Shattered Myths

All of us need truths to hang onto, strongly held beliefs that govern our activity and rule how we behave in our environment. We develop these beliefs by observing the world around us, and, over time, the most widely shared beliefs assume mythological proportions. They become ingrained, challenged by only the most inquiring and skeptical minds of the times.

Classic myths developed over centuries, from times when the earliest inhabitants of the planet sought to explain natural phenomena. Why did the sun appear every day? Why did storms come? What happened after death?
Business myths haven’t had the ages to form, and banking myths have developed over an even shorter timespan. Yet develop they have, and over the brief 25 years since deregulation of the financial industry began, a set of beliefs arose, became gospel, and were honored in practice by the vast majority of American bankers.
Now they are crumbling.

Myth Number One

The 80/20 rule

No rule of thumb more completely runs across industries and businesses than the 80/20 Rule: Twenty percent of your customers will bring 80% of your profits, and that’s pretty much true whether you’re talking top line or bottom line. When you look at who’s doing business with you, a heavy percentage is done with a relatively small segment of your customers. There are few exceptions to this longstanding rule; if anything, it is conservative, with businesses often finding that 90% or more of their profits are provided by 10% or fewer of their customers.
In the 1980s, a procession of business gurus popularized the 80/20 rule among bankers. Jack Whittle, a former Continental Bank marketing head and later a prominent consultant, chided bankers for treating the 80% of customers just as well as they treated the highly profitable 20%. Whittle promoted a philosophy that said, “If it moves, price it” and ridiculed banks for giving away the store. S&Ls were held up as especially bad examples of businesses that paid far too little attention to the bottom line, while handing out cookies and setting up private lounges for profitable and unprofitable customers alike. Whittle urged banks to place high minimum-balance requirements for free checking and encouraged bankers to explicitly price services, going so far as to suggest fees for answering telephone inquiries and for providing elderly customers with assistance in balancing their checkbooks. If the result was to run off customers, so be itu00e2u20ac”these were customers the bank needed to lose, anyway.

But there’s a problem in this application of the 80/20 rule: It ignores the fact that fixed costs need to be spread over a large customer base; if the customer base of a retail bank shrinks, the fixed cost per customer grows. More critically, it ignores the very great potential 80% of customers have for using other mass-market financial services like auto loans, credit cards, home equity loans, and new products that banks are perfectly well qualified to design. Moreover, driving away customers runs totally counter to everything a community bank has historically stood for. Run off customers, and a bank is not only limiting its opportunity to sell new services to those customers, it is damaging its hard-earned reputation in the community.

Myth Number Two

Internet banking, telephone banking, and ATMs will make branches obsolete.

ATMs started to come into their own in the early ’70s, when they were set up inside or immediately outside their banks’ branch offices and were seen by banks largely as a way of saving money, by reducing the need for tellers. Soon there were a couple of thousand ATMs nationwide, and banks found the cost of processing deposits and withdrawals via ATMs proved to be less than the cost of training and employing tellers to do the same work. The numbers in subsequent years rose exponentially and by 2004, there were 383,000 ATM machines in use in all manner of banks and retail outlets, according to Dove Consulting. Over the years, consultants and industry gurus weighed in on the trends: ATM usage was becoming widespread; young people didn’t want to go into the bank; older users, who stayed away from ATMs in droves in the early days, were becoming true believers, using their ATM cards as enthusiastically and frequently as their children.

At the same time, branches were becoming more costly to establish. Real estate was booming, and competing with fast-food franchises and oil companies for prime locations was putting costs through the roof. Bankers were worrying about winding up with a portfolio of unneeded branches. Why not instead bet on the coming technology and put ATMs on every corner, providing a level of convenience branches couldn’t match? Following that logic, many banks slowed their branching strategy even as the legal barriers to widespread branching were tumbling down.

As banks entered the ’90s, the case for bricks and mortar looked ever weaker. Wouldn’t people gravitate toward handling all their banking from a distance, paying their bills by phone or computer, and banking with an aggressive new Internet bank or the online service of their own bank? The numbers seemed to be bearing this out: In 1988 there were 86,000 banking locationsu00e2u20ac”main offices and branches. By 1994, the number had shrunk to 81,000.

But it now appears that was a short-term bump in the branching juggernaut. In fact, the last few years have seen a resurgence in branch banking. By 2001, the number of branches had bounced back to 86,000, and last year it had grown to nearly 89,000. The trend seems to be continuing.

More impressive than the raw number is which banks are branching. It is the most vital of the banks that are making the biggest commitment to growing their branch structure. Bank of America announced in June that it would add 200 branches a year for the next three years. Though recent mortgage-related problems have slowed Washington Mutual’s branching, it was opening 20 new branches a month through most of the past two years. Except where regulatory authorities require it, consolidating banks have pretty much stopped closing branches after the merger is complete. More often, they view branches as part and parcel of the bank’s growth plan, the linchpin, in fact, of their deposit-gathering strategy.

