Banking on Innovation

Solving the Retail Puzzle with New Ideas

It’s been a tough few years for the banking industry. The days of easy money are gone, and all signs point to a slower, more measured growth trajectory going forward. The U.S. consumer is focused on deleveraging; there will be fewer dollars to chase, and they will be harder to win. Add to this low interest rates for the foreseeable future, new regulations and aggressive restrictions on fees and trading activities that will cut banks off from valuable—and once reliable—sources of income, and it becomes increasingly clear that banks are facing a brave new world. To succeed in this new environment, banks will need to devise a new way of operating and a new paradigm of offerings to engage an increasingly reluctant consumer. Banks now are forced to rely on what is arguably their weakest skill: finding new out-of-the-box ways to approach change and improvement. And so banks face what may well be their biggest challenge of all: using innovation to deliver value to the customer while concurrently making profits for te bank.

ALL MAIN REVENUE SOURCES ARE SHRINKING

Top-line revenue is under pressure. And it’s no secret why. New regulations limit overdraft fees and credit card penalties. The cost of servicing delinquent mortgages is increasing, and at the same time, tighter credit standards are shrinking the volume of consumer loans. Furthermore, the Federal Reserve recently capped the interchange fees banks charge retailers for debit card purchases at 21 to 24 cents per transaction, down from an average of 44 cents.

The reductions in revenue have not yet been reflected in profits due to loan loss reserve accounting practices. From the outside in, banks may appear to be doing quite well. In 2010, profits rose almost sevenfold, to about $70 billion. But these figures haven’t been boosted by revenue growth. Instead, they’re driven by releasing reserves as loan losses eased. Wells Fargo, the nation’s largest retail bank, posted $3.9 billion in profit for Q2 2011, but the bank also reduced loss reserves by $2.8 billion amid a decrease in revenue of 6.5%. In Q2 2011, Wells’ mortgage originations continued to decline to $64 billion, down 24% from the previous quarter and 21% from the same quarter last year.

Citigroup reported $3.3 billion in Q1 profit, largely because it released $2 billion of reserves. JP MorganChase saw its Q2 profit increase 13%, to $5.4 billion, mainly because its investment banking and trading operations helped offset losses on the retail side, where the bank is still dealing with sour loans and has reserved an extra $620 million to cover potential legal claims. Recovering from a Q4 2010 loss, Bank of America reported a profitable Q1 this year. However, in Q2, the bank posted net losses of $8.8 billion, reflecting $20.7 billion of pre-tax mortgage related charges. Revenue declined by12% compared to Q2 2010, as new regulations limited overdraft fees. And these trends are not limited to these specific banks: overall, of the $70 billion in profits in 2010, about $20 billion came from the release of loss reserves, while revenue decreased 1% to $790 billion.

THE RESPONSE: CONVENTIONAL VS. CREATIVE

So how are banks adapting to the changing marketplace? In the short term, it is likely banks will try to boost retail revenue using an array of traditional tactics. These could range from shrinking credit card rewards programs and eliminating free checking to rolling out more transaction and minimum-balance fees, and charging higher insufficient-funds and checkcancellation fees. These conventional tactics may help marginally in the short-term, but ultimately they reduce value for the customer and do little to set banks on a path of sustainable growth.

A more transformative approach, on the other hand, would seek to create value for customers rather than eliminate it. Rather than relying on their old bag of tricks, banks could choose to cultivate and drive innovation. And this is the first challenge. Banks typically don’t invest in research-and-development departments—unlike companies in other industries. According to a study conducted by the National Science Foundation, only 8% of finance and insurance companies reported at least one process or product innovation between 2006 and 2008. This is compared to 45% of pharmaceutical companies, 45% of computer and electronic product companies, and 77% of software publishing companies. Critically, there is strong correlation between the size of investment in R&D activity and the rate of innovation. Seventy percent of companies that invest between $10 and $50 million report innovation annually, versus only 7% of companies without any R&D activity. It’s worth noting that those companies that increased their spendingon R&D by more than 10% during the five-year period of 2004-2009 saw a compound annual revenue growth rate (CAGR) of 10.4%—nearly double those companies that increased R&D spend by less than 10% and nearly four times that of companies who decreased R&D spending in the same period.

The lack of R&D investment is clearly an issue, but perhaps even more problematic is the issue of industry culture. The banking industry doesn’t seek out and reward innovative thinkers. The idea that innovation has more to do with people and visionary leadership than with size of R&D investment was reinforced by Jack Welch, former CEO of General Electric, during his recent appearance on CNN’s Piers Morgan Tonight. Welch said: “I was never the smartest guy in the room. And that’s a big deal. If you’re a leader and you’re the smartest guy in the room, you’ve got real problems.” Welch referred to Steve Jobs as the obvious example of an innovative leader who surrounds himself with innovative thinkers, whether at Apple or at Pixar. Welch concluded: “Creating great people will make a great company. Shareholder value is the dumbest idea in the world. I want people who dream and I want people who sweat.” The trick for banks is finding ways to apply this wisdom that works so well in other industries to their own retail sector. It has to start with innovative leadership.

