Consider the CEO who has diligently pursued all the popular cost and productivity programs, only to find the bank's efficiency ratio (ER) stalled at around 55 percent. Our CEO knows that regaining efficiency momentum is key to creating shareholder value and maintaining strategic flexibility, but is unsure how to proceed. A new round of cuts might stall revenue momentum, and some past solutions produced unanticipated results, e.g., free transaction alternatives that encouraged customers to use such channels in addition to, rather than instead of, tellers.

the New Approach

The old technology is not up to the task. A new cost reduction approach is needed. Retail banking, which accounts for half the cost in many regional banks, can illustrate the point. In the past, retail bankers have tried to serve consumers with a standard menu of sales and service transactions because they had a limited understanding of differences in customer behavior and preferences. The result is many dislocations among the cost of service transactions, product pricing, and value perceived by customers.

The new approach, however, identifies dislocations among revenue and cost-to-serve by customer. It also combines customer profit information with insights about customer needs, attitudes, and behaviors to align cost with perceived value.

profitability skews

The first step in addressing the problem is to identify and understand customer revenue and cost dislocations that underlie profitability skews.

The most profitable 20 percent of customers have an ER around 30 percent. This revenue-to-cost ratio is not sustainable. The bank will need to provide more value through rate or service to keep the customer. The ER will decline, but cost to replace lost customers should decline as well.

The least profitable 30 percent of customers have an ER around 190 percent. This group uses a lot more service than it is willing to pay for. The middle 50 percent are also a challenge, with an ER of 60 percent.

To serve these last two groups profitably, the bank must redesign the business system to deliver services customers value through streamlined distribution. Pricing must also motivate customers to use efficient channels.

First Manhattan Consulting Group (FMCG) has found that banks can use profitability information and insights from behavior analysis and research to design and test products and delivery systems within customer's affordability. This Customer Knowledge Based (CKB) cost alignment approach has four components:

Identify sales and service transactions required to meet each customer objective and define the cost of each based on the type of interaction, activities required and resources used. The impact of staff support and back office transactions must also be addressed.

Calculate customer profitability, combining data about products used, volume, margins, transaction levels, and transaction cost by distribution channel, and other costs.

Build on behavior insights and research about preferences to develop value propositions that align customers' perceptions of value and profit potential with cost to serve.

Eliminate features customers do not value, e.g., returning paid checks, while adding features that reduce cost, such as an ACH draft to collect a loan payment. Tailor service levels to a customer's willingness to pay and configure the distribution system to meet the needs customers value cost effectively.

This step may require a "clean street" redesign of the system since many customers in the bottom half of the profitability scale do not value and will not pay for more than essential banking services.

Test each alternative, through research or a controlled market test, to confirm how customers react to the new value proposition, and tune it up as required.

The improved value-cost alignment should also improve customer retention, avoiding the cost of attrition and building new relationships.

Productivity Gains

FMCG's experience shows this approach can cut costs, and improve productivity up to 10 ER points. In this case, the cost of retention efforts raises the ER from 30 percent to 35 percent for the best 20 percent of customers; reconfigured delivery and pricing improve the bottom third's ER from 190 percent to 80 percent through lowered cost to serve and moderate revenue gains; and service delivery to the middle deciles can be redesigned to reduce cost by 20 percent and drop the ER from 60 percent to 48 percent.

The unit goes from a 55 percent to a 45 percent ER. As part of a typical regional bank that achieved an ER of 55 percent through traditional cost fixes, its ER would drop to 49 percent through customer value optimization in its retail business alone.

Our concerned CEO can now breathe a little easier.

Rodgers L. Harper is managing vice president of First Manhattan Consulting Group.

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