer and the bank. in one instance, the retail banking division of a major bank initially evaluated more than 200 cross-sell possibilities, eventually narrowing

down the consideration set to somewhere between 12 and 15 possibilities that would capture the lion’s share of the op-portunity.

the importance of this exercise is underscored by the current retail banking emphasis on promoting home equity loans to the “best customers.” this likely will be ineffective for customers who are valuable on the basis of money market deposit balances, given that they already are liquid and probably don’t need additional interim credit. CLV analysis helps to uncover these critical nuances.

marketing, products and sales. the success of CLV- guided cross-sell initiatives largely will hinge on targeted marketing — matching the right offers with the right groups of targeted customers. there are also implications for product packaging and relationship pricing. then, within the branch network and call centers, the retail bank will need to supply timely sales leads, review sales processes and reconsider performance goals and incentives for front-line staff.

in following through on these three steps, various kinds of preparation will be needed inside the bank. the market-ing team will need to develop robust models that accurately measure the total lifetime value of every customer. individual product teams will need to collaborate with distribution in deploying centrally-designed cross-sell propositions that branch and call center reps can sell within a relationship context.

Meanwhile, executive management will need to resolve simmering issues with performance measurement, given the persistent emphasis on splintered metrics centered on indi-vidual products. executives also will need to promote coop-eration among the product, distribution and marketing teams so that the bank can proceed in a focused way that unlocks opportunity with a minimum of strife and wasted effort.

Sherief Meleis is a Partner in the New York office of Novantas LLC, a management consultancy.

“This tight product focus tends to ignore the bigger picture of customer needs, and the lifetime economic potential of meeting them.”

Mass affluent: tilting from investments to Payments

��December 2010

Transform the Branch Model— Before It’s Too Late

The physical distribution network remains critical to banking, but old-style branches may soon go the way of the corner bookstore.

BY dAve kAYteS

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despite a difficult outlook, branches are not dead. However, the events of the past few years may have dealt a death blow to traditional branch strategy.

More than 40% of U.s. branches are financially un-derwater today, and most of these will not become prof-itable under almost any conceivable economic scenario. More concerning is that even among the profitable 60% of branches, most newly originated customer relationships are unlikely to ever become profitable. in turn, branch profit-ability becomes increasingly dependent on an ebbing base of legacy customers.

some of these issues stem from tougher regulations, fee restrictions and the current rate environment. this situa-tion calls for more than hunkering down and making small changes around the perimeter. rather, renewal will require a fundamental change in the distribution of banking products and services.

the traditional branch has started down the road trav-eled by full service gas stations, corner drugstores and air-line counter reservationists. Banking may remain a branch-delivered product, but the day-to-day role of branches will evolve into something quite different.

Historically, branches functioned as deposit gathering centers with transaction services support. in the current envi-ronment, deposits are neither in high demand, nor do they provide much margin. and the cost of providing counter ser-vice personnel for branch-based transactions has become prohibitive. the traditional branch network is failing to de-liver profits, yet for most banks, the branch system is simply too big to fail.

we believe this gridlock will be broken by new models of branch networks that are evolving today and will inevi-tably dominate the banking market. each model will face challenges, and it is not yet apparent which will prove the best fit.

one emerging model is based on a locally dense, multi-product distribution network, with such outlets being steadily introduced by HsBC Bank Usa along the east Coast. in Po-tomac, Maryland, for example, a spacious new HsBC facil-ity offers a full range of financial services to both consum-ers and businesses, including mortgages, loans and wealth management (including private banking), staffed by seven banking professionals.

increasingly, personnel in such multi-line branches will be primarily responsible for consultative sales, rather than teller functions. some representatives may assist customers in using branch technology to conduct transactions, but they will also capitalize on interactions to deepen and extend the banking relationship.

