The economics of customer retention have been the subject of much discussion. In recent years, the fine work of Bain & Co. and the Advisory Board shed some light on the profitability of customer retention and moved it from voodoo economics to reality.
The first step in understanding the economics of customer retention is to recognize that the value of a customer to the bank is not in current annual income. A customer's value is the net present value of the stream of annual marginal profit contributions over time.
Therefore, the longer the customer's tenure with the institution, the greater the stream of profit contributions from that single customer, and the greater the net present value.
Often, we do not approach customers considering their full profit potential and, as a result, low annual contributions may result in undervaluing customer worth. For example, the annual net present value of an average checking account customer is $27, which pales in comparison with money market accounts, at over $180.
However, that fact may be compensated for by the longer average retention rate of DDA accounts.
The hypothesis behind customer retention is that increased retention results in greater profits. The facts seem to bear that out. Customers with over 10 years' tenure represent 29% of the customer base on an average, but 71% of a typical retail bank's profit.
The 80-20 Rule
Not only are the longest-tenured customers the major contributors to the retail bank's profitability, but the very best customers also provide much more than their share of the profits.
The 80-20 rule is even more concentrated in retail banking. The top 5% of customers provide over 40% of the core balances. The result: The net present value of the top money market customer is 14 times that of the average account customer.
While effective customer retention implies improved profitability, the lack of customer retention is a costly proposition as well. In other words, customer retention enhances profitability, but the absence of customer retention has a cost associated with it.
The Advisory Board calculated, for example, that the loss of a demand deposit account on an average equals $25 in forgone profit, and the loss of the money market account equals $200 in forgone profit. For a typical $10 billion-asset bank, 95% of all customer defections occur in demand deposits and savings.
The net present value of the cost of the loss of these accounts is significant. For a $5 billion-asset bank, the defection cost is $12 million in net present value loss. For a $20 billion bank, the loss is as high as $33 million.
As evidence is gathered regarding the profitability dynamics of customer retention, the case becomes more and more compelling. A 5% improvement in retention represents significant value, with a profit rate increase between 6% and 40%, and a customer franchise value increase of 27%.
In fact, a 5% improved retention yields 70% more profit than a 10% reduction in operating costs. While cost management is an essential competitive ingredient in the '90s, revenue enhancement through customer retention represents an unlimited upside potential, unlike the finite nature of cost cutting.
Consequently, banks may elect to focus on improving profitability through improved retention rather than putting the scalpel to their operating budget yet one more year. Not only is it a much more pleasant proposition, but it appears to be much more profitable.