Here's the Truth About Customer Retention

Bain & Co.'s customer retention paradigm has provoked a great deal of interest and debate because it has challenged traditional business thinking.

We have been very pleased to see the impact of our work over the past two years as bankers have sharpened their customer knowledge and refined their appreciation of retention economics.

We have also seen well-intentioned but hollow commitments to customer focus and service quality evolve into meaningful changes in management practices. These changes have occurred across a wide range of businesses, including credit card, branch deposits, lending, insurance, investment management, and processing.

Interesting Arguments

The fundamental principles of customer retention have become well established, and meaningful debate has now shifted from these principles to implementation approaches and appropriate retention targets. However, the July 23 article by Peter Carroll of Oliver, Wyman & Co. regressed to the basics; it tried to argue that customer retention is fundamentally flawed and doesn't work.

While it seems unproductive to return to the basics, Mr. Carroll makes several interesting arguments, which deserve closer scrutiny. More important, his conclusions are completely inconsistent with the experience of our clients.

The author makes a number of claims along three general lines:

* Retention economics is not very powerful in retail banking.

* Simple-minded retention-improvement programs won't work.

* The retention paradigm offers little insight for improved management of the business.

I will respond to each claim so that readers can make their own judgments about the truth and value of our respective positions.

Four claims relate to the importance of retention economics for branch deposits.

Claim No. 1: Retention merely correlates with profits. Therefore, the economics of branch deposits is not driven by retention.

But our position has never been that simply increasing retention rates would magically bolster profits. For example, foolish investments to retain hopelessly unprofitable customers would destroy profits. Our point is that sustainably high profits require high retention. Therefore, understanding the link between retention and profits is essential.

Bain & Co. has developed a rigorous microeconomic model that explains how retention drives profits. It has been pressure-tested by numerous Bain clients and by members of the Harvard Business School faculty. The model was further tested by comparing the implied swings in profits from retention shifts based on internal economics to those actually being achieved in the macrocompetitive arena.

We studied four industries in which retention rates and competitor profits could be determined: credit card, commercial insurance brokering, advertising, and auto insurance. This research fully confirmed our model. High profits do require high retention, and Bain's model accurately explains why.

The No-Growth Claim

Claim No. 2: In retail banking, customer balances and number of products purchased do not grow over time. They only appear to grow because low-balance customers defect at higher rates than high-balance customers.

But at our clients' businesses, we have seen average account balances and number of products purchased grow with customer tenure. It is indeed true that low-balance customers tend to defect at higher rates than high-balance ones. Therefore, our standard practice is to stratify customers into segments based on profit potential (not unlike the A-B-C scheme described by Mr. Carroll) and then to quantify growth rates.

If one were to estimate balance growth in the simplistic manner described by Mr. Carroll, there would be an error, but more sophisticated analysis would confirm our position.

Most banks must use cross-sectional data to estimate customer balance growth, but we are also aware of two institutions that track individual customers over time. Their data corroborate our findings; balances grow over time.

Finally, common sense would argue against his contention that average balances don't grow as customers age. That implies that 20-year-olds have the same profitability as 40-year-olds. We think that unlikely.

Word of Mouth

Claim No. 3: Referrals do not make a big difference.

Across banks, however, we find that 20% to 40% of new customers choose a bank based on referral. This is very consistent with similar industries in which we find that referrals by customers and employees are the primary source of profitable growth.

Traditional market research often misses this truth because customers often respond to surveys about branch selection criteria with top-of-mind answers like "convenience." But when pushed to explain why they picked their branch instead of an equally convenient one next door, they typically mention referral by a colleague or family member.

What may not be obvious to Mr. Carroll is that an effective retention-improvement program employs a two-pronged approach. Not only must defections be decreased but also, and equally important, the number of enthusiasts (people who refer) must be increased. We do the same kind of root-cause interviews with loyal enthusiasts as we do with defectors to determine the specific drivers of referrals - so they can be reinforced.

The Pricing Question

Claim No. 4: The price insensitivity of long-term customers cannot be responsible for much profit impact.

However, price insensitivity is one of the six effects of the generic model described in my article in the Harvard Business Review, "Zero Defections: Quality Comes to Services," with W. Earl Sasser Jr. of the Harvard Business School as coauthor.

This model is applicable to any business - not just banking. In our estimate of an 85% profit swing that results from a five-point retention increase for branch deposits, we did not try to quantify this pricing effect. Therefore, 85% is something of an understatement.

Our subsequent research has discovered that, in two major metropolitan markets, the bank with the leading retention rate managed to price 10 basis points below the local deposit market and still gain share. We suspect the pricing effect is quite important indeed.

Retention Programs

Two further claims relate to an asserted inutility of simplistic retention-improvement programs.

Claim No. 5: Retention-improvement efforts may be very unproductive if they focus on unprofitable customers or if they assume all customers are equally profitable. Therefore, retention programs can be damaging if applied in simple-minded ways.