Myth Number Three

The checking account is a costly bank serviceu00e2u20ac”at worst, a drag on profits; at best, a loss leader.

When the Federal Reserve began publishing its functional cost analyses in the ’50s, banks learned what it cost to provide a checking account, yet even so, some banks had a bedrock belief that checking accounts should be free, especially for seniors who were price-conscious and would seek out free checking elsewhere if their bank failed to offer it.

Other banks had a dramatically different set of beliefs regarding checking accounts: They knew it was expensive to maintain a checking accountu00e2u20ac”a belief supported by the functional cost analysis figures that usually showed it cost a bank in excess of $6 a month to offer a checking account. Such banks responded either by placing a metered fee on checking (“dime a time” checking fees were common) or by placing a high-average or minimum-balance requirement on the accountu00e2u20ac””Checking with us is free, provided you keep $1,000 in your account at all times during the month.”

Both approaches failed to recognize a number of things about checking accounts. First, it is now clear that the checking account is the hub account for other services. Those banks that offered free checking (or free with a low minimum balance) until the mid-’90s often provided this explanation: We do it because free checking is a loss leader for other services. Implicit in that explanation is an understanding of the checking account as the hub service, but very few banks actually took advantage of this by aggressively selling other services to checking account holders.

Second, it has become clear that free checking can move market share. Banks offering free checking, when first in the market to do so, were regularly chalking up double-digit growth, even in no-growth markets. Ralph Haberfeld, whose California-based consulting firm had been touting the benefits of free checking to community banks for years, was finding success in much larger banks, and in ever more competitive communities. When banks like Fifth Third and Washington Mutual made free checking the cornerstone of their move into new markets, bankers everywhere got the message.

Third, the one major problem with free checkingu00e2u20ac”the loss of service-charge revenueu00e2u20ac”is being overcome by offering customers an alternative to regular checking, a “package” or “club account.” Banks offering such a package, containing accidental death insurance and other services with a fee as high as $8 or $9 a month, have found that a high percentage of customers voluntarily choose such a package instead of the free account. As a result, banks are able to have the best of both worlds: a “free” account that may prove successful in attracting customers from other banks, and a package that can more than make up for the fee revenue forfeited by going to free checking.

Finally, the potential for fee income associated with checking accounts has grown dramatically. Initially, it was overdraft charges. For decades, the customer who overdrew his account balance received a stern letter from the bank, was tolerated for a while, and eventually was asked to move his account. As banks have raised their overdraft charges from $2 per overdraft to $20 and more, overdrafts have become a major profit center. And with the development of overdraft protection services, marketed aggressively by third-party vendors and developed internally by many banks, the desirability of building a huge base of checking account customers, even low-balance ones, has been heightened dramatically.

In short, checking accounts moved from a necessary evilu00e2u20ac”when savings and loans first got checking powers many S&Ls chose not to offer themu00e2u20ac”to the primary vehicle by which dynamic banks are fueling their growth.

Myth Number Four

Seniors won’t move their accounts.

Banks for years have misunderstood the senior market. Until the ’80s, banks usually offered seniors, typically defined as those 60 or 65 and older, free checking. And that was pretty much it. A few banks had senior “clubs” that might take members on field trips now and then, but little more. Some banks viewed their seniors as a needy subgroup who clogged their lobbies “when the eagle flies” (the day of the month when social security checks arrive), and thus provided the free account, because seniors needed the extra help.

As banks more closely analyzed the profitability of their accounts, it became clear that seniors were not only profitable customers, they were disproportionately responsible for bank profitability. They kept huge balances in both checking accounts and savings accounts. They were somewhat yield consciousu00e2u20ac”after all, they had for decades supported S&Ls because of a quarter percentage rate differential, hadn’t theyu00e2u20ac”but they weren’t as yield-driven as bankers thought. They were, in fact, much more concerned with service and convenience than with rate. And contrary to the belief that seniors don’t move accounts, when aggressive banks began offering package checking accounts specifically tailored to seniors, they moved their accounts. What’s more, if the bank offered insurance and other benefits, seniors, to most everyone’s surprise, would actually pay for new services.

This misunderstanding of the mature market, so ingrained in the belief system of the industry for so long, is especially meaningful in teaching bankers not to take their customers for granted. Bank customers of all ages, it seems, are pretty much like customers of every other service business: Give them a better product, price it fairly, and they will make a conscious decision to switch providers if doing so is relatively painless.

Myth Number Five

S&Ls were stupid.

