The industry has lost a major slice of the financial services pie to nonbank competitors. To win it back, banks must modernize their product delivery--and quickly.
Ed Crotchfield has seen the future of banking, and it looks an awful lot like a mail order house in Maine that's known for mackintoshes rather than mortgages: L.L. Bean. "Call them and tell them you need a new pair of soles on your L.L. Bean shoes and they'll take care of that, and then they'll ask if you've seen their new fly rods," says Crutchfield in the rich drawl of his native North Carolina.
Crutchfield is intrigued with Bean's approach because as chairman and chief executive of Charlotte-based First Union Corp., he knows that commercial banks must modernize their own distribution system. He intends to build a call-in center and staff it with a couple of hundred telemarketers who understand all the products, so when a First Union customer calls with a problem about his credit card, they can fix that--and then offer him a home equity line of credit "We're going to copy that," says Crutchfield of L.L. Bean's technique. "We're going to knock this off."
Crutchfield's dream of electronic delivery is probably a few years away, and First Union certainly isn't preparing to dump all its branches in favor of telephone banking. But the evolution toward a more efficient delivery system is one of his solutions to the substantial--some would say stunning--chunks of market share that commercial banks have surrendered to nonbank competitors of late. After spending a year examining the phenomenon, an American Bankers Association task force concluded in late June that "by all measures, the importance of traditional banking is declining"--a development with "significan public policy implications" inasmuch as a strong economy is inexorably linked t a strong banking system.
Whether this what's-good-for-banking-is-good-for-America connection truly exists, at least to the extent the ABA argues, is open to debate. While banks are still major providers of credit and other important services, a growing number of individuals and businesses seem to be getting along just fine without them--and with little damage to the nation's economy. But if the argument is that commercial banks are in danger of becoming marginalized--pushed to the sidelines as alternative sources of credit, investment advice and other banking-type services spring up to take their place--that's another matter. "Th banking industry isn't just dwindling--it's dying!" said Crutchfield earlier this year in a speech at a conference sponsored by the Federal Reserve Bank of Atlanta. "Nonbank competitors are circling for the kill."
Crutchfield's goal of building a highly effective and productive distribution system that would mirror an important advantage of the nonbank crowd is one strategy for reversing the industry's market share decline, but there are others. The ABA turned its market share report into a political manifesto for broad regulatory reform of the sort that would level the playing field by eliminating some of the industry's built-in disadvantages. Norwest Corp. Chairman and CEO Richard Kovacevich gives voice to this view when he says, "We've got to shake up--wake up--legislators to give us some change." Kovacevic would go even further: "My own opinion is I would give up the insurance fund to get regulatory relief."
No Holy Grail
But searching for the Holy Grail of reform in Washington has been a frustrating and, despite an apparent victory on interstate banking, largely unproductive exercise. It's not that the banking system, with its inefficient regulation and a long-as-your-arm list of prohibitions that ignore the realities of the marketplace, hasn't come to resemble a Rube Goldberg machine. But by the time Washington takes the industry's pleas seriously, there may not be an industry left to save; when it comes to banking, the "doctors" in Congress usually function more like coroners than practioners of preventative medicine.
The uncomfortable truth is this: Banks may have to solve their market share problems themselves. And a good place to start is with an outmoded delivery mechanism that is one of the principal reasons why banks have surrendered so much turf. The challenge, says Crutchfield, "is to hang on until you can solve the fundamental problem, which is a bloated distribution system."
The erosion in market share is not a pretty picture. Between 1980 and the third quarter of 1993, total business credit in the U.S. grew from $2 trillion to $3. trillion. Over that period, nonbank market share grew from about 55% to nearly 70%--while the industry's piece of the pie shrank from about 45% to a little over 30%. In other words, banks lost ground even while the overall market was growing.
