US retail banks go to war

November 5 was bank transfer day in the US. Started simply as a Facebook page by disgruntled Bank of America customer Kristen Christian, a gallery owner in Los Angeles, the initiative was designed to encourage retail customers to leave their large banks and join small credit unions.

It illustrates the frustration customers in the US are feeling at growing fees and poor customer service, and is undoubtedly also spurred by the ill-feeling towards the financial industry over the economic crisis. The Credit Union National Association reported that more than 40,000 individuals joined their members on the day and estimated that 650,000 have joined since the end of September. The Independent Community Bankers of America (ICBA), which represents community banks, said visits to its members had risen 500% from the first week of October to the first week of November.

This collective rallying of a nation to remove deposits from the big banks and transfer them to smaller ones could not have come at a worse time for the large banks. Retail banking is crucial for the universal banks, and profits for retail banks, be those as part of universal banks or just large regional banks, are under such pressure that losing customers is disastrous. The large retail banks in the US are having to revisit their models, and they are having to do it fast in a period of uncertainty, regulatory burden, low interest rates and anti-big bank sentiment.

For the universal banks, retail banking is now of utmost importance as it must compensate for reduced revenues from investment banking. Dodd-Frank regulation, inhibiting the use of deposits or client money in proprietary trading, is hitting the profitability. Basle III and domestic regulation also mean banks are having to set aside more capital to engage in higher-risk and more profitable activities in their investment banks.

Universal banks will therefore not be able to grow their investment banking businesses at a speed that will bring their return on equity back to pre-crisis levels.

"They are looking at RoEs now of between 8% and 9%, which is just above the water in terms of returns to shareholders," says Likhit Wagle, global banking leader at IBM GBS. "Prior to the crisis, those RoEs were more like 20%; it is unlikely that we will return to that level in the near future. As a result, the universal banks will have to focus very hard on making their retail side of the banks more profitable in addition to higher growth in order to get to an acceptable rate of return for shareholders."

To boot, the capital requirement regulation makes retail banking even more appealing. "It makes retail deposits more valuable as they help lower capital requirements relative to corporate assets," says Laurent Desmangles, a partner in the financial institutions practice of Boston Consulting Group.

But retail banking has its own issues. Retail has suffered from the macroeconomic environment and regulatory changes in the same way as investment banking. In the lower interest rate environment, margins on the deposit side have been crushed.

Historically, banks priced deposits 100 to 150 basis points below the Fed Funds rate. Now, with Fed Funds at zero, that is impossible. Loan volumes are sluggish as there is less demand for loans and less appetite to underwrite loans. According to a national consumer research study, only about 30% of consumers are planning to take out new loans – the lowest figure since 2003.

On the regulation side, Reg E adversely affected overdraft fee revenues for banks by allowing customer funds to go overdrawn only if customers have agreed to an overdraft, although there has been an increase more recently in overdraft revenues as consumers have struggled with expenses. According to economics research firm Moebs $ervices, in September, while revenue from overdraft fees has fallen for six quarters in a row from its peak of $37.1 billion in 2009, it has begun to climb again.

The Durbin Amendment, which came into effect in October this year, is also expected to have a negative impact on deposit margins. It reduces the amount that banks are able to take as a fee from retail merchants on debit card transactions.

Retail businesses have been paying banks an average of 44 cents every time a debit card transaction goes through. As of October the fee is now capped at 21 cents. Banks have made as much as $16 billion from the fees annually, and although they are now pushing customers to pay with credit cards, which are not subject to the amendment, their profits will not recover until 2013. The largest banks in the US are expected to take a hit of $6 billion to revenues as a result of the legislation.

The response from the banks was to propose fee increases for customers with debit cards. However, opposition from politicians and customers to the $5 to $12 charges forced all the banks to abandon the proposal.

Indeed, when Bank of America announced that it planned to introduce $5 per month charges for debit card users in early October, president Obama called on customers to withdraw their funds – prompting one BofA employee to remark to Euromoney that it "was the only time in history that a head of state has actively sought a run on a bank".

CUTTING COSTS SEEMS INEVITABLE if banks are to make up for their losses from regulation and the macroeconomic impact of lower interest rates and fewer loans. But three years on from the beginning of the economic crisis there are few places left for banks to cut costs. Branches are often the first to go as banks push their clients into call centres and online banking.

