Good customers are good customers right up until they’re not. This is the fundamental paradox of credit risk analysis. The most profitable customers are often the ones that are closest to being unprofitable.

A customer who uses their credit card heavily and frequently pays late (but always pays) is very profitable. A customer who behaves in exactly the same way, but doesn’t pay off their balances or fees is very unprofitable.

This is the challenge faced by credit risk analysts—separating profitable and unprofitable customers despite the fact that, behaviorally, the two groups are remarkably similar.

Overcoming this challenge—segmenting customers based on small but important behavioral differences—is no longer the sole responsibility of credit risk analysts. They must also identify the right mix of products for individual customers to ensure profitability in the wake of new regulatory and consumer behavior changes.

There is a clear need to realign retail banking costs with retail banking revenue drivers based on customer behaviors. There are certain parts of retail banking that cost a lot of money. Branches, for example, are expensive. The costs to build, staff, and run person-to-person channels like branches or call centers dramatically outweigh the costs to support self-service channels like online or mobile banking.

Certain customer behaviors are also absurdly expensive. It costs significantly more to process a check than it does to process a debit card transaction. In that same vein, due to recent regulatory changes, it is now more cost effective for banks to process credit card transactions than it is to process debit card transactions.

All of these retail banking costs are driven by consumer preference. Banks need to build branches and accept checks because some of their customers still want to use branches and write checks. This leads us to two questions:

1. Can we realign the costs of retail banking with the revenue drivers for retail banking?

2. Can we incent customers to behave in less costly/more profitable ways?

Let’s consider the first question. Cross-subsidization gets us in trouble. We know this now. Each part of the bank should make financial sense, independently. This should extend all the way down to each individual customer.

If a customer’s financial preferences and behaviors are expensive, the cost of the financial products and services to them should be comparable. People who design financial products for a living call this a fair value exchange.

The customer is paying for the value they are receiving. This can also be called relationship-based pricing. And the idea is exactly the same. Let’s say that a bank wants to cross-sell a credit card to a current DDA customer.

This customer rarely utilizes branches or call centers, writes very few checks and uses direct deposit. Because of their small support cost footprint, the bank can automatically decision and approve them for a credit card offer with an extremely low interest rate. This approach ensures that each customer relationship is independently profitable to the bank.

The second question that we want to address is can we incent customers to behave in less costly or more profitable ways? Banks need to continue to support all of the channels and features that customers want, even though some of them may seem prohibitively expensive.

If you decide to get rid of all your branches because they were so expensive to operate, you will save yourself a ton of money but you may also lose a big portion of your customers (even the ones that only occasionally use branch banking) to your branch-enabled competitors. The same argument applies to free checking. If consumers really want a product, or service, or channel, or feature, there will always be a competitor who is willing to offer it.

However, this doesn’t mean that banks have no power to change their customers’ preferences and behaviors. Incentives can range from subtle to overt, but I think the key is for the incentives to be framed positively.

The first response of large banks to the Durbin Amendment is an excellent case study:
• The profitability of DDA portfolios takes a major hit—many banks respond with the planned introduction of a new debit fee which they hope will balance out the profitability of their DDA portfolios—consumers perceive these fees as a new and unfair “tax” and react negatively—the banks cancel their planned fees—roll credits.

For all practical purposes, the planned debit fee was an incentive. From the perspective of the banks that tried to introduce them, it seemed like a logical move. “DDA accounts are not as profitable as they used to be. If customers want to keep using them, they will have to pay a higher price.”

By raising the price of their DDA products, the banks gave their customers a clear economic incentive—switch to a different product or a different bank.

Unfortunately, many of their customers chose the latter option. Instead of moving from their bank’s debit card to their bank’s credit card as their main payment product (which would have been a profitable transition for the bank), many consumers chose to move their DDA account to a different bank.

The reason that this fee incentive failed was because it was a negative incentive rather than a positive one. It was a stick, not a carrot. If there is one thing that every company should have learned from the aforementioned debit fee example (and Netflix’s disastrous price change for that matter) it’s that today’s consumers don’t respond well to negative incentives.

So again we come back to the question, what can we do to incent customers to act in more profitable ways? Well, if negative incentives don’t work, then we need to focus on positive incentives. There are numerous examples of how this can work in the financial industry.

A special rewards program for customers who switch from debit cards to credit cards. A donation to the non-profit of a customer’s choice if they switch to paperless statements. The elimination of account fees for customers who frequently use self-service channels. There are thousands of possible incentives that could work. The key is to reward customers with a carrot rather than threatening them with a stick.

The landscape for credit risk analysis will continue to evolve. There is a tendency, when profitability is challenged, for whatever reason, to take drastic and immediate action. “Revenues are down? We need to close 200 branches! We need to introduce a $5 fee! We need to act!”

It is much harder to react subtly and strategically, to make small realignments, to create positive, long-term customer incentives.

However, in a market where customer trust and loyalty is at a low point, subtle operational adjustments and positive behavioral incentives are much better strategies for restoring profitability without angering customers or empowering competitors.

Alex Johnson is the online marketing specialist for Zoot Enterprises, located in Bozeman, Mont. His email is alex.johnson@zootweb.com.

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