Buyer Beware

As the revenue drought drags on in retail banking, regional players are facing growing pressure for another major round of merger-based consolidation. Based on a recent Novantas analysis of the entire U.S. branch system, about 16,000 outlets, or about 18 percent of the total, will either need to be closed or reworked over the next three years.

Traditional merger models, however, will be only partially useful in meeting this challenge. To justify takeover premiums, in-market acquirers typically rely on back office and branch combinations for cost savings, while also looking for pricing power as they bulk up in local markets. In other cases, acquirers seek geographic market expansion.

These familiar merger concepts assume that branches are the core of franchise. But these former stars of the show are being relegated to more of a supportive role in retail banking. Novantas research, in fact, suggests that up to a third of all branch customers actually transact the majority of their banking business through remote channels, including online, mobile, call centers and automated teller machines. Overall, we estimate that up to a fourth of the retail customer base is receptive to using alternative channels as complete substitutes, caring about branches but rarely, if ever, using them.

This profound customer migration is accelerating, and it has serious implications for merger strategy in 2012 and beyond. In the context of a merger, the entire decision chain about branches will need to be reconsidered, including the question of what they are really worth. Traditional networks are in danger of becoming wasting assets, and it is not clear that acquirers and their investment bankers have factored this trend into valuation models.

Beyond basic deal factors, moreover, are critical questions about repositioning branches for a very different future: how they should be placed, configured and staffed; and how to cost effectively retain and build customer relationships. Acquirers will need a strong multi-channel vision for the merged entity, backed by appropriate developmental resources and an innovative sales and service culture.

From this multi-channel perspective, a regional merger could begin life with a serious competitive handicap if the predecessor companies had not already started transforming their networks. There still would be initial cost savings from capacity reduction, but the merged entity would be forced to spend heavily to catch up elsewhere, while facing an extended disadvantage in winning customers and building revenues.

There are three major steps that potential acquirers should take. One is to come up to speed on the growing base of “virtual customers” in the target networks. Another is to identify and aggressively address any competitive gaps in multi-channel capabilities. A third is to incorporate these factors into decisions about the post-merger branch network.

Novantas research shows that in the realm of everyday banking transactions, the center of gravity is clearly shifting away from the physical branch. These days, many consumers freely roam between distribution channels to fulfill their banking needs.

Based on our national survey, for example, 70 percent of consumers first go online when researching banking products and services, up from 42 percent five years ago. The preference to check deposit balances online has jumped to 68 percent from 40 percent. Consumers increasingly are looking beyond the branch for financial advice as well, with 35 percent of survey respondents saying they first turn online or to the call center.

When transferring funds, 60 percent of consumers primarily use the online channel, twice the rate five years ago. Twenty-six percent now primarily use ATMs for depositing funds, up from 19 percent. Various flavors of online deposit also have gained popularity, with 15 percent of consumers now saying they prefer channels such as automated clearinghouse transactions, person-to-person payments and remote deposit capture.

Consumers are also making greater use of mobile for basic banking services, such as account information and balance transfers, strengthening the tilt away from branch-delivered basics. More than a third of consumers now have smartphones.

These trends have significant implications for M&A, given that the physical branch has become an extremely thin tether for a large, growing and valuable portion of retail customers. As more branch-originated relationships take on a virtual life, there is a growing risk of overpaying for physical capacity.

In tandem, there is the question of how to retain and grow virtual (i.e., non-branch) customer relationships under the disruptive conditions that accompany mergers. Bankers generally know about the relationship stickiness that comes with electronic services such as online banking and bill pay. What the industry is only beginning to think about, however, is the relationship slipperiness that builds when customers heavily embrace alternative delivery and begin to lose the branch frame of reference.

While switching costs and frictions don’t go away in the online space, they often are dramatically lowered. Also, there are different provider choices (such as online banks and brokers) for virtual banking customers, and different decision factors about where to place accounts as well. This is a huge new component of merger strategy.

