How to Triumph over Disintermediation
Not too many years ago, the financial marketplace was easy to understand. There were commercial banks, savings and loans, insurance companies, and brokerage firms. Customers knew exactly where to put their money, where to borrow money, and where to make investments.
How times have changed. Deregulation, coupled with a more sophisticated and demanding customer, has created a financial arena that is anything but simple. Customers have myriad choices before them and are taking advantage of this financial freedom.
More than One Game in Town
When brokerage houses began offering cash management accounts, customers could do their banking and purchase investment products in one location.
This put banks and thrifts in a precarious position.
Over the years, deposits had been considered the "raw material" of the financial services industry. This raw material was manufactured into loans and investments to generate interest income.
Suddenly, banks and savings institutions could no longer think of themselves as the only game in town for depositors - and their deposits.
Learning to Cope
Some in the industry may have viewed this new competition as a threat. But others saw it as an opportunity for banks and thrifts to rethink long-term strategies.
They clearly had to find ways to maintain customer relationships. That meant changing the way they do business.
They also could no longer rely on the spread between interest charged and interest paid as their sole source of income. They would have to find additional sources of off-balance-sheet revenue.
By selling alternative investment products, such as annuities and mutual funds, banks and thrifts had hopes of preventing their customers from taking deposits to competing institutions that could offer these products as well as savings and checking accounts.
Alternative investment products also generated additional revenue for banks and thrifts, in the form of riskless fee income.
Disintermediation Angst
On the surface this sounded great, but not all banks jumped on the bandwagon.
Many still resist the notion that selling investments to their customers is a good idea.
Why? Simple: fear of disintermediation.
Disintermediation is the movement of funds out of insured depository institutions into noninsured investment alternatives.
The thought of losing precious deposits goes against the grain of many bankers. Some banks would rather risk losing customers and incremental revenue than make it seemingly easy to withdraw deposits.
Disintermediation hit its peak in the late '70s and early '80s with the introduction of money-market mutual funds that offered high rates, liquidity, and relative safety.
Stemming the Outflow
The resulting massive shift of funds out of the banking and thrift industry also threatened the government's ability to effectively control the money supply and set monetary policy.
Congress, therefore, belatedly moved to deregulate customer deposit interest rates. Deregulation, it was hoped, would stem this outflow and allow banks and thrifts to compete on a more level playing field.
Many in the banking industry don't understand the true nature of the potential disintermediation problem. The industry is moving into an era in which funds will be far more plentiful and demand for credit scarce.
Disintermediation will occur, but not because of the availability of more attractive interest rates. It will happen because customers demand alternative investment products.
The new generation of consumers will choose providers that offer more convenient ways of saving and investing, more flexibility in product options and choices, and higher total returns.
The real threat, therefore, is not deposit disintermediation. More likely, there will be customer disintermediation, as consumers abandon bank and thrifts at a continuously increasing rate.
Fear of Dwindling Deposits
Some institutions utilize salaried staff who take orders for mutual funds and other products. Other institutions employ a more aggressive approach, contracting with specialty companies that employ high-powered salespeople.
Although customer disintermediation is the real threat, possible deposit disintermediation should be taken seriously.
The vigilant bank or specialty company will continually monitor investment activities for signs of deposit disintermediation.
Over the past few years, techniques developed in the marketing of investment products have lowered levels of disintermediation.
In some cases, these techniques have actually stimulated the inflow of deposits to a bank. For example:
* Higher payouts to investment representatives when funds come from other financial institutions.
A representative who sells an investment product to a bank customer will earn significantly higher commissions when those funds originate from a source other than the bank where the representative is selling. This provides an incentive to encourage clients to tap deposits in other institutions.
* Investment representatives are paid to cross-sell bank products.
Representatives are paid to sell certificates of deposit and other products offered by the banks in which they sell. This is a cost to the investment company, but is effective in bringing deposits into the bank.
Turning the Tide
Do these procedures work? A 1990 survey of 30 Liberty Financial client institutions found on average a net disintermediation level of minus 6.8%. In effect, when new funds brought into the institution by investment representatives are included, intermediation has occurred.
It must be underscored that the conditions that created the historical view of disintermediation no longer apply. The customer is changing - and so are the competition, regulations, and the fundamental factors that drive profitability.
All of these factors are contributing to the need for a new management and strategic perspective - a perspective. Maximizing total customer profitability must be defined as the combination of intermediation income and new sources of fee income.
Taking Charge
The strategic challenge of the 1990s and beyond will be to understand customers' attitudes more fully.
This understanding can lead to the design of a system of doing business that provides superior convenience and flexibility, and actively manages the flow of funds between insured and non-insured investment products.
Successful organizations will take the appropriate steps to re-engineer themselves, adapt to this emerging environment, and thus revitalize earnings.
Mr. Ken Liebler is president of Liberty Financial Cos., whose activities include packaging investments and selling them in bank branches. The parent company is Liberty Mutual Insurance Co., Boston.