THE RETAIL REVOLUTION

It has happened before. Commerce Bank’s Vernon Hill turned the traditional approach to retail banking on its head by leaning hard on retail elements that emphasized friendly service, convenience, and a sense of transparency. Commerce became famous for sevenday lobby or drive-through hours, no overdraft fees on debit cards, no-fee Visa gift cards, free use of coincounting machines, and giveaways of small items like pens, pencils, and dog biscuits. In other words, Commerce approached banking from the customer’s point of view, not the bank’s. Between 1990 and 2007, Commerce Bank’s market cap grew on average 37%. In comparison, the SNL US Banking Index grew by 12% per annum for the same period.

ING Direct accomplished a similar feat of innovation, albeit in the opposite direction. The branchless bank launched in 2000 pitching straightforward products and services. The bank adopted a nontraditional marketing strategy pegged to its “great rates, no fees no minimums” slogan, its distinctive orange-ball logo, its “Save Your Money” motto, and its city-by-city blanket marketing campaigns. The product line stuck to the basics: high-yield savings accounts, interestearning checking accounts, CD accounts, home loans, retirement accounts, and services for those who want to invest. As a result, deposits grew on average at a staggering 118% per year for the period 2000- 2006, compared to an overall deposit growth of 7% during the same period. And ING has continued to evolve with consumers’ tastes. Today, ING does have branches in the US as well as ING cafes, where customers can have coffee, use the internet, and learn more about ING product offerings, under the tagline, “Saving money should be as easy as gettinga cup of coffee.” New visitors are given their first beverage free, and special programming focused on earning, saving, and investing money is offered for kids.

EVERYONE ELSE IS DOING IT—WHY AREN’T YOU?

The value of a dedicated corporate innovation program is easy to find across industry. Companies like Proctor and Gamble (Connect +Develop) and GE (Ecoimagination) have well-known programs that have delivered significant quantifiable results. Indeed, it’s not hard to find examples of companies whose dedicated and systematic focus on innovation has paid off handsomely—it’s just hard to find it in the banking industry. From software to consumer products, companies fund innovation institutes, employ “entrepreneurs-in-residence” and—critically—maintain these investments during difficult times.

Financial Services companies don’t do this; and as a result, they may be missing chances to create the breakthrough innovation that will deliver exceptional value to the customer. To be fair, the retail banking industry has made sweeping changes to its business by its adaption of technology, but these changes are more reactive—keeping up with technologicaladvances—than they are proactive. According to Don Tapscott, Wikinomics co-author and innovation expert: “In retail banking there are still great opportunities
for individual companies to move up the food chain from doing transactions to creating deep relationships and experiences for customers.” So how to do it? By asking different questions. Rather than ask “How can we make up for lost revenues?" banks need to start asking “How do we make our customers’ lives better?”

While technology has indeed driven increases in productivity and convenience in retail banking, it can seem that this benefits the bank more than it does the customer. Anyone who has attempted to get detailed questions answered via an automated “help” line or online menu of FAQs or troubleshooting tips is reminded how heavily commoditized retail banking services have become. Looking at innovation from the customer's point of view rather than from the companies has been called ‘empathic design’: an approach that observes customers’ behavior in their own elements (rather than in focus groups or other controlled settings) and uses that information to devise solutions that are valuable to the customer—not just the corporation. This approach could reveal to banks new opportunities to differentiate themselves from their competitors.

WHAT HAVE YOU DONE FOR ME LATELY?

As banks look around at the rapidly changing economic and regulatory landscape that surrounds them, they should resist the temptation to react conservatively and act to protect their revenue streams at the consumer’s expense. Customers are one of the best sources of breakthrough ideas. Rather than focusing on squeezing or selling or finding new fees, banks could start with the question “How can we make ourselves irreplaceable to our customers?” Deceptively simple, it speaks to a fundamental truth—the customer is the heart of the business. Banks must think first about what will benefit the customer and figure out how to monetize it later. It’s an approach adopted by many companies in the internet/technology space—think Google, Apple, Facebook—where the needs and experience of the user is the starting point for everything else. And it’s the approach that will create loyal brand advocates out of customers and industry and innovation leaders out of financial institutions.

This is a critical and defining time for bankers. The current business model is, if not broken, then badly damaged, at best. Loan volume is tepid, interest rates are low, and new sources of revenue are uncertain. Banks that stick to business-as-usual will lose. Instead, banks must do the unnatural: think from the outside in and find ways to innovate. Do this with precision, discipline, and rigor, and banks will win the loyalty of their own and their competitors’ customers, and deliver shareholder value along the way.