While the branch will continue to play a powerful role in retail banking, the rules of the game have clearly changed. Along with a nearly $40 billion gap in revenues created by regulatory and economic conditions, the U.S. branch system is experiencing annual declines in productivity for sales and transaction services.

Between 2003 and 2010, for example, the average U.S. branch experienced a roughly one-third decline in the number of daily sales generated by each non-teller staff member, according to Novantas research. Meanwhile, branches overall are experiencing a 4 percent annual decline in teller transaction productivity. Over the next three to five years, a fourth to a third of full-time teller staff may become surplus to network requirements.

This problem cannot be cleanly solved by pulling the internal levers of branch cost reduction. Major customer-facing adaptations are needed as well. Specifically, banks must work to accelerate the pace of customer online migration so that technology-enabled channels become an ever-stronger substitute for physical branch transactions.

In the new era of demand engineering, there is a pressing need to consider trends in customer behavior and identify opportunities to change activity patterns and “bend the cost curve” in the bank’s favor. The idea is to study specific categories of customer branch activity, including major types of customer transaction behaviors and the value associated with them, and then establish migratory paths that proactively guide customers into new arrangements. In the best outcome, efficiency and revenue improves, customers are more satisfied and job assignments are more valuable and rewarding for employees.

One example outside of banking is airline self-service, where customers routinely book their own flights, reserve seats, print their own boarding passes and participate in baggage check-in. Not only have air passengers adapted to these changes relatively quickly, but most strongly prefer the new arrangements, which have given them more control over transactions while also saving time.

Another example is the customize program at NIKE Inc., which allows online shoppers to tweak the designs of shoes, garments and sports gear. Such “co-production” enables customers to produce their own outcomes by interacting directly with the provider’s systems, strengthening ties between customers and organizations.

So how does this apply to branch banking? Consider the burden of manual deposit taking and check cashing, which accounts for roughly 80 percent of the daily activity in a typical teller line. We believe that retail banks should strive to convert at least 50 percent of that manual activity to customer self-service over the next three to five years, keeping in mind that this can’t be a dictated outcome-customers must see an advantage in electronic alternatives, learn the particulars of how to fulfill various transactions and incorporate new arrangements into their banking routines.

The journey starts with a customer-based transaction segmentation, which helps the bank analyze key groups such as check-only depositors and everyday small business cash depositors. This research provides key guidance in matching customers with new enabling technologies for branch self-service.

Specific campaigns to deploy and promote self-service alternatives will be needed. Examples include: 1) increased promotion of bank-at-work programs and technology that permits remote deposit capture for small businesses; 2) revised policies that provide immediate balance credit on remote deposits, placing funds immediacy on par with in-branch transactions; and 3) significant promotion of online transaction alternatives, with emphasis on customers with high transaction intensity.

Such customer-facing initiatives are critical in permitting banks to decisively lower the branch operating burden.

Ongoing trends in customer channel migration also have major implications for the shape of the physical network, not only today, but well into the future. As more sales and service transactions shift online, merger partners need to understand the implications for network configuration. Branches still have an important role to play, but there is a clear need for new strategies to maintain local market presence at much lower cost.

Sweeping measures, such as simply closing the bottom 10 percent of branches, will prove too blunt given the risk of gutting local market presence. A better approach is to steadily introduce more efficient physical touch-points into the overall network mix, including small footprint branches, storefront-style ATM installations and in-store branches and ATMs-all of which reduce the overhead for staffing and facilities.

To guide such efforts, acquirers will need a detailed understanding of the combined franchise, ranging from regional variations all the way down to micro-markets. In our experience, many banks are greatly in need of improved network diagnostics to more precisely identify the market potential and customer requirements in each cluster of local branches within the overall network.

By framing the analysis around future revenue potential, acquirers can develop appropriate treatments for various parts of the network. Some areas may need to be carefully protected, even augmented. Others are definitely in need of stringent cost reduction in light of insufficient customer demand and/or isolated placement within a weak network that is not competitive in the local marketplace.

