Growth strategies for an industry in subprime times
These are trying times for commercial banks. After a wave of successful mergers and acquisitions bolstered the bottom line for many institutions, the move into the subprime market has proven disastrous. Selling loans to high-risk customers was a successful growth initiative so long as the housing market rose, but the problems are now plain to see: billions of dollars of write downs and fallout for the global economy. From an innovation perspective, banks failed to drive enough “good” innovation—offerings of high integrity that meet customer needs while balancing risk and business performance.
To survive the subprime meltdown and recover momentum, commercial banks need to rethink the way they innovate. Instead of taking a tactical, short-term approach, they need to develop a portfolio of four types of innovation: lending products that better meet the needs of appropriate customers; services (non-interest-bearing offerings) that build durable customer relationships; business models that support strong long-term value propositions; and operational models that enhance the customer experience while controlling costs.
Types of Innovation
Product innovation. Thanks to the advent of wireless and other technologies, a new wave of banking products is emerging to supplement traditional interest-bearing loans and mortgages (Table 1). Turnkey mobile banking, for example, has been made possible by companies like Motorola and Nokia, which have put chips into phones so people can manage their banking transactions wirelessly. Some parts of Asia are already using this technology, and Standard Bank has teamed up with local wireless carrier MTN to make it available in South Africa. Aided by other technological innovations, such as the platforms introduced by the Apple iPhone, mobile banking will soon be pervasive.
Service innovation. For most commercial banks, developing new non-interest service offerings is more important than growing the lending business. Innovative services contribute to revenue growth and at the same time increase opportunities for cross-selling products, raising product adoption overall. Selling to existing customers is advantageous because it lowers risk, raises efficiency, and increases retention. Also, because services are non-interest bearing, they are not directly affected by the inverted yield curve, which occurs when long-term yields fall below short-term yields and interest rates decline. Consequently, services generally have higher profit potential than products.
In the effort to build larger services portfolios, leading banking companies are developing ways to expand their relationships with customers. Umpqua Bank, which is located in Oregon and California, built 144 retail-like branches with this in mind. The café-like neighborhood stores provide more than a comfortable setting to let customers make banking transactions while having a cup of coffee: These stores are key for promoting customer retention and revenue growth.
Business model innovation. Another important source of growth for the banking sector is new business models—that is, ways of creating value that go beyond the company’s traditional products and services. In the commercial banking sector, the new value propositions can take different forms, including products that bring new annuity-based revenue streams, and bundled products and services that provide banking along with other services. Some of these business models have the potential to transform the industry. Wells Fargo, for example, is now offering individual health insurance plans to those who don’t have employer-provided healthcare benefits. This innovation promises to create important new revenue streams for the bank while meeting a pressing need of millions of people.
Other disruptive innovations are on the horizon. Wal-Mart has already entered the scene, establishing more than 1100 in-store independent bank branches that provide convenient no-frill services to the retail giant’s enormous customer base. This is a winning scenario all the way around. The participating banks get the opportunity to reach the “unbanked”—that is, people without an account at banks and other mainstream financial institutions—and leverage Wal-Mart’s brand recognition and portal. Wal-Mart gets increased financing and customer service, and the possibility of increased store traffic and sales. And customers get access to banking in a convenient setting.
Analysts are closely watching Wal-Mart’s next step, which is currently in limbo under an FDIC moratorium. If the retail giant were to gain permission to operate an industrial loan company, it could lower costs by processing credit card and other transactions in house. And if Wal-Mart is allowed to go a step further and enter the banking industry, it could leverage its extensive proprietary customer information to offer a range of banking services to a demographic that traditional banks typically avoid. Not surprisingly, legislators and banks are strongly in favor of keeping commerce and banking separate. But this scenario augurs a new level of competition for traditional banking. Other major retailers are watching closely and are expected to join the fray, pending the legislative outcome later this year.
Wal-Mart is not the only company that understands the value of connecting businesses and banking for the benefit of multiple players. Kaiser Permanente, the largest managed care organization in the U.S., is looking to link credit cards to healthcare spending accounts. This strategy will simplify life for customers, who in the past had to pay co-payments up front and then reclaim them by filling out tedious forms. It also adds value to the bank’s credit card. And, from Kaiser’s perspective, it creates an easy way to collect co-payments. Taken together, these are a handy collection of benefits from a deceptively simple concept.
Operational model innovation. Today, leading banks are revising their operational models to do more than raise efficiency. High on their list of goals is to create the optimal customer experience. Typically, this requires a rethink of an organization’s operational model—that is, the architecture, processes, people, and technology in place to support the business model—to ensure these elements are integrated across the different lines of business.
Take Capital One, for example. Its key differentiator is its “information-based strategy,” which uses information, technology, and testing to create customized solutions for consumers; and targeted, data-driven marketing helps drive adoption of these offerings. In a separate initiative, Capital One leveraged a seamless VOIP installation to enable employee telecommuting with a single phone number. This innovation has significantly improved the company’s responsiveness to customers.
Size Matters
Clearly, innovation is essential. But how do you know which type of innovation will drive sustainable value for your situation? It depends on the size of the bank. (Small banks are defined as having assets worth up to US$100B; mid-sized banks, between $100B and $500B; and large banks, more than $500B.) For all three sizes, operational model innovation is the price of admission. Real competitive advantage depends on investing in product, service, and business model innovation to varying degrees.