HOW TO BREAK THROUGH

Breakthrough innovation is the key to banks driving top line revenue moving forward. Its role in creating financial value for the organization while concurrently creating real value for the customer has been proven in other industries and now it is banking’s turn to get serious in this space. But how to start and where to begin?

Start At The Top. While it may come as no surprise, it’s worth stating the obvious: serious results from innovation will require a serious commitment from the organization, starting with the CEO and the executive management team. Only with leadership from the top will banking find its equivalent of Herb Kelleher’s/Southwest’s “10 minute turn”—the seemingly impossible, made possible. The CEO’s commitment can be institutionalized through a variety of tactical efforts, such as making it part of the performance review program, building it into reward and recognition programs, and adding it to the board meeting agenda and management meeting agendas.
Pick The Right Spots (create a “CFO-Innovation Map”). Breakthrough innovation that doesn’t also deliver breakthrough results is interesting, but not helpful. Profitably innovative organizations “scientifically” identify where to focus investment and effort. The rigor involved here is not to be underestimated. Try to innovate everywhere and the result will likely be a huge bill and little breakthrough. Instead, start from the outside and work in—begin with the Customer. Identify where innovation would be most valued by the customer. Traditional forums such as surveys and focus groups are a start, but must be customized to serve this purpose. Further, customers have already told banks much of what they need to know—it’s in the data that banks already have and own. Apply a series of overlays—Financial and Operational (hence, “CFO-Innovation Map”)—to the customer data and an answer begins to emerge: a short-list of those areas where breakthrough innovation offers the most promise. Banks that apply this type of smar t, disciplined approach toward innovation position themselves to solve their revenue woes and build the foundation for being not just survivors, but leaders, separating themselves from the rest of the pack.
Build Some, Buy The Rest. A deliberate, smart approach toward approaching the decisions of what to “build,” or develop internally, and what to “buy” or acquire from outside the bank, is critical to success. Results from the “CFO innovation map” will provide facts and insights to help inform this decision. In general, banks should not attempt to become what they are not; the idea here is not to attempt to create a bank culture that rivals that of the creative group at an advertising firm. That approach is likely to fail. Instead, apply a decision framework against the map to make informed, pragmatic decisions about what to look for internally and what to focus on outside the bank. This can reduce wasted capital and deliver far superior results. A small, high-powered team of appropriately skilled people can lead the charge on acquiring or buying breakthrough innovation from the outside; this is no small task and is an effort that requires informed effort and design. The right team and approach can exceed even the most aggressive expectations; getting this wrong will result in failure or lackluster results at best.
Make A Real Investment (over a real period of time). Getting the most out of breakthrough innovation requires making an investment—not just capital, but also and importantly, energy and effort. On the capital front, begin by including it as a “line item” on the corporate P&L, in much the same way seen in industries such as pharmaceutical or manufacturing. Giving it its own “line item” will ensure it receives the attention it deserves and that the right questions are being asked: “What have we done to innovate?” “How has our investment benefited our customers?” “What has been the financial impact to the bank?” “How has this helped distinguish us in the marketplace?” As a rule of thumb, R&D typically runs about 5% of revenue for companies serious about innovation, but can sometimes be as high as 10% or more. Of course, it can be much lower, and starting on the low side puts less at risk. Finally, breakthrough innovation is not a “program” or “event,” it’s a way of doing business. Thus, success requires not a long-term but a “forever-term” commitment. If the results – for the customer and for the bank – are not meeting expectations, the response should be to “do more, do it better, or do it differently,”—not “stop doing it.”
Track, Measure and Manage. Last but not least, develop and implement a robust tracking and measurement of both the investment and results of your innovation program. Many companies have detailed balanced scorecards and monthly reports that measure a plethora of financial and operational metrics but fall short of measuring and promoting innovation. The key in measuring is not how many but which variables you track. Focusing on the wrong metric can not only hinder innovation but also move you in the opposite direction by promoting behavior you want to avoid. Another pitfall is oversimplifying the measurement of innovation. Quite often companies make the mistake of trying to encapsulate results of innovation in a single metric (e.g. total investments as a percent of revenues) while overlooking other important pieces of the puzzle such as management time spent on innovation, number of products launched, and number of new customers directly acquired as a result of innovation. Capturing this type of information will of course require the right technology platform, information processes and feedback mechanisms that will allow for the constant fine tuning of innovation engine.

*AlixPartners, 2011. U.S. Economic Outlook, May 2011.
**Info Brief: Science Resources Statistics: “NSF Releases New Statistics on Business Innovation”, October 2010

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