In its skeptical response to recent bank mergers, Wall Street may be overlooking the potential of these companies to capitalize on the power of market segmentation.

These larger entities can use their scale to segment their customer bases more finely than before. Companies with the vision and competencies to take advantage of this opportunity will gain market share and enjoy higher revenue and profit growth.

To deliver to investors, acquisitions increasingly have to produce benefits in both cost and revenue.

On the cost-reduction front, the easy cuts associated with overlapping branches do not apply in some recent mergers. But First Manhattan Consulting Group's benchmarks for what can be achieved in nonoverlapping deals indicate that these merging companies have more than 50% of the opportunities available to in-market players. Discipline in setting cost targets and tracking results is key, and First Manhattan is optimistic that the managements in the recent deals will deliver.

The bigger challenge is on the revenue side. Banking industry revenues grew only 6% a year between 1993 and 1997, not enough to meet investor expectations of income growth in the teens.

Acquirers have an even bigger challenge. As a group they have not yet proven they can deliver revenues. For example, in core deposits, the average acquirer lost 15% relative to other banks from 1993 to 1997.

Often there are two problems: attrition rates higher than industry levels, and a slowdown in sales momentum.

In the case of attrition, some banks have built data bases that calculate customer profitability. They are taking steps to make sure the 10% of households that provide over 90% of the profits are handled in a merger with extraordinary care. The result of this approach for one client was an 80% reduction in revenue attrition.

Beyond stemming attrition, megabank managers have the opportunity to use their scale to further segment their customer bases and spur revenue growth.

Historically banks did not need to excel at market segmentation. Virtually everyone needed a checking account, opened them at convenient branches, stood in the same teller lines, and did their banking pretty much the same way.

Attempts at segmentation in retail banking through the mid-1990s often failed. Simplistic use of age- and income-based demographic schemes that had common-sense appeal often did not predict customer profitability, revenues in a household's wallet, distribution channel preference, price sensitivity, or other needs.

The lack of predictive power was recently discovered when clients with effective data bases saw little correlation between what segmentation schemes projected and the realities of their customer portfolios. Also, early forays into segmentation often used price promotions, which tended to attract unprofitable, low-revenue customers.

Now banks are investing again in segmentation. Several factors are behind this, including the low revenue growth rate in core businesses such as consumer deposits, recognition of segmentation successes in specialty lines of business such as credit cards and mutual funds, availability of advanced data base and analysis tools, and recognition that today's status quo is unstable.

The last point results from analysis that has uncovered extreme profit skews among customers-well beyond the 80/20 rule. In recent work with over 15 major banks in the United States, Canada, Latin America, Europe, and Australia, we have found that the top 20% of customers provide 120% to 150% of profits in many bank product lines. These customers are at risk of attrition, and attrition of high-profit balances has been increasing.

On the other hand, the worst 50% of customers are currently unprofitable to serve, and many do not even cover variable costs. About one-third of customers are obsessive price shoppers. They often buy the lowest-priced service, typically on a promotional basis-such as free checking or a teaser rate on loans. They make trade-offs to the bank at very low cost, using a savings account as a transaction account to avoid minimum balances and fees, for example. Many of these same households churn among long-distance providers to obtain the lowest price per minute, and are heavy users of coupons for packaged goods.

These price shoppers as a group have higher than average household income, but because of their cherry picking they are uneconomic for many bank products. Subsidizing these accounts is untenable, as this would require excess profit-taking from better customers.

What should banks do?

Some degree of repricing is possible and warranted. We call this "surgical repricing," and we have helped banks redesign prices so that the impact is focused on the most uneconomic customers, not on the most profitable (which tends to be the case when spreads are increased, say, in NOW accounts).

However, pricing will not be enough, and more fundamentally, banks need to design an approach to doing business at half of today's cost or less, to serve low-revenue customers. Banks that meet this challenge will redesign the way they do business with this segment and become the Wal-Marts or E- Trades of basic banking for the price-sensitive set.

Such redesign cannot be accomplished by tweaking current approaches. A fresh start is needed.

Bankers need to figure out what households will pay, and then build an infrastructure within affordability constraints. In some cases, scale will be the key. This would be a total departure from attempts to increase cross-selling through price promotions that can result in uneconomic households' becoming even more unprofitable.

Lessons must be learned from super discount Web-based securities trading firms that garnered 30% of the market by offering prices that were unfathomable a year ago.

At the other extreme are the customers who provide significant profits. Banks are starting to establish special facilities-exclusive 800 numbers, dedicated representatives, rewards programs-for their best customers. So far, companies adopting these "phase one" approaches are seeing very promising improvements in retention. One client achieved a 500-basis-point improvement in balance levels versus a control group.

Segmenting by profitability is only the beginning. Some creative and analytically sophisticated players will find ways to make selective use of age, income, life events, other third-party information, and clues revealed by interactions with the bank. Profitable and potentially profitable households will be subdivided into segments that have different needs and values.

Top-notch marketing skills will identify features, packages, and distribution channels that will appeal to groups of customers in ways not imagined today. For example, some households might be interested in a "snowbird" package designed for people who commute between two homes, a "bride and groom" package, an advisory-oriented program geared to subsets of retired people with the same attitudes about investing, or a set of services for time-starved professionals or entrepreneurs.

Consumers who provide most of the revenues by dint of their balance levels will realize that they can get something they particularly value from banks that have services and features tailored to them. In our experience, such segmentation approaches will be applicable not only to consumers, but also to small businesses and larger corporates.

Sometimes segmentation will merely require the ability to identify new, tailored features. In other instances, banks will need to develop dedicated business systems to deliver either up-tiered or de-featured, lower-cost services. And in some cases these segmented offerings may have to be branded differently to have marketing impact.

Some of the biggest sustainable wins will occur when a segment's needs are sufficiently different as to require a meaningful investment to serve distinctively. Larger banks have intrinsic advantages in the segmentation game, but they will need to be nimble, and to invest. Segments that would be small niches at other banks will be of sufficient scale to justify the investment in unique offerings.

Alternatively, if the large players persist in merely tweaking generic banking, they will find that other banks or nonbanks with segment specialties will be the ones who gain share, leaving the megabanks fighting for the shrinking pie of customers for whom basic services will suffice.

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