Under this scenario, rather than a source of transaction volume, customer traffic provides entrée to present the best products and services to prospective buyers. a rich menu of offerings includes loans, lines of credit, investments, payments, financial advice, brokerage services and insurance, both for consumers and businesses.

this operating model presents its own challenges. in the past, branches were located to optimize service traffic patterns. in the future, they will need to be distributed with sales traffic in mind. Banks also need to determine how to deploy and manage a new expertise-based sales force. as it would be too costly to staff each branch with personnel that could expertly sell each type of product, there likely branches will need to utilize a rotating sales force, akin to department stores. in this case, business would be transacted both on a walk-in basis and by appointment.

a different approach is the low-density superstore model supported by distributed technologies. think apple store: a few select high-touch centers, complemented by a dense net-work of atMs with extensive mobile services. according to a recent report by the financial times, Citigroup will pursue the apple store distribution model in western europe, “with a slim network of flagship outlets” supported by a robust online banking capability. Closer to home, ing direct Cafés can be seen in select sites in major U.s. cities, putting a vis-ible face on a vast online banking operation.

Here too, the objective is to generate traffic and capital-ize on each customer interaction to create cross-sales. But unlike the first model, where the brand promise is established through ubiquitous locations, these branches create brand splash through technology, personnel expertise and market-ing pizzazz.

while distinctly different, we see these two models as the future of branch banking. as they begin to dominate high potential markets, traditional branches will be steadily phased out.

such changes spell opportunity for innovation leaders. new-style branches in high potential markets would gener-ate significantly higher balances, margins and profitability than today’s branches. on average, local markets would have fewer branches with greater capabilities, fostering a richer customer interaction and a more positive customer experience.

Dave Kaytes is a Managing Partner of Novantas LLC, a management consultancy headquartered in New York City.

transform the Branch Model — Before it’s too Late

��December 2010

EDITORIALeditor in chief

steve Klinkerman

editorial Board

robert Vokes

steve turner

J.d. richards

DESIGNDesign Director

Marianne Maguire

production

Bora shehu

CONTRIBUTORSdave Kaytes

rick spitler

wayne Cutler

Les dinkin

sherief Meleis

steve turner

annetta Cortez

wei Ke

MARKETINGVp marketing

edward van eckert

212-419-2525

evaneckert@novantas.com

NOVANTAS,LLCmanaging partners

dave Kaytes

rick spitler

corporate headquarters

485 Lexington avenue

new York, nY 10017

Phone: 212-953-4444

fax: 212-972-4602

info@novantas.com

subscriptions

www.novantas.com

212-953-4444

ABOUTNOVANTASnovantas is a leading advisory and information services company to the financial ser-vices industry. the firm’s consulting services are focused on issues of revenue strategy, which we describe as “customer science.” Customer science encompasses the disci-plines of defining, building, managing and measuring revenue-generating capabilities — branding, market mix management, segmentation, product design, pricing, distribu-tion management, sales execution effectiveness and customer experience.

we work with clients to develop these customer-focused strategies, and provide strat-egy implementation and information services to help clients measure and maximize competitive positioning. novantas counts among its clients most of the top-30 companies in the banking, brokerage, insurance, and credit card industries.

novantas review is published quarterly by novantas, LLC, 485 Lexington avenue, new York, nY 10017.

© 2010 novantas, LLC. all rights reserved. “novantas review” and “novantas” are trademarks of novantas,

LLC. no reproduction is permitted in whole or part without written permission from novantas, LLC.

For more on these topics, view our multimedia at: www.novantas.com

Rebuilding Retail DistributionPreserving old-style branches will be of limited value in a permanently changed market. for renewal, winning banks will look to the future of multi-channel retail distribution.

Strategies for the New Future of Branch Bankingacute pressure for branch cost reduction is much more than a temporary operating challenge. instead, new strategies will be needed for a permanently changed market.

Consumers in Motion: Stepping Away from Branchesa national consumer survey by novantas shows that customers are broadly moving online for basic banking activities, yet still prefer the branch for high-value transactions.

The New Formula for Branch Productivityretail branch banking has entered a period of radical change. Comprehensive strategies, as permitted by staff mapping, will be needed to transform the branch workforce.

Making the Most of Small Business Specialistssmall business specialists available in individual bank branches can be very powerful in setting the stage for accelerated small business growth at that branch.