We certainly agree that retaining bad customers is a losing proposition - but this is merely a restatement of principles we established in previous articles and speeches.

Our consulting approach carefully segments customers by their actual profit potential, then focuses root-cause analyses on defectors from the most attractive segments. Retention-improvement targets are set by segment, based on the investment required and on expected return. When clients lack trustworthy customer-product line profitability systems, one of our first tasks is to help create that capability.

|Costly' Customers

Claim No. 6: Since 60% or more of retail customers cost their bank money on a contribution basis, according to Mr. Carroll, the most significant profit opportunity for a retail banker is not a retention focus but pricing up these freeloaders or showing them the door.

However, I have consulted with more than 20 major financial services companies in the past 14 years, and I have never seen 60% of the retail deposit customers' making negative contribution when fixed and variable costs were fully understood.

Typically, that proportion of customers may show very modest or even negative profits on a full-cost basis, but this customer group makes a significant contribution to the fixed expenses of a branch distribution system. Our work in branch distribution systems across a wide array of retailing businesses (including many bank branch networks) has taught us that the kind of customer-profitability analysis and actions recommended by Mr. Carroll will yield disappointing results.

In fact, his approach has been tried before.

Shooting Yourself in the Foot

In the early 1980s, a major financial services consulting firm marketed a profitability-analysis product demonstrating that "many of the bank's retail customers lose money!" Then the consultant helped bankers raise prices to these C customers and adopt service policies to squeeze them out of the branch system.

The results were disastrous. Why? The percentage of fixed costs was much greater than anticipated, so losing business from these C's hurt the bottom line.

Moreover, many C customers were sons, daughters, or employees of A customers. In some cases, C customers were partial relationships of A customers. The bad will and churning that resulted were enormous and were partially responsible for many banks' current retention deficiencies.

Why is a retention focus on the A and B customers more productive than actions to raise prices and cut services to the C's? First, it is motivating to branch employees who would prefer to earn the loyalty of their best customers rather than deal with the wrath of unhappy C's. Second, the important contribution of most C customers will not be lost. Third, given the relatively high defection rate of true hard-core C customers - 25% in a typical bank - most will wash themselves out of the system within several years on their own volition.

Instead of irritating them (and their parents, employers, etc.) with a push, banks should focus on improving the customer mix through programs that attract a richer mix of A's. This kind of customer targeting is a basic tool of leading retention companies and a key part of our consulting approach.

Insights from Retention

Finally, regarding the third general line of claims, the assertion that our retention paradigm offers little new insight about how to better manage the business is stinging criticism, indeed, particularly to those bankers who have increased their focus on customer retention.

Why have so many people become convinced of retention's powerful potential? The answer is that, despite a general awareness among bankers that keeping their profitable customers is a good thing, very few have developed a detailed understanding of retention economics in their business.

If they had, they would know the actual balance growth by account in their institution and not need to read articles debating the topic. Very few bankers have developed a clear definition of loyalty (which includes penetration within households) or rigorous measurement systems to track retention rates by customer segment.

Most banks have not quantified the important relationship between employee retention and customer retention. Their current career paths and incentive programs often thwart customer loyalty by churning key employees through the branch system - measuring their performance on dimensions not linked to customer retention.

Not Investigating Hard

Perhaps most important, few banks are pursuing the powerful insights available from probing into the root causes of customer and employee defections. This is the most valuable pool of untapped insight in any business. It clarifies what is, or is not, working in the business.

Smart bankers recognize that retention is not a simple formula but, rather, a challenging yet pragmatic process for discovering and acting on the most leveraged opportunities to improve their business. We have found that banks making the required investment in measurement, retention economics analysis, root-cause technology, and customer early-warning/recovery systems have discovered powerful potential in their retail bank systems.

It is not unusual to uncover opportunities that can increase earnings by 25% to 75% in five years. These opportunities range from the tactical to the strategic.

Investments required to achieve these improvements are substantial, but leading bankers are making them because of their powerful payoff and a recognition that, if they procrastinate, their competitors will lock up most of the good customers in their markets.

A Powerful Framework

In 1989, Bain & Co. developed management principles, tools, and processes to improve profits through improved customer retention. The goal of zero defections was carefully defined as "retaining every customer whom it is profitable to serve."

The zero defections paradigm gives bank marketers a powerful framework by helping them target customer acquisition efforts on segments that have the highest propensity for loyalty. And loyalty-marketing investments can be effectively focused on customers with the greatest long-term potential.

Retention also offers a new set of tools to manage costs and productivity. Addressing what drives turnover among customers and employees yields much more sustainable cost improvement than traditional industrial engineering approaches.

Perhaps the greatest impact of customer retention on banking will be regarding acquisitions and mergers. Bankers have become increasingly expert at forecasting and realizing cost synergies in mergers. But most bankers are much less effective at managing the post-merger runoff of their most valuable assets: key customers.

Leading banks have already begun to apply customer retention tools effectively in this regard. We believe customer retention will be the critical weapon that differentiates winners from also-rans in the industry's consolidation.

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