The network analysis should be supplemented with a thorough exploration of staffing possibilities. Improved product cross-training, for example, enables the branch to maintain full service with a leaner staff. Also, there are substantial opportunities for flexible staffing arrangements that lower the full-time equivalent burden while providing quality part-time employment. Hours of operation also can be artfully trimmed.

While all of these branch-related issues are important, the larger questions revolve around the multi-channel vision and strategy for the merged institution. What is the competitive proposition for the customer?

So-called alternative channels are quickly becoming primary channels for a large and growing segment of the customer base. In turn, progressive banks are beginning to upgrade the functionality of their online and mobile capabilities and blend channel features to serve the cyber crowd more fully and keep people firmly engaged with the overall bank. Examples include:

  • continued investment in mobile banking, moving from account information, to transaction capabilities, to integrated functionality that supports customer decision-making and transactions at the point of sale.
  • cross-channel integration, so that a customer could start an application on an iPad, work together with a call center or chat agent who is working in real-time on the same application, and then finalize a transaction in the branch if so desired.
  • location services on smartphones to identify customers when they arrive at branches, and provide higher levels of service to higher value customers.
  • technology that enables customers to shape their branch experience before they arrive. An example is making a real-time appointment for advice via mobile phone, and then checking wait times in the teller line or drive-through before getting off the highway.

Some banks are going so far as to consider managing non-branch-oriented customer groups independently from the branches, with separate organizational reporting lines, budgets and dedicated resources.

It will be important for these teams to keep sight of potential revenue-enhancing offerings and the customers who might actually use them. Otherwise, scarce resources could be wasted on features and functionality that ultimately do not improve customer acquisition, retention or relationship profitability.

An example of this balancing act is mobile banking, where there is a tendency to design offers to suit the tastes of the Generation Y crowd, who are the leaders in owning smartphones. As underscored by Novantas research, this approach can go wrong by ignoring the preferences of other customers who potentially could make more extensive and financially meaningful use of mobile banking.

For example, we identified a select group of ultra-connected mobile customers who defy the Generation Y stereotype. Having a more affluent profile and spanning the age brackets, these customers are adept with all forms of consumer communications technology. They are also far more willing to undertake complex financial services transactions via remote channels.

The Gen Y segment may be quite happy to seek guidance from “the cloud,” based on ratings, user comments and feedback from friends. But in providing and promoting this arrangement, for example through a social network link, the bank could be turning off the ultra-connected, a group that is hungry for more expert advice and that would be much more trusting of a personal advisor at the bank.

The upshot is that acquirers will need to do far more homework on customers as they consider alternative channel applications and innovations, particularly products that are expensive to build and complex to manage.

As banks consider their merger options for 2012, there is a clear need to look beyond branch-centric plays based on cost reduction and market expansion. Acquirers could merely wind up with a tighter rendition of yesterday’s obsolete network configuration.

Successful acquirers will be those that correctly value both the network and the customer base within it. When performing due diligence, for example, it is critical to understand how many of the target bank’s customers are de-linked from the network.

For example, what percentage of customers visit the branch less than 12 times a year, or once a month? Which branches and local markets have the largest concentrations of those customers? What about future waves of virtual customers?

Acquirers should also diagnose the current and planned capabilities of the target’s online and mobile platforms. How far from market parity are these systems? How much investment will be needed to not only integrate the two franchises, but also to become (or remain) competitive from a call center, online and mobile perspective?

Lastly, potential acquirers will want to understand the true economics of the physical branch network, netting out the revenues and expenses assigned to virtual customers. What is the real cost-to-serve for the branch-centric customer segment? What is the rate of customer attrition in this segment? Is there really significant customer gravity in all the branches, or are some deteriorating faster than others?

Such customer-informed navigation will provide critical guidance in repositioning the combined franchise for multi-channel competition.

Kevin Travis

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