financial services’ shifting profit poolsmake significant market share gains. they also point to...

Financial services’ shifting profit pools

By Andrew Schwedel and Antonio Rodrigues

How the contraction plays out will be determined by how nimbly financial serviceleaders respond

Copyright © 2009 Bain & Company, Inc. All rights reserved.Content: Lou Richman, Elaine CummingsLayout: Global Design

Andrew Schwedel is a partner with Bain & Company. Based in the New Yorkoffice, he leads the firm’s Financial Services practice of the Americas. AntonioRodrigues is a partner in Bain’s Toronto office and a member of the firm’sFinancial Services practice.

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How the contractionplays out will bedetermined by hownimbly financial serviceleaders respond

Financial services companies have spent along, turbulent spell wrestling with the hugecredit and liquidity challenges that have rockedthe sector. They’ve skirted insolvency, survivedvertiginous drops in asset prices, raised freshcapital and adapted to tough governmentoversight. Unfortunately, much more workremains to be done.

Despite recent rallies by some commercialand investment banks, the industry’s structuralprofit pools have shifted, with little sign thatthey will return to precrisis levels anytime

soon. The sector, which nearly doubled itsshare of gross domestic product (GDP) between1980 and 2007, now faces a major contraction,as industry returns will lag over the next severalyears. Based on Bain & Company analysis,profits shriveled to $17 billion in 2008, froman annual average of $430 billion between2004 and 2007. (See Figure 1.) While theindustry is likely to rebound in 2009, it won’tregain precrisis levels until 2013.

As they struggle to find their footing amidcontinued economic turbulence, all threemajor sectors of the financial services industry—banks, insurers and investment houses—will remain hobbled by the legacies of pastbusiness practices. How the contraction playsout across each sector, or affects any particularcompany, will be determined by the changedbehavior of customers battered by the down-turn and how nimbly the financial serviceleaders respond.

Note: Average (excluding capital markets)

Total U.S. financial services pre�tax profits

0

100

200

300

400

$500B

2004–07

416

2007

408

2008

17

2009F

49

2010F

168

2011F

236

2012F

346

2013F

412

Figure 1: Sector profits will not return to historic levels until 2013

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But at least for the next few years the outlookis sobering. According to a Bain & Companyanalysis, banking returns on equity will notreturn to their 2006 peak until at least 2013,as further credit losses mount. Bain calculatesthat the sector is likely to earn at least $200billion less than its cost of capital over the nextfive years—a gap that could widen if therecession lingers. Insurers face an overhangof guarantees on annuity and life insurancepolicies they have underwritten, leading to a sharp increase in unrealized losses. Bainestimates that insurers will need to add some$65 billion in new capital to restore the sector’s equity-to-asset ratio to 2007 levels.Profits in retail asset management will remainbelow their cyclical peak through 2013, as values gradually recover.

Companies will also confront a tougher newregulatory landscape that will close off someof their paths to restore earnings and requirethem to invest in good scenario planning.Though specifics are still uncertain, lenderswill almost surely face new consumer disclosurerules, caps on fees and limits on securitizationthat will significantly crimp their profitability.They will also be required to raise fresh capital—an additional $200 billion on top of the $390 billion the big U.S. banks raisedover the past year, according to Bain’s calcu-lations—which will reduce their returns onequity. Such big changes will force banks toreassess their current business models. Forexample, new rules that will dramatically cutback overdraft fees will call into question thebasic economics behind the popular “free”checking account model that has dominatedretail banking for better than a decade.

Climbing out of this hole will challenge financialservice companies fundamentally to retoolthree key elements of their businesses wherethey retain critical room to maneuver.

Customers: Meet the new, newinvestor class

As recently as early 2008, U.S. householdswere sitting on huge home-equity appreciation,had retirement nest eggs swollen by stockmarket gains and kept their broker’s cell phonenumber on speed-dial. Dubbed the “newinvestor class” for their enthusiastic accumu-lation of financial assets, they embraced invest-ment risks, eagerly topped up on credit andwere willing to pay premium commissions andfees to financial service providers whopromised market-beating returns.

