Despite the litany of challenges we face as an industry, I remain optimistic.  I believe the future can be bright for those who can and do adapt.  However, it’s going to take an effort to overcome the challenges that are readily apparent.

• Despite eleven consecutive quarters of positive GDP growth, the economy is tracking $2 trillion below where it should be.  That is no typo – $2 trillion, or about 15% of our economy, is simply missing since 2008.  This equates to almost $17,000 of lost GDP per household in the US.
• Over-leveraged consumers have simply walked away from existing debt, and those who can still borrow don’t want to.  Lack of aggregate loan demand is likely to be an industry concern for the next three to five years.
• Over-zealous regulators are tripping over each other to prove their worth to an administration intent on laying the blame for the economic collapse entirely on the financial services industry.  This is regardless of the fact that community-based banks and credit unions did not participate in the sub-prime orgy in any significant way. Excessive regulation is likely to plague financial service providers for the foreseeable future.  The collective impact of these regulations will not only be a reduction in fee income but also much higher compliance costs.  Want proof?  Think back to your experience with the Credit Card Act of 2009.  While most community-based banks and credit unions were in substantial if not complete compliance with the provisions of the Act, remember the amount of time that was spent by your staff simply to modify the credit card statement?  This is the burden of regulation.  It prevents you from getting more meaningful things done.
• Chairman Bernanke of the Federal Reserve has re-affirmed that interest rates are likely to remain low through 2014.  The Fed has made these guarantees because of the perceived weakness in the economy.  While there is a perceived benefit for borrowers, the impact on savers, especially retirees, is significant.  And the impact on financial service providers is potentially catastrophic.  For the past two years, as loans and investments have re-priced down, the industry maintained and even improved its net interest margin by even more aggressively lowering the cost of funds.  However, while the downward pressure on asset yields will continue for the next two to three years, the cost of funds will run into a floor: zero percent.  Unless the industry is willing to charge depositors for holding their money (last done, I believe, by Wells Fargo in the 19th century), the industry is likely to experience even further margin compression in 2012 and beyond.
• One last factor to consider: as you added mobile banking to your pantheon of delivery options, which older delivery option did you retire?  Probably none.  The point is that delivery channels (and their associated expense) are additive.  Delivery technology has the perverse impact of hurting our operational efficiency, not improving it, at least in the short term.  As new technologies continue to be introduced, expect that your expenses will not decline but instead grow.  We may see a significant reduction in branch counts 10 to 15 years from now.  We will not see them next year.

Couple margin compression, higher compliance and regulatory costs, reductions in non-interest income, and increasing service delivery and what do you have?  A recipe for potential disaster.  It is not far-fetched to believe that the ongoing consolidation of the industry (down by about 35% since 1997) will accelerate. Nor is it hard to believe that earnings pressure will continue to be significant. If you examine both the banking and credit union aggregate income statements, the improvement in earnings over the last two years is ENTIRELY due to the reduction in provision expense.  How long can that continue?  It’s not surprising that there were only three new bank charters in 2011 and one new credit union charter.

Having said all this, I happen to be an optimist.

I am a firm believer in the notion of creative destruction first described by Joseph Schumpeter in the 1940s.  This is the notion that inherent in capitalism is a continual revolution in products, processes, and competitors.  This revolution often causes the failure of those unwilling or unable to change, and also results in great opportunity for those who can and do adapt.  It also results in a much stronger economic system and society, as resources are better utilized and more aggregate value is created.

Creative destruction best describes the current state of the financial services industry.  Those competitors who will survive and prosper are those who best identify the major trends and adapt accordingly.

So what are the macro trends that are occurring to which successful banks and credit unions will pay attention?  I can think of three major trends, although I am sure there are many others.  In this article I will briefly address these three macro trends.

Focus on Share of Wallet

The financial services industry is a generally inefficient industry.  History is replete with inefficient strategies such as the “churn and burn” checking model which dominated much of the 1990s and the first two-thirds of the 2000s.  Many banks, including WAMU, essentially blanketed markets with branches in order to attract checking accounts, which at that time were highly profitable due to both soaring overdraft income and rapidly growing debit card interchange.  Any cross-selling was only gravy.  These activities generated glowing analyst reports around growth, but the long-term viability of the strategy should have been questioned from the beginning.

A much more efficient model centers around share of wallet.  The deeper the share of customer’s wallet, the more efficient the organization tends to be.  We have clearly seen this in our analysis of our clients’ data.  The reason for is that as wallet share deepens, retention lengthens, and account acquisition becomes significantly less expensive.