But wait, there's more. In 1973, bank deposits accounted for 34% of all household financial assets, behind stocks and bonds (38%) but comfortably ahead of mutual funds and insurance and pension reserves. Twenty years later, insurance and pensions--fueled by the rise of defined-contribution plans like 401(k)s and the growing concept of pension portability--led with 36%. Mutual funds had grown to 10%, while bank deposits had slipped to 19%. Indeed, mutual fund assets now exceed $2 trillion--more than the total deposits of the country's 100 largest banks.
Clearly, the industry is not keeping pace with its nonbank competition. "Financial assets are growing dramatically, and we're lucky to hold our own wit inflation," complains Kovacevich. Like many other bankers, Crutchfield finds th growth of mutual funds very alarming. "It's just absolutely stark," he says of this dramatic reversal. "We're just not growing deposits, and (First Union is) supposed to be in a growth part of the country."
The industry's loss of market share is hardly a new phenomenon, of course. It began decades ago, exemplified by the growth of commercial paper and money market funds--both of which took deadly aim at traditional bank products.
But the sudden shift in the balance of power between bank deposits and mutual fund assets has given the problem a renewed sense of urgency. While the industr has been elbowing its way into the business, bank-managed mutual funds still account for only 11% of all funds. And while it would seem that deposit totals are sufficient to support loan demand at this time, which implies that banks aren't really being hurt by the decline, the industry has good reason to be concerned. "I'm not sure what it will require to get these deposits back," says Richard Aspinwall, chief economist at Chase Manhattan Corp. Absent some "terrible shock to the mutual fund business" like a collapse of the stock market, he adds, "people will ask 'Why should I ever come back?'"
Blame It on the Bommers
Banking's market share decline is partly a function of broad changes in the U.S economy. In an era of low interest rates that currently prevail, many savers--still accustomed to the high rates that banks used to pay on certificates of deposits in the late 1970s and early 1980s--have become investors through mutual funds. Many of these savers-turned-investors are older baby boomers who are beginning to fund their children's college education, or save for their own retirement.
But the ABA offers another reason for the industry's declining share: the regulatory burden that all banks are saddled with. The manifestations of this burden are two-fold, beginning with the restrictiveness of a regulatory system in which it takes longer for banks to react to market changes than nonbanks. "While changing customer needs, financial innovation and technological advances are telling bankers to move into new markets, regulatory restrictions and excessive regulatory costs are making this transition very difficult," the ABA market share report concluded.
The other aspect of banking's burden is the cost of regulation itself. There's no question that Washington has imposed a great many restrictions on banks that nonbanks oftentimes escape. Although the industry is prohibited by the Glass-Steagall Act from engaging in many aspects of the securities business, a small but growing number of commercial banks are permitted to do so through so-called Section 20 subsidiaries. But these vehicles are so tightly controlled and bound up with various restrictions that it automatically raises a commercia bank's costs compared to those of an investment bank like Merrill Lynch & Co.--which has no such restrictions. And Kovacevich estimates that it costs banks an extra 15% to 25% to distribute mutual funds solely because of additional regulations that don't apply to nonbanks.
And yet the true cost of regulation is a slippery subject. Although the ABA did not include any estimates in its market share study, the trade association estimated last June that regulation cost the industry about $10.7 billion in 1992. Add to this figure another $5 billion for the industry's Federal Deposit Insurance Corp. premiums in 1992, and you get $17.5 billion.
But this is not the net cost of regulation, because it fails to take various offsetting factors into consideration, like the benefits of deposit insurance. David Humphrey, a professor of finance at Florida State University and former economist with the Federal Reserve, says it would be considerably more expensiv for banks to purchase deposit insurance from the private sector.
While it's impossible to gauge exactly how much it would cost, Humphrey provide an educated guess. From 1978 through 1990, the spread between a three-month Treasury bill--a very safe investment--and an uninsured certificate of deposit in excess of $100,000 was 84 basis points. Another way of looking at this is that investors expected an additional return of 84 basis points to compensate them for the risk of investing in an uninsured CD. "In a very rudimentary way, this represents a first cut at what the market will charge the industry to insure their deposits," Humphrey says.
