The industry's recent problems have driven home a new business reality: Retail banking is a key to earnings success.

The income potential and risk characteristics of retail banking make it worth at least as much strategic attention as wholesale operations have received. This is especially true in view of repeated asset-quality debacles on the wholesale side - in lesser-developed-country debt, energy lending, highly-leveraged-transaction finance, commercial real estate, and so on.

Increasingly, senior managers are confronted with two questions: Does our bank's retail effort measure up? How do we improve our retail performance?

Positive Indicators Lacking

It is easy to tell which banks are the largest (assets, deposits) or the most profitable (net income, return on equity, return on assets), and which made the most bad loans (non-performers, net chargeoffs). But few managers know what constitutes world-class retail performance.

The industry has lacked a rigorous evaluation method for retail success that would yield information for peer comparisons.

In response to requests from members, the Council on Financial Competition developed the "retail performance index." It identifies institutions pursuing the strategies most instrumental to long-term retail success.

The index yields a multitude of benchmark figures that can help institutions improve performance.

Strategies in Common

Moreover, an analysis of the top retail performers as indicated by the index reveals they pursue a common set of strategies that allow them to excel.

The retail performance index is not perfect, and we make no claim that it is the ultimate measure of an institution's efforts.

Yet, even as a first attempt, the index is a powerful tool for revealing "how good is good" and why the best institutions are so much further along in optimizing their retail operations.

Underlying the index is a conviction - based on extensive research - that excellence in retail banking is linked to superior performance in four key areas: deposit intermediation, fee income generation, cost control, and productivity.

Institutions that are strong in these areas are creating the best-positioned retail franchises.

Revealing Ratios

Therefore, the index looks at key ratios that measure success in each of these areas.

For example, the council used retail net income per employee as an indicator of retail productivity, while noninterest expense per office was used to capture an institution's ability to control costs.

Since no pure retail figures are publicly available, the council created a set of proxies to isolate retail measures from call report statistics.

For example, to compute retail net income, the council standardized for differences in asset yields, loan-loss provisions, nonrecurring items (such as foreign currency gains and losses), and taxes.

The council then established a three-step process to calculate retail performance, rank institutions, and identify the world-class retail banks.

The first step was to calculate the absolute performance of every institution for each of the 19 ratios singled out as indicators of retail success.

For 1990, the council calculated figures for all U.S. commercial banks with more than $1 billion in assets. (At the request of members, we are expanding our analysis of 1991 data to include both commercial banks and thrifts.)

The second step was to convert absolute figures into relative scores. The retail performance index measures institutional performance on a relative scale in order to make it possible to combine disparate measures (for example, reconciling ratios calculated in dollars with ratios calculated in percentages).

A Single Statistic

Once relative scores have been calculated for all 19 ratios, the final step is to combine these scores to yield an overall retail performance index.

The beauty of the index is that it captures an institution's performance across 19 separate ratios in a single statistic.

The result is a rank ordering of all banks according to their demonstrated retail success.

Analysis of the data base indicates that the top performers are achieving a position of overwhelming competitive superiority relative to their peers. The most salient finding was just how great the disparity is between the top 5% of institutions and the others.

Retail performance is not constrained to a narrow band; world-class institutions are outperforming the rest of the industry by a substantial margin.

Institutions in the top 5% of the retail performance index are performing at levels 20% to 140% above their peers across each of the four broad indicators of long-term retail banking success:

* Deposit intermediation. The most striking area of advantage for the top 5% is in the straightforward intermediation of retail deposits.

The best institutions have a significant interest rate advantage, contributing to an even larger retail net income differential.

Top-performing institutions are achieving a 94-basis-point advantage over peers in the cost of retail funds, which contributes to a net retail income per dollar of deposits that is 115% above peers.

* Fee income. The strong net income of top performers is powered by a superior ability to generate fees. The top 5% are earning significantly higher service charges per employee and noninterest income per deposit dollar.

They produce an additional $3,850 in service charges on deposits per employee, as well as 40 basis points more in fee income per deposit dollar than peers.

* Cost control. Top-performing retail banks are operating under a decidedly lighter burden of noninterest expense, with cost structures about half those of peers.

Their office expenses are 54% those of peers, allowing the top 5% of institutions to enjoy an 89-basis-point overhead advantage.

* Productivity. Per employee, the top institutions are producing 140% more net retail income than peers, while each office generates, on average, $623,000 more in net income than the rest of the industry.

The levels of retail banking excellence are not the result of idiosyncratic market conditions or exotic strategies. Our research points to determined efforts in three areas: Market share, retailing, and cost management. These are the areas in which "best practices" lessons can best be learned.

In brief, we have found that top performers are either becoming market leaders in target markets, or else withdrawing.

They are shaping market share strategies around well-defined demographic and geographic segments, as opposed to the mass market strategies of competitors.

|Share of Wallet'

The top performers are also redefining market share to include "share of wallet" among targeted consumer segments. The goal is to capture not only a banking relationship, but also an increasing share of all financial services used by these households.

Top performers are also incorporating practices from the retailing industry into their marketing and positioning. This phenomenon has shown up most obviously in retail pricing and promotions.

The best institutions emulate retailers in no longer pricing by way of a simple "cost plus" calculation.

Instead, pricing is viewed as an opportunity to differentiate or position products and enhance income.

Strategic Cost Management

The retailing influence can also be seen in attempts to establish and extend branding principles. The goal is to move beyond promotions based on an institutional image to marketing based on successful product lines.

Finally, top performers are clearly doing a better job of managing costs. This advantage is the result of strategic cost management, not one-time cost slashing. Strategic cost control manages the institution's cost structure against a lowest-cost-provider standard.

Top performers are guided by the use of sophisticated benchmarking of competitors' performance.

Costs for discrete retail banking functions are managed down, over a period of years, to the levels achieved by an industry's lowest-cost operators.

The Council on Financial Competition is updating the retail performance index to reflect yearend 1991 data.

By developing a data base on long-term performance at the retail level, we should be able to understand better the strategic trends among the top retail banks.

Mr. Olson is director and Mr. Murray a consultant at the Council on Financial Competition, the retail banking affiliate of the Washington-based Advisory Board Co., a research company.

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