Most retail bankers would agree with the assertion that 80% of their profits are provided by 20% of their customers. However, this well-worn rubric is misleading, in large part because it's often interpreted to mean that only those with superior wallet size are capable of creating profits for their banks.

The less elitist truth is that all income groups have the potential to become profitable bank customers. In fact, in some cases banks today earn more in aggregate from moderate and even low-income customers than they do from better-heeled ones.

That's because a fair proportion of the latter have already turned over the bulk of their business - at least the more lucrative nontransactional components - to nonbanks. Banks must not assume, as many now do, that their retail profitability problem is a CRA one. It isn't.

Rule Change

In place of the 80-20 rule, we propose substituting the 20-60-20 rule. Correction: Call it an observation rather than a rule because the situation it describes is, and ought to be, subject to change.

Based on our client research and work done with the Bank Administration Institute, we have found that, yes, 20% of retail branch customers typically generate virtually all the profit. But we have also found that 60% of customers are just about breakeven and could, with a little creative nudging by knowledgeable banks, become profitable.

The last 20% create red ink - so much, in fact, that for some banks in today's environment, they erase all the customer branch banking profits generated by the first 20%. This results in a situation in which aggregate retail branch profits come only from small business; consumer profits are just about nonexistent, on a true bottom-line, if not on a "contribution," basis.

Threefold Problem

Thus, the problem in retail banking is threefold: retaining the first 20%, who are being cherry-picked away by non-banks, casing the middle 60% into the profit column, and eliminating the drain of the last 20%.

In order to understand how to approach each task, a bank must first segment its customer base in finer, more detailed ways than is usually done and then calculate fully costed, risk-adjusted profitability. The 20-60-20 breakdown is interesting but far too aggregative. There are many crucial insights to be derived by further subdividing these three categories.

Segmenting by Income

Let us assume, for the sake of simplicity, that a bank segments its customers into four income groups - the wealthy, the affluent, the mass market, and the downscale. Our research in several large banks suggests that, if the bank is typical, $40 of every $100 of gross profit will be provided by the mass-market income segment, $30 by the affluent segment, $20 by the wealthy, and $10 by the downscale group.

Unfortunately, however, each of these segments will also contain a number of customers on whom the bank loses money. Our experience indicates that the unprofitable wealthy customers will typically erase about half the gross returns generated by their profitable segment counterparts. Thus, net profit creation in the wealthy segment will amount to only $10.

Among the affluent and the downscale, profit decrements can approximate increments, resulting in a zero net contribution. And among the mass-market group, decrements can exceed increments, resulting in a net loss that approximates the $10 net gain realized from the wealthy.

Penetrating the Veil

Simplistically, therefore, the wealthy will appear to generate all the profit, while the other three demographic segments either break even or lose money. Penetrating the veil of averages (or aggregated segment returns) results in a different, and also a richer, assessment.

Such an analysis confirms our earlier statement that there arc profitable customers in every segment. In fact, the segment adding the largest amount of gross profit ($40) was not the wealthy, but the numerically larger mass-market group.

That being the case, instead of generalizing about segment profitability, the bank needs to obtain still more disaggregated information that will reveal (1) why it is possible to earn enough on some mass-market customers while losing even more on others and (2) why so many people with the apparent wherewithal (income endowment) to compensate their banks adequately are not, in fact, doing so.

The Cross-Sell Myth

Another myth is that the key to improving retail profitability is to raise the cross-sell ratio. In fact, just the reverse can be the case. In some of the banks we studied, the average number of products held by profitable customers was no different from the number held by unprofitable ones. These banks were cross-selling the wrong people.

The reason banks sometimes cross-sell themselves into poverty is linked to more fundamental drivers of customer profitability, which can be uncovered only by creating a segmentation model that reveals, among other things, customer transaction behavior and its all-in cost.

By disaggregating the customers in our multibank sample according to transaction behavior, we found that although some who transact primarily in the branch are profitable, most branch users are under water on a fully costed basis.

By contrast, those who transact via remote channels end up as net contributors to their banks' bottom line, even when they use these alternative channels quite heavily.