Bankers, it must be said, have always secretly believed themselves superior to others of their species. After all, credit unions couldn’t help but succeed, what with all those tax breaks not afforded a commercial bank. And S&Ls? Well, the S&L sort of falls into the “other competitor” category. Historically, the savings and loan was that sleepy institution on the corner that survived because it could pay a fraction of a percent more on regular savings accounts, and because it had a monopoly on home mortgages.

Looking back, it’s clear that the S&Ls were doing a lot of things right. As banks across the country are falling all over themselves to replicate Umpqua Bank’s coffee bars and branded coffee, and as Wamu patents its “system” of doing business with special areas dedicated to specific activities, it is useful to remember the heyday of S&Ls. That was when coffee and doughnuts and customer-focused services like checkbook balancing were the exclusive province of those laid-back S&Lsu00e2u20ac”financial institutions with some of the most loyal customer bases seen before or since.

Myth Number Six

Banking is different from other businesses.

Bankers like to think their profession is different. And for most of the history of American banking, it has been different. While most professionals have long worked from 8 a.m. to 5 p.m., it wasn’t long ago that banks were open from 9 a.m. to 2 p.m., and, with an hour or two for reconciling the day, it was the rare banker who wasn’t home for the evening news, or maybe even squeezing in a late afternoon round of golf. Weekend hours were unheard of. White shirts and suits prevailed long after workplace fashions had changed in America.

But in fact, the idea that banking is somehow different from other businesses retarded the development of the industry. Long after retailers were discovering that long hours of operation, weekend openings, and a generally customer-centric way of doing business separated the winners from the losers, bankers were still viewing their business as one that was immune to the competitive incursions of new players and to the demands of its customers.

Myth Number Seven

Banking is a commodity business.

Underlying all the myths above is the idea that banking has become a commodity business. This concept is death for a bank, because the logical extension of viewing banking as a commodity is to believe that price (for services) and rate (for deposits and loans) will prevail. The successful bank will be the low-cost provider. This is the easiest of myths to sell internally because it has a seductive logic to it: All we have to do is offer the highest yield on deposits and charge the lowest rate for loans and other services, and if we keep our expenses lower than anyone else, we’ll do fine.
Yet, look at the retail banks that are setting new standards. Decidedly, it is the banks that aren’t viewing banking as a commodity business that are winning.

Tom Brown, whose investment firm, Second Curve Capital, has long been a vocal supporter of New Jersey’s Commerce Bank, did a quick survey in August of bank deposit rates in New York (see chart). Here’s what he found: At a time when arguably the most aggressive of the deposit gatherers, Commerce Bank, was entering the most competitive market in the country, one would have expected to find cutthroat savings rates as the battering ram. Yet clearly, Commerce Bank wasn’t buying deposits, as its critics had widely charged. Something else had to explain Commerce Bank’s success in entering New York City, just as something else must explain Commerce Bank’s 30% annual deposit growth rate since 1991.

What about fees? Given the recent flight to free checking, doesn’t this prove the banking-as-commodity argument? Yet here, too, a look at the better banks shows otherwise. Washington Mutual has been offering free checking for more than 10 years now, far longer than most of the big banks that have used that strategy to gain market share recently. Yet a close look at its customer base shows that while many of its customers may be attracted initially by a free checking account, they have in fact chosen an enhanced account that provides benefits beyond a free account. In exchange, these customers are paying a fee to the bank for the package that is significantly higher than even the service charge they would have had before the bank adopted free checking.

Going down the list of bank services, the commodity concept fails on loans, as well. The fact is, businesses and individuals alike rarely shop for loans. Businesses tend to work with a bank and a loan officer they know, and individuals seldom shop for car loans or personal loans. And even in an environment of Lending Tree and other low-cost, out-for-bid mortgage opportunities, it is a traditional financial institution that still tends to end up with the bulk of the business.

Once again, customers seem not to want a commodity products; they want their bank to enhance its service with longer hours and days of operation, to provide convenient branch access with knowledgeable employees available onsite, and to offer enhanced products for which they will willingly pay a premium.

Myths die hard, though, in banking as elsewhere. There remain many banks in this country who still subscribe to some or all of these myths that have ruled for so long. But the number of such banks is dwindling. They are the banks that are selling out to join more aggressive franchises. Or they are the banks that are dying slowly, plodding along, losing market share, giving up their franchise value, and focusing on a bottom line that, at least for a while, can still satisfy the nonquestioning, nondemanding board.

Meanwhile, a handful of savvy banksu00e2u20ac”often led by bankers who have cut their teeth at companies totally outside of the financial services industryu00e2u20ac”have been setting new standards. They’ve shattered the myths as they establish new ways of doing things in a very old industry.