As they ponder their post-crisis future, finan-cial services companies need to reckon withcustomers whose assets are depleted, worriedabout job security and weighted down bydebt. The financial crisis has fundamentallychanged their views of investing, temperedtheir tolerance for risk and diminished theirexpectations for investment returns.

The new, new investor class’s chief objectiveswill be to pay down debt and rebuild cashreserves. But even as their savings rate rises(from just one percent in 2007 to some 7 percent, by Bain’s calculation), the net flowof household income into financial assets willbe some 20 percent lower on average through2013 than they were during the flush yearsfrom 2004 to 2008. (See Figure 2.) Thisyear, Bain forecasts that total flows will plungeto $390 billion, from $800 billion in 2007.Given the very shaky balance sheets of middle-income households, the bulk of these flowswill come from high-net-worth customers. As investment flows contract, financial serviceproviders will need to wage a high-stakes battleto attract and retain the smaller population ofwealthier clients whose balance sheets haveheld up best.

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To attract their share of investors’ dollars,

financial service companies will need to shift

their mix of product offerings away from volatile

investment funds and other asset classes that

offered high returns but required investors to

assume more risk. While reducing debt loads

will be a top priority for most customers, even

investors who remain open to shouldering risk

to rebuild wealth will be looking for simpler,

lower-cost vehicles that provide greater liquidity,

like stock index funds and exchange-traded funds,

or greater safety, like fixed-income annuities.

In the wake of the credit and stock market

meltdown that so undermined their credibility,

financial service providers will need to take

customer loyalty seriously. They have a lot of

ground to make up to regain customers’ trust.

Using a measurement called Net Promoter®

Score (NPS) that Bain & Company codeveloped

with Satmetrix, a customer-experience software

firm, we have tracked trends in customer loyalty

at scores of financial services companies over

the past five years.

With disgruntled customers looking for new,low-cost ways to save and invest and increas-ingly open to switching service providers, thepotential prize is huge. Our work across 13industries in 24 countries has found thatcompanies that are loyalty leaders capture ahigher proportion of sales from customerswho trust them. They also experience lowerlevels of customer churn, which holds downmarketing costs. Their loyal customers, too,are also more willing to recommend them tolike-minded friends and colleagues who areapt to become loyalists themselves.

When Bain last surveyed customers of financialservice providers in mid-2009, NPS for thesector overall had sunk to all-time lowsfrom where they had been the previousspring as they absorbed the harsh realitiesof the cratering credit and security markets.(See Figure 3.) The volatile scores suggestthat customer relationships are in play andthat firms that excel as loyalty leaders canmake significant market share gains. They alsopoint to distinct pockets of opportunity forsome institutions. Specifically, scores for

Source: Federal Reserve, Bain analysis

0

200

400

600

$800B

Annual flows into financial assets (nominal dollars)

2004−2008

736

2009−2013

584

21% decline

Figure 2: Declining inflows of household assets will make customer retention a top priority

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regional banks have held up far better thanthose of the troubled big banks. Among bro-kerage firms, the traditional high-cost wire-houses have lost significant ground to theindependent broker dealers that have workedto position themselves with investors asvalue-oriented trusted advisers.

The brokerage firm Charles Schwab is seizingthe advantages of loyalty leadership to pullaway from the competition during the down-turn. Over the past five years, the companyhas driven disciplines of customer focusdeep into the organization, empoweringbranch office staff to convert clients intoadvocates and holding them accountable forresults. Schwab is beginning to reap therewards of that patient investment. In a yearwhen retail investors were pulling money out of tumbling markets, the brokerage businessgrew by $113 billion, as the company postedrecord operating profits.

Costs: Rethink the businessmodel for deep savings

As revenues rose sharply with economicexpansion through the end of 2007, banks,insurers and asset managers felt little pressureto hold down operating expenses. But withcustomers more price sensitive than ever and profit margins squeezed, they need todig in much deeper to bring down costs.

They have a long way to go. To restore 2011returns to 2007 levels, for example, life insurersand asset managers will need to find some$15 billion in cost savings, according to Bain’sanalysis. Among banks, the cost savings havenot kept up with shrinking interest and feeincome or with the big jump in provisionsthey have been forced