What is necessary to deepen share of wallet?  First, differential or relationship pricing should be deployed.  The notion that every customer receives the same rate on a CD is not logical, unless you are willing to consistently pay lowest rates in the market.  Build price benefits, either rate or fee-based, around the behavior of the customer.  But the behavior requirements should be specific to the demographic segment you are targeting.  High balance-based requirements make sense for an older demographic but make little sense for Gen Y, who for the most part do not have significant balances.  Behavior requirements for Gen Y might center around transactional channel usage, such as debit card usage or e-statement usage.

In addition, your technology should be built around the individual – not the transaction – and be able to display and interpret the variety of relationships and connections a customer has.  BI (business intelligence) tools will be essential for deepening share of wallet, both in the back office and in the front lines.  These tools should be able to track all past customer interactions, identify the next product of need, and even identify when customers are using products elsewhere – for example by reading credit reports.

The third requirement to improve share of wallet is cultural transformation.  Most financial institutions think about and reward for “transaction competence.” Shifting the culture at the organization to reward sales and service competence will be key.  More and more transactions are being conducted in a self-service manner – via mobile banking, online banking, ATMs – so re-orient the staff around sales and service in order to deepen share of wallet.

Shifting Demographics

A second major trend is the shifting demographic profile of the country.  The dominant demographic segment in this country for the last thirty years has been the Baby-boomer group, but the reality is that over the next five to ten years the economic impact of the Gen Y group, born between 1978 and 1999, will begin to be felt in a major way.  The sheer size of this group – the largest generational cohort in US history – will ensure that its economic impact is significant.

But the reality is that the emergence of this generation coincides with a technological shift that threatens the viability of financial service providers that do not respond.  The major banks have recognized this and have tailored their marketing efforts and technology innovation towards this group.  Note for example how Chase Bank uses “20-somethings” extensively in its marketing efforts, and these tend to emphasize Chase’s technology, such as P2P and RDC.  Our research as well as other research we have seen gives evidence that this is working with Gen Y.  For example, Gen Y is much more likely to view big banks as “better” providers of high technology services such as mobile banking. I would argue that any financial service provider offering mobile banking can match the functionality of what the major banks offer in regard to mobile banking.  However, your customers may not think so, especially your Gen Y customers.

What does this mean for the community-based financial institution?  First, you must be able to discern which new technologies are relevant.  Second, you cannot be too far behind the curve in the adoption of new relevant technology.  Third, when you introduce new relevant technology you need to launch aggressively, not defensively.  Fourth, the launch should center around the value of the technology to the customer, not simply the “me-too” aspect of copying the big banks.  How does this new technology improve the customer’s financial well-being?

Value Exchange and Transparency

The third major trend I would emphasize that financial service providers need to pay attention to is the notion of value exchange and a related notion, transparency.  To understand this, think of the concept of the zero-sum game.

In economic theory, a zero-sum game is a mathematical representation of a situation in which one participant’s gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

This describes the financial services industry fairly well, at least perceptually.  Most customers of major banks would view their relationship as a zero-sum game, where most often they lose as the bank wins.  This is the reason that banks tend to have less favorable customer ratings compared with many other industries.  The implication?  Financial service providers are ripe to have major parts of their value chain migrate to other providers.  PayPal, Google Wallet, and others are key examples of this.  PayPal and Google are making major forays into the payments space, not because of the income generated by transaction processing, but because of the wealth of information that can be obtained from a payment transaction. This is the most valuable part of the transaction and it is at risk.

Critical to a financial institution’s continued viability is moving to a non-zero-sum situation with its customers.  When the interaction between an institution and its customers is viewed by both parties as a value exchange, then both parties benefit.  The exchange of value has to be far more than simply monetary in nature.  To quote Shumpeter:

Economists are at long last emerging from the stage in which price competition was all they saw. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position.*

What this means in simple terms is that the value to the customer should not be centered around price.  Price may be a component of value, but it should not be the central value.  Unless you are the low cost provider, generally a result of scale, you cannot compete on price in perpetuity.  If you live on price, ultimately you will die on price.  Instead, look for ways to differentiate your organization on a non-price basis.

A corollary to this is transparency.  It is likely that in the new environment “free” will not be the main marketing differentiation as it was for the decades of the 1990s and 2000s.  Consumers will need to know this, and disguised (non-transparent) fees for services are likely to be a major turnoff.  Simple and clear will be better.

What are the other major trends that I have not included here?  We welcome your feedback on this topic.  We will use future articles to discuss other ideas you bring to us.

* Joseph Shumpeter, Capitalism, Socialism and Democracy (New York: Harper, 1975) [orig. pub. 1942]

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