The FDIC Subsidy
Subtract, say, 25 basis points for the cost of FDIC coverage, and this analysis suggests that the federal government is subsidizing the industry's deposit insurance costs on the order of 59 basis points. Now, if the industry paid $5 billion in FDIC premiums in 1992 on total assets of $3.5 trillion, that works out to 14 basis points. Granted, these are back-of-the-envelope calculations, but even so it's obvious that banks are getting quite a bargain from the FDIC. Or as Humphrey puts it, "It's clear there's a subsidy going on here." And the value of that subsidy will increase once the Bank Insurance Fund has been replenished and FDIC premiums are lowered for most banks, probably in 1996.
Although he may be in the minority, Crutchfield is one banker who dismisses the cost of regulation as a significant factor in the market share war--at least fo an institution the size of First Union, which has about $71 billion in assets. First Union made a 17.4% return on equity in 1993, and Crutchfield doubts whether regulatory costs reduced that by more than 50 basis points. "It's not crippling," he says. Even Kovacevich concedes that while the regulatory burden "makes it difficult, it doesn't make it impossible." Where regulation can be a significant factor is for bankers running much smaller institutions, since it helps to be able to spread your costs over a larger base. "For them, it may be 200 basis points (of ROE), and it is bigger," Crutchfield says.
Commercial banks have other disadvantages that aren't just a function of regulation. Since they generally sell fewer products--just credit cards or home mortgages, for example--nonbanks often find that specialization becomes their ally. "There is a benefit to business focus," says Scott Marks, an executive vice president who runs First Chicago Corp.'s credit card operation. "When an organization focuses on a particular business, it gets pretty good at it."
Consumers have also grown accustomed to buying their financial services product from different sources, and see little value in one-stop shopping. "As a genera statement," says Marks, "American consumers have been very willing to buy mortgages and credit card services on a stand-alone basis."
Most importantly, perhaps, many nonbanks have less costly distribution, since they sell most of their products through the mail or over the phone. Aspinwall says the total operating costs for The Vanguard Group are no more than 25 basis points of assets under management. "Twenty-five basis points is less than our FDIC insurance premiums!" he laments. Crutchfield couldn't agree more. "The mutual fund guy can manage money at a fraction of what we do it at," he says. "He can do it cheaper because he has cut out the middle person."
Branch Costs Too High
Ultimately, the problem lies in "the enormous fixed costs that banks are dragging along in the branch system," Aspinwall says. "The (regulatory) burdens are not trivial. But to me, they are only part of a dynamic that is a difficult adjustment for the banks. I just think the branch system is in many respects obsolete."
The problem ends up being one of structure, because the consumer side of many banks is still organized around the branch. A great many banks have hived off their credit card units into national product companies that solicit customers through direct marketing programs, which lowers their costs. A bank could certainly do the same thing with its mutual fund activities, or operate its mortgage banking operations from less expensive storefront locations like Countrywide Funding Corp. Arguably, breaking as many products as possible out o the core bank and giving them their own structure will yield similar gains in efficiency and focus that work so well for the nonbanks.
But Kovacevich says that organizing a bank into a collection of stand-alone product companies is a poor trade-off for customers and banks alike: the costs are still too high, and it encourages single-product relationships. Says Kovacevich, "We want to say to our customers, 'There's a dinning room here, don't order a la carte."'
Nor does this approach solve the problem of that expensive branch network. "Wha do I do with the bank that's left over?" asks Crutchfield. "I can open a fast food operation, but what do I do with the 1,000-seat restaurant that I used to fill up at $100 a head?"
Indeed, part of the answer may lie in pressing one of the advantages that banks still enjoy--the ability to offer their customers a variety of different products from a single source. Vanguard doesn't offer mortgages and Countrywide Funding doesn't sell credit cards--and yet banks do both. Whether you call it one-stop shopping or relationship banking, it's a strategy that many banks are counting on to recapture consumer market share.
When used effectively, it can make a difference. Geoffrey Nicholson, a vice president with the Boston Consulting Group, says that Wachovia Corp. does a better job of expanding its customer relationships than most banks. According t Boston Consulting, the average U.S. household has 4.75 product relationships. The average bank has 1.85 of those, while Wachovia--at 2.3--does considerably better.
