The roaring mortgage market of recent past, fueled by a strong housing market and the US Federal Reserve’s policy of increasing liquidity at an unprecedented rate, has contributed significantly to the profitability of the retail banking industry through the interactions of three factors:
1. Increased lending activity
Increased volume of mortgage lending, refinancing, home equity loans and lines have generated a steady stream of non-interest income for retail banks. Additionally, banks have realized gains on the sale of their mortgage portfolios in secondary markets.
2. Growth of core deposits
Retail banks have also enjoyed a healthy growth in their core deposits. The average annual deposit growth of ~10%, which is high by historical standards, has been fueled by the lack of availability of alternative investment vehicles for consumers who deposit their post-refinancing gains with their local bank.
3. Gains from investing in mortgage-backed securities (MBS)
Weak commercial lending has led banks to invest the money from deposits into mortgage-backed securities to improve their income from investments. Considered as safe as Treasuries but with higher yield, these securities have comprised more than 25% of bank assets in the last couple of years compared to 10% in 1987.
If interest rates were to rise significantly, the housing and mortgage markets would cool and all three factors would be negatively affected: consumer-lending activity would decline, MBS values would drop creating unrealized losses, and deposits would move to higher yielding investments with other financial institutions.
The retail banking institutions have to determine how they will sustain income and profit growth given the prospect of increased rates. These firms need to develop and implement strategies for securing profitable revenues while mitigating potential losses. In this article we examine some of the key issues and challenges in developing growth strategies in a rising interest rate environment.
Understanding the Drivers of Your Bank or Credit Union’s Economic Engine
The first step in formulating growth strategies requires developing an understanding of how retail consumers drive the economic engine of bank profits. Fundamentally, retail consumers drive profits through their deposit activity and non-interest income or fee-based activities at the branch level. Deposits provide liquidity at a much lower cost than what may be available through borrowing, and this lower cost of funds yields higher profits. Every depositor also acts as a potential source of non-interest income and as a target for cross-selling opportunities. It is often much easier and more cost effective to sell car loans and other lending products to consumers who are already in the habit of depositing their money at a particular institution.
Developing Growth Strategies
Given the significant role that depositors play in driving banking profits, we cannot develop growth strategies without considering how the retail banking institution intends to identify, attract and retain depositors. This is a fundamental question that needs to be answered before a successful growth strategy can be developed. As in any other retail business, the key is finding and keeping the right customers.
Much in the same way that Old Navy, GAP, Nordstrom, Neiman Marcus or other successful retailers have a clear vision of who they cater to and what is their differentiated value proposition, retail banks have to be clear as to who they wish to serve and how. In most cases, banks and credit unions have a retail model and supporting organization in place. The challenge is either to identify the population with the highest level of affinity for the existing retail model or to develop a new retail model designed to meet the needs of the target population in a differentiated fashion.
Step one of the process of developing growth strategies is to determine whether you need a new retail model or not. You can do so by measuring the year-on-year core deposit growth and non-interest income measured at the branch level much the same way that retailers measure same-store sales over time. If you have experienced sustained growth in your branches’ core deposits for two or more years, then you do not need to develop a new model or repair the existing one. You can begin the process of identifying the right customers. Otherwise you have to address the deficiencies in your model. In some cases this may entail reassessing the target population as well as your ability to create and deliver a differentiated retail product with a unique value proposition.
Step two entails identifying the customer population with the most affinity for your retail model as well as the most proclivity to purchase. In what population segments do you achieve the greatest fit between the value proposition offered by your retail model and the needs and preferences of the population? Where is this population located in your target geography? What is the competitive intensity in this segment? Ideally you want to target a segment with a high propensity to purchase and low competitive intensity. Once you have identified your target customer type and their characteristics, you need to concentrate your organizational resources in developing a compelling message and delivering it to the target population effectively and efficiently.
Having completed steps one and two, you are now ready to replicate your retail model by creating points of presence/retail outlets across your target geography. Properly designed, your branching model allows you to reach out to your target segments in select areas where you can maximize the contrast effect relative to your competitors.
Figure 1 – Strategic Direction and Supporting Functional Strategies
By following a systematic process of assessing your retail model and its market potential, you can answer key foundational questions in formulating your growth strategy: What markets should we target? In which segments has our retail model been most successful? Which competitors should we compete against? What is our differentiated value proposition? Once you have articulated your organization’s growth strategy and created alignment around it, you can develop supporting functional strategies for IT, HR, Marketing, Community Relations, Product Strategies (deposits, lending, pricing, new products), and Business Services and Operations. At the end of this process of strategic discovery, you will not only have identified the strategies to sustain your organization’s growth by concentrating your efforts and resources on the most attractive customer segments, but also the means to execute your chosen strategy.
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