During the 1980s, as an analyst searching for the secrets that set high-performing institutions apart, a group I led studied approximately 35 commercial and savings banks and a sprinkling of nonbanks such as American Express.

The study was an extension of a Harvard Business School program on line-of-business analysis to identify the laws of the marketplace. The technique used by pioneered at General Electric Co.

The goal was to relate profit-ability to market and competitive factors as well as financial data such as return on capital and market share growth.

We wanted to explain the differences in performance of specific lines of business among institutions that offer reasonably similar products and services.

Specifically, we sought to learn:

* What performance levels can you expect to achieve if you pursue a given strategy for a business facing a specific market and competitive environment?

* What performance standards - profit and operational ratios - are the norms for a business line?

* What are the principal traits, policies, and practices of winners? How do they differ from the losers? That is, how can you select the factors that offer the greatest chance for success and the least chance for failure in a given environment?

* What are your best ongoing opportunities? Which ones are your losers? Which businesses are in the best position to help your bank achieve growth and profit goals?

Analyzing Business Units

The key to such evaluation is not peer bank analysis, the traditional approach banks use to assess their performance.

Peer analysis has two major drawbacks.

First, averages of various banks of similar size or from similar regions do not by themselves indicate what is good performance. The average bank may be rather poor and composed of a group of business lines that are mediocre.

Second, the success or failure of a bank as a whole is determined primarily by competition in various individual markets (for example, consumer or institutional), not at the "whole bank" level.

We decided for our study to focus on business units. A business unit is usually a component of the bank that sells a cluster of products and services to satisfy the coherent needs of a distinct set of customers.

In a small bank's consumer services group, for example, two typical businesses are:

* The consumer mass-market business, serving households with less than $80,000 in annual income. These customers are depository and transaction oriented.

* The private banking business, serving people with incomes in excess of $80,000 and net worth over $400,000, who have more need for financial and advisory services.

Wherever a business unit operates, it competes with a distinct set of competitors.

In our study, the benchmark for judging the financial performance of each business was return on capital employed. Pre-tax profit was used, because it is less susceptible than after-tax figures to creative accounting.

We identified more than 15 factors that will drive profitability in the new and bumpy financial landscape.

Market share was one - the percentage you hold of your target market.

The target market is that part of the total market where a business is really competing - that is, where it has a purposeful marketing effort reaching out for a customer group a coherent product offering tailored to that group's core needs.

For example, if you were to say that your market is in the New England states and if 80% of your customers were from Connecticut, your target market would be not New England but Connecticut.

As the market-share dominance of a business increases, its profitability also increases - up to a point. Profitability does not appreciably increase after market share reaches a threshold level of approximately 13%.

It appears that beyond this threshold, the business does not generate appreciably greater profit increases.

Except in automated services, very large dominance of a market does not seem like a good idea. Beyond a point, further economies of scale seem to be unavailable. However, many small banks hold relatively high shares in their target markets - their communities.

What Customers Notice

Quality is in the eye of the customer.

When selecting a bank, customers consider such quality issues as the convenience of the delivery system, courtesy, staff training and product know-how, response time, rapport with customers and prospects, commitment to the market, and the availability and dependability of support services.

Qualitty is computed by rating your business against your three principal competitors. The computation can be developed by market research or a group of knowledgeable people in the business. Price is not considered, because price is another profit driver related to profitability.

We found that customers in the financial markets seem not to notice very high quality. Cost-effective service quality seems like the most profitable position.

It was also found that to achieve the maximum benefit, it is important to augment quality with aggressive marketing. Quality without customers knowing about it is unprofitable.

Marketing Outlays

A third key determinant of profitability turned out to be marketing expenditures as a percentage of a business' total revenues.

In marketing we included direct selling, advertising, and promotional costs as well as marketing administration. Market research expenditures were excluded.

An effective and aggressive marketing program requiring over 6% of revenues is highly profitable, we found. But to our surprise, spending less than 1% of revenues on marketing was also very lucrative.

We concluded that this means a bank can do very well by choosing a particular component of the total marketing mix for some businesses. For example, direct selling without advertisement and promotional programs might be chosen for commodity products such as large commercial loans.

The key message here is that, depending on the chosen markets, both aggressive marketing and selective marketing can be highly profitable. But half-baked marketing cannot.

Role of Pricing

A fourth factor of significance to profitability was found to be the relative price of products.

A price index was computed by comparing the interest rates, service charge, or fee income of a business to those of its three key competitos. If the figures are approximately equivalent, the index is 100. If on the other hand your charges are, say, 2% higher than key competitors', your price index is 102.

We found bank businesses to be highly sensitive to price. Profitability is drastically reduced when charging premium prices. Most bank products are commodity products.

Don't Overwhelm the Market

New-product intensity - that is, revenues from new products as a percentage of a business' total revenues - was another factor in profitability.

By new products we meant those introduced in the three preceding years with substantially new distinguishing features and benefits. These might include product packages that offer greater convenience and ease of service delivery, time savings, reduced costs, or service enhancements.

Moderate levels of new-product revenues increase profits. But high levels depress profits drastically, leading to very unacceptable returns.

This finding demonstrated clearly that the wave of products introduced by many banks in the 1980s were not all brilliant.

A Delicate Balance

A few high-value-added products fashioned to meet target customers' needs will lead to higher profits and market growth than will a number of unprofitable "me too" products.

High-value product offerings result in greater customer loyalty and repeat customers.

Since customers do not easily perceive very high quality, however, the trick is to combine price competitiveness with competitiveness in support services. Thus the bank would be offering not a pure service, but an augmented product - such as a package geared to the life-cycle stages of a consumer or a business customer.

A large number of successful new products will generate higher profits in nongrowth markets than elsewhere. This may be because there is less customer switching in nongrowth markets.

In growth markets, on the other hand, introduction of many new products does not seem like a good bet. Customers in such markets may become confused by an abundance of new products whose features and applications are not very well distinguished.

Again, what makes for ample profits in growth markets is a few high-value-added products, not many.

Investment Intensity

Another finding: The more capital employed to generate a unit of revenue - that is, the higher the "investment intensity" - the lower a business' profit returns are likely to be.

This means products and services that are not investment-intensive are to be preferred, when the choice is feasible.

Leasing, franchising, and licensing of services should therefore be considered for increasing long-term profits. And so should partnerships or coalitions in noncompetitive or mutually beneficial situations. Such steps can increase the flexibility that the 1990s will demand.


In sum, appropriate tactics for survival and success in the new financial world include:

* Target a share of up to 10 to 13% of the served market in your service area.

* Offcer customers "more bang for the buck" - that is, high product value or, alternatively, lower prices than key competitors ask for products of comparable quality.

* Offcer products and services of reasonably good (that is, cost-effective) quality, even when you enjoy a strong position in a target market.

* Market high-quality products aggressively, especially in growth markets.

* Offer services of low investment intensity whenever feasible.

A final observation:

The financial businesses in our study earned a 33% return on capital employed - well ahead of the 22% average for industrial businesses. But almost 40% of the financial businesses were either marginally profitable (earning less than 11% pretax) or nonearners.

These unprofitable businesses were primarily traditional mass-market depository services and pure lending businesses - the mainstays of most banks.

However, 20% of the financial businesses were highly profitable - that is, earning 48% or more pretax.

These were primarily the fee-earning businesses such as advisory services and complex financing-type services.

I am planning to extend this study to include other banks that would be interested in participating.

Mr. Thamara is principal of FSIC Associates, a financial services consulting firm based in North Andover, Mass. He is the author of "Banker's Guide to New Growth Opportunities."

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