Relationship Banking Works
This didn't happen by accident. Wachovia has pursued a relationship banking strategy--called Personal Banker--since 1973. Because of increasing product complexity, a Wachovia Personal Banker now acts more like a quarterback, oftentimes handling off the customer to specialists within the bank. But the intent hasn't changed. "I think people enjoy one-stop shopping for their bankin needs," says Wachovia senior vice president Wil Spence, who runs the bank's consumer financial services division. "I think we've proven to ourselves that people like having one person at the bank to call. As busy as people are today, that's important."
Wachovia's success notwithstanding, why should most Americans alter their norma pattern of buying financial products from a variety of vendors? "It's not only one-stop shopping," says Michael Zucchini, a vice chairman who runs Fleet Financial Group's retail business. "It's the ability of these products to operate in concert with each other." Example: Providing Fleet customers with a consolidated financial statement and a toll-free telephone number for service, all tied together with an ATM card or, eventually, a debit card.
Relationship banking also gives the institution pricing leverage, since the expense of adding new products to existing accounts is considerably less than acquiring new ones. Some of these savings can be passed on to the customer.
Zucchini acknowledges the challenge of getting bank customers to change their behavior, but he believes it can be done. "It's not that you will satisfy everybody, but you will satisfy a large segment of the population at a profit," he argues. "Maybe someone wants a frequent flyer program and we don't offer one but that doesn't mean (relationship banking) won't work."
Unfortunately, it does require that banks learn to cross-sell different product to the same customer, a significant cultural change for many of them. Spinning various products out into profit centers has helped their performance, but it also has created a fiefdom syndrome that must be overcome if the cross-sell--an relationship banking--is going to succeed. "Now the goal is to get people to work together," says Nicholson. "If banks are going to survive, either they completely isolate their companies, or they make the cross-sell work."
And yet even if it does succeed, one-stop shopping by itself will not overcome the disadvantages of the branch's high cost. While they learn to build broader relationships with their customers, banks must do so through a variety of distribution channels, of which the branch is only one. "A branch today is just one element and shouldn't be the focal point," says Zucchini. "The customer defines good service"--as well as the method through which she accesses the bank, whether it's a branch, the telephone or an ATM.
Boston Consulting says the mix of "banking channels" is still evolving. The branch, which it says accounts for about 43% of all transactions today, will drop as low as 30% by 2005. Penetration by ATMs, which comprise 31% of all transactions, is forecasted to drop as well--to between 15% and 25%. The big gainers are the telephone, which should jump from 24% today to as much as 35% b 2005; and debit cards, which account for a scant 2% of all transactions today, but could grow to 30% by then.
How Many, and Where?
If branches are creeping toward obsolescence, why not eliminate them now? After all, maintaining multiple channels will itself be expensive, and the object is to bring delivery costs more in line with the non-banks. The reason: Because a significant number of people still want to bank at a branch. "There may be more expense, but the real issue here is profit," says Zucchini. "I can tell you today that if we eliminate all our branches, we'd have reduced profit." He adds "The real question today is how many and where?"
The object, then, is to pursue a strategy that weans the customer away from the branch to other, less costly forms of distribution. Spence believes it can be done, and points to a call-in service center that Wachovia opened this June in Columbia, SC. Although it's still being tested and Wachovia has done little advertising, Spence says "the number of telephone calls coming into the center has been tremendous." He adds: "Today, a lot of (relationship banking) is being done on the telephone. A lot of this will be done on the phone 24 hours a day."
For his part, Crutchfield says the problem is not figuring out the destination--but getting there. First Union has eight million customers. "The job is to cycle those eight million customers from the current distribution system into this new distribution system," he says. "(The customer's) fear is that change is coming, but my fear is that it won't come fast enough."
Change always entails risk. But as Boston Consulting's Nicholson puts it: "If you don't change, you're dead." And that's Crutchfield's point exactly.