However, although customer use of branches has dropped some 60% as they move to virtual channels, they still want a physical presence. "Cost-cutting works for the first couple of quarters and then you see revenues start to drop. The banks have already taken out 10% to 15% of headcount, can they continue by cutting into the bone?" says Brian Foran, regional bank analyst at Nomura. Furthermore regulatory expenses are about 5% to 7% of bank revenues but are growing at double-digit rates. "That’s expense growth without doing anything," says Foran. "So even if banks cut expenses, overall expenses are not reducing. And litigation expenses are also rising for banks."

Despite the reaction from customers, Foran says it is inevitable that banks will have to start charging fees. "Banks have spent a decade with the model of providing for free upfront and charging on the back end. Now, with overdraft fees reduced and the interchange fee reduced, the banks will find new fees, as they simply have to. It costs money to store money with a bank and not under the mattress – consumers will have to realize that to some extent." He points to the new fee structures introduced by airlines as an indicator of where retail banks will go.

Indeed it does seem inevitable, and although the banks have abandoned a sweeping fee for all deposit accounts, they have found ways to add fees elsewhere. Fees for bank accounts that fall below a minimum balance, for example, are being added. Fees for checkbooks appeared several years ago. Fees are being charged if a customer does not have a regular monthly deposit of more than $2,000. ATM fees are being charged for customers that use competitors’ machines – meaning it can cost as much as $6 to withdraw cash.

But banks are walking a fine line if they want customers to stay with them.

Tim Sloan, chief financial officer of Wells Fargo, says customers will need to be given more for paying more. "There will be some price rises, but the consumers are telling us they are stretched already. They need to be given more value."

It is as a result of this fine line that retail banking in the US is being forced to become what it should have become years ago – more in tune with its customer base. If banks want to charge for services, they need to know what services their clients are prepared to pay for. "If the industry does not understand profitability from customers, how can they know what to charge, how much to charge, and what they should be giving as free?" says Wagle. He says retail banks have been vastly behind the curve in the overall retail sector in how they approach clients. "If you compare retail banks with supermarkets or electronic retailers, you can see the way that the former understands the customer – and provides products and services based on that understanding – is very behind, particularly when it comes to using channels other than branches such as mobile and online.

"Banks will have to get more and better data about their customers’ behaviour, and carry out more analytics to understand how to proceed," says Wagle. "That will enable them to price the service around the customer and will create better efficiencies." Wagle points to credit card companies as a good example of products having been priced specifically to individuals.

Without understanding how individual customers interact with the bank and what revenues they add, banks will never be able to price their products efficiently. "If you have $1,200 in the bank and don’t use the bank for loans, then the minute you use a bank teller once, the bank is making a loss on your behalf," says Foran. It costs roughly $250 a year for a bank just to manage a deposit account. Banks will have to start understanding each customer’s behaviour with the bank to decide whether they should keep them by offering a free check account and less fees, in return for credit card and loan revenues, or whether to risk losing them by charging them an account fee.

One way of better analysing clients would be to consolidate data warehouses. Many large banks joined together through mergers have several data warehouses that could be combined to provide better analysis; that would also mean hundreds of millions of dollars in efficiency savings.

Analysing each customer is a new model for banks that have ordinarily just segmented their clients by ethnicity, age and income. This segmentation model is no longer valid, says Wagle, yet the larger banks seem to be moving towards segmenting their clients by wealth in a bid to increase revenues. Bank of America launched Merrill Edge in January this year to offer investment advice and products to its mass-affluent clients. JPMorgan Chase has also announced that it is bumping up its services and expanding its mass-affluent business to bring together its private and retail banks.

Such moves have not gone unnoticed. Concern is building that the large banks will turn their backs on lower-income earners as they don’t make as much profit for the banks. Some customers feel that the banks are deliberately raising minimum deposits to force lower-income customers out.

One branch manager of a New York-based large bank is blunt: "When we could make loans at high interest rates to lower-income earners, and when we could sell them mortgages, they made us money. They would go overdrawn, which made us money also. They would rack up credit card debt, which was profitable. Now those customers are no longer profitable. Now we prefer higher-income earners who will make deposits, have safer loans, and who will pay for premium services."

Foran says no large bank can focus solely on the mass affluent but he concedes that banks might start to de-emphasize their focus on the less-wealthy customer base. He says it misses the point. "The main issue is that these banks need to make all their clients more profitable."