Joys of Remote Banking

The latter often become profitable customers for supplementary bank products despite maintaining relatively modest balances. That's because the cost of serving customers through nonbranch channels can sum to only about 40% of the expense of branch service. In fact, some cross-sold households incur costs that are $500 lower than others, based on their propensity to transact remotely rather than through labor-intensive branch channels.

Once we understand these facts, we can better appreciate why cross-selling can magnify losses instead of creating profits. When platform personnel are encouraged to cross-sell, they are most likely to reach out to those people who bank only by branch or visit the branch with excess frequency. (We found that a fair proportion of unprofitable customers visit about 10 times a month).

Because of their transaction patterns, these customers are apt to become unprofitable users of cross-sold products.

Waiver Worries

Habitual branch visitors contribute to red ink in still another way. Being in the branch so often, they have multiple opportunities to request waivers of the fees needed to compensate for inadequate balances. The experience of many banks shows that idiosyncratic, or nonprogrammed, fee waivers can eat up a huge chunk - perhaps as much as half- of expected fee dollars.

Besides transaction information, other elements required for adequate customer segmentation include data on balances, fees, waivers, purchase history, trends that would flag incipient signs of eroding "wallet share," and purchase-propensity indicators (indicators of customer receptivity to product sales).

Existing PC and data base technology makes it feasible for motivated banks to assemble most of this information within as little as three to four months.

Moderating Skews

With this analytic capability, banks can proceed to manage their profitability skews in such a way as to moderate them. The need for moderation is pressing.

Clearly, banks can't live with customers from whom they earn below a minimally acceptable rate of return. But can they also have customers from whom they currently earn such a high rate of return that nonbank competitors are encouraged to move in? Unlike the banks, these competitors don't need excessive profits to offset the losses incurred in branch systems.

Avoiding the Doom Loop

So there is a fundamental reason for the nonviability of existing profit skews over any long-term horizon. Because banks have a hard core of large loss creators, they cannot earn enough to make the investments needed to expand product offerings to their profit stalwarts - that first 20%.

For this reason, the retail picture shows many of the carmarks of a classic self-feeding downward spiral (or doom loop). Unless banks find a way to "fix" the hugely unprofitable, they will continue to lose the hugely profitable, which will serve to further depress overall return levels and set the stage for a new cycle of customer loss.

To extricate themselves from this position, banks must first appreciate that they can and do make money from a variety of customer types. Understanding, through meticulous analysis, how they make money in any given customer segment is the key to upgrading those within that segment who generate losses.

Sometimes the upgrade will necessitate repricing or a cessation of fee waivers; sometimes it will require an effort to incent customers to transact remotely.

Offering Value

In the affluent and wealthy customer segments, profit turnarounds will likely depend on persuading customers to bring back those revenues that have migrated to nonbanks. That effort necessarily requires a tooling up to offer superior "value propositions," which may include financial planning and investment advisory and management services.

Often, however, the value proposition can be much simpler - e.g., creating special 800 numbers to connect upscale retired customers to personal bankers trained to satisfy their specific needs.

In summary, rescuing retail franchises requires that banks pull together a great deal of customer-specific information for use in a detailed segmentation model.

Such a model will uncover substantial opportunities to upgrade those who are presently unprofitable as well as to cement ties with those who are still attractive. Banks that undertake these tasks can look forward to rebuilding shrunken retail margins and at the same time arresting the progressive erosion of market share.

Turning the Tables

Looking ahead, banks can be big winners if they (1) understand segment product needs and transaction preferences, (2) craft competitive "value propositions," and (3) redesign their business systems so that this value is delivered at an economic cost.

There is no reason banks can't capitalize on their position as the most trusted providers of some financial services to virtually every household to broaden their product lines while emerging with the most cost-effective set of distribution alternatives.

These will include electronic self-service and telephonic modalities as well as person-to-person interface. Having accomplished this, banks will have turned the tables; the high-cost, high-commission brokers and insurance companies will then become the challenged businesses.

Mr. McCormick is president of First Manhattan Consulting Group, New York.

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