Small. Top-performing small banks typically differentiate themselves through developing innovative products and services, finding a profitable niche, and growing it. Laggards, by contrast, focus much more on business model innovation (Figure 1).
One small bank leading the pack is Boston Private Bank and Trust Company. “Each client is a client of the entire bank, not of one officer or of one business area,” says President and COO James Dawson. “We bring all of the bank’s resources to the relationship. This is very different from larger banks where the officer, department, or division feels they own the customer relationship, and are awkward responding to client needs that require cooperation from other areas.”
Another success story, U.S. Bancorp, introduced the integrated bank account, which combines traditional checking and savings accounts with credit cards, loans, and insurance. Customers that do a lot of business with the bank can receive interest rate deductions on car loans, among other benefits. Recently, the company identified 15 different services initiatives, which are expected to generate between $500 million and $750 million in incremental revenue by 2009.
Medium. The challenges are probably the greatest for mid-sized banks, squeezed as they are between small banks with niches and large banks looking for acquisitions. Competitive advantage, therefore, depends on keeping many balls in the air: creating a uniquely satisfying customer experience and a best-in-class platform that will make it easy to develop a diversified range of products and services. The high-performing mid-sized banks therefore invest in new products and services, and to a lesser extent, new operational models, while the bottom performers invest more heavily in creating innovative business models (Figure 2).
Figure 2
Innovation Strategies of Mid-Sized Banks
View Diagram
Standard Bank, a major financial services institution in South Africa, is one company that has managed to balance on all axes. Take, for example, the joint venture launched three years ago with another major South African company, telecom services provider MTN. The core product, MobileMoney, which allows customers to do their banking via cell phone any time, day or night, has made low-cost 24/7 banking available to millions of less-advantaged South Africans. And it has helped Standard reach many “unbanked” customers—a major untapped financial services market.
Large. The past decade has seen a huge wave of consolidation in the commercial banking sector. But because asset growth alone is insufficient, the most successful large banks have viewed innovative offerings as mandatory to growing net income and driving premium market valuations. New products have been important, but our research shows that new services are even more important (Figure 3). This stands in contrast with low-performing banks in this size category, which focus more on operational model innovation.
For a bank that has managed its innovation portfolio with great success, look no further than Bank of America (BoA), known for innovation since launching the first credit card in 1958. Over the past six years, BoA has been the first bank to provide online bill paying as well as international ATM remittance free of charge. More recently, it made news with its “Keep the Change®” service, which rounds up all BoA debit card purchases to the nearest dollar and transfers the difference from the customer’s checking account to savings.
Bank of America’s M&A strategy supported its innovation efforts (Figure 4). The acquisition of Fleet Boston Financial gave BoA access to new business models and a presence in the northeastern U.S., while the acquisitions of MBNA and U.S. Trust bolstered its credit card services. Although BoA has suffered its share of subprime woes, it is taking steps to get back on track. The bank, in fact, is now moving forward with plans to expand its lending business through the acquisition of Countrywide Financial.
Tips for Success
One thing our research has made clear: For banking companies interested in growth, there is no single best type of innovation. The best strategies focus on multiple areas of innovation at once—product, service, business model, and operational model. This holds true for many industries today, as the Economist Intelligence Unit’s recent survey on operational strategy has revealed.
The following guidelines can help banks of all sizes get the most from their innovation efforts.
Take a portfolio approach. Innovation initiatives should be treated as a portfolio, with attention paid to ensuring the focus is best for the business environment at hand. As is the case with any investment portfolio, it’s important to review progress routinely to ensure that resources are best allocated to achieve long-term objectives.
Be agile. As banks grow, the strategy that worked in the past may not work in the future. Consequently, success requires being attuned to the external forces that have an impact on innovation activities—customer expectations, consumer trends, regulatory requirements, new markets, and so on—and also being agile in translating these needs into viable innovation strategies. By continuously adapting innovation efforts to changing circumstances, it will be possible to exploit growth opportunities wherever they arise.
Institutionalize an innovation management system and culture. Innovation efforts won’t amount to much unless the right management system is in place to ensure that processes, technology, funding mechanisms, and governance are innovation friendly. At the same time, the culture needs to support ideation and the sharing of ideas across all functions and levels. While it is important to reward successful innovation, tolerance for failure and willingness to learn from experience are also essential.
For the banking industry as well as for other industries, innovation is no longer optional. As more and more outsiders—whether telecom, retail, or managed healthcare companies—look to get a piece of the action, commercial banks that want to outperform the competition need to make their innovation portfolios a top priority. Success during this challenging period depends upon it.
Survey Methodology
Data sources. The data used in this article came principally from Thomson ONE Banker’s database and includes all commercial banks and savings and loan institutions in the Forbes 500. Any company with at least 50% of its revenues coming from banking activities was included, so some diversified financial companies made the cut as well. Since Thomson ONE Banker standardizes its data to make it comparable across companies, the numbers may occasionally differ from those reported by individual banks.
Innovation metrics. Most product companies measure the success of innovations by looking at the R&D line item on the income statement. But since the R&D line item doesn’t exist in the banking industry, we used other metrics to assess innovation efforts.
Leading banks were defined as the top 25% of companies, while laggards were defined as the bottom 25% based on a combination of growth and performance metrics.