Just where the deposits of lower-income earners will go gives some indication of the new competitive landscape. Wagle points to South Africa as an example of new entrants to retail banking might be paralleled in the US. "In South Africa, there are four dominant large banks that serve only the middle class and affluent segments of society," he says. "That led to the emergence of low-cost entrants that charge little for checking accounts but higher rates of interest on loans to reflect higher risk. The profitability is impressive."

He says that something similar could happen in the US. Already there is greater competition in online banking. Online-centric banks control an estimated $203 billion of the total $7 trillion dollars of deposits – 3%. "If banks start charging fees, then that opens the door for banks like ING Direct," says Foran. Financial services company Discover is also in the process of rolling out online check accounts, while E*trade is trying to woo more customers. Competition also plays into the hands of the community banks and credit unions, which are regarded as more open to all segments of a community.

COMMUNITY BANKS AND CREDIT UNIONS ARE LIKELY TO BE a growing part of the changing competitive landscape of retail banking in the US. The ethos behind bank transfer day is one reason. Community banks are considered to be more caring about their customers. Not driven by shareholder demands for returns on equity, community banks are less pressured to pump up fees and turn their backs on customers that are unprofitable. Foran says: "Community banks are willing to accept lower margins as they don’t have big public shareholders demanding ROEs of 12% to 13%."

Although there is evidence that community banks are seeing more interest from retail banking customers looking to leave larger banks, Boston Consulting Group’s Desmangles says it is not clear yet how much they have benefited. "There has always been a 12% to 15% annual churn of bank relationships. A lot of that is simply from relocation of client. Community banks may be picking up more of that churn, but there is no evidence to suggest it is putting the big banks under threat." But he points out that it has long been the case that community banks offer better relationships and more personalized service. "The notion that the large banks were better at customer service or were cheap is a fallacy," he says.

Steve Throgmartin, also a partner at Boston Consulting Group, says, however, that their success might be short lived. "When the cycle turns back to lending, the community banks will find it tough to compete against the lending scale of the large banks."

Foran agrees that scale is important for some lending activities, but is not as relevant as is often believed. "Scale is important on national consumer lending," he says. "It is hard to compete in credit cards as it is data driven, is based on the best customer selection and therefore requires a large footprint to compete." He adds, though, that local business lending and commercial real estate lending do not require scale. "Even the big banks like Bank of America say they are going to scale back." He adds that there is a shift in focus away from mortgages, upon which the banks were too dependent. "Banks are now looking to move into commercial lending, as well as credit cards and auto loans," he says.

But scale does lead to convenience. With increasing fees to use competitors’ ATMs, the banks that have more ATMs will naturally win. That can mean working with a retail partner to increase presence rather than opening a branch. Chase Bank, for example, has its ATMs in pharmacy chain Duane Reade.

Competition is increasing. Wagle goes as far as to say that there is a "war on for deposits". If you can attract deposits, then you can lend, and that will drive your profitability, he points out. Wells Fargo’s Sloan agrees that deposits are important. "The two most important things retail customers are looking for is a checking account and a mortgage. And then around their checking account they generally will want a credit card, online banking, bill pay, electronic paycheck deposit, ATM servicing – so by having a checking account you are opening up the opportunity to create a broader relationship. So deposits are very important."

While the community banks carve their niche as the best in service, the large banks aim at convenience, and the online banks target those fed up with fees to attract deposits. Wagle says there is another form of competition that might cause the biggest shake-up of all: that of the non-bank. "Mobile phone companies are entering to some extent (although not in the US), PayPal and Amazon are taking share, iTunes is looking to offer a payments service. These non-banks are really beginning to take share of the retail financial services sector."

And Wagle points out that these non-bank customers are more adept at providing good-quality service over less costly channels, such as mobile phones and the internet. He says that banks fall down as they provide one level of service in the branch, but the services through call centres and online are not of the same quality and will not attract the right demographic.

"It is Generation Y that a lot of the banks are interested in, yet if they cannot provide them with the same quality of service and price points as these alternatives, they will not attract that segment," he says.

Sloan says banks have to be aware of these new competitors and adapt. "The financial industry always goes through periods of change and periods that stretch the system. Even though there will probably be consolidation among the small to medium-sized players, there are new competitors. We have to be cognizant of trends such as retailers getting into financial services, how technology is creating increased competition, other non-bank competition, such as Paypal. You don’t want to wake up and find a tech firm has disintermediated you. Some banks will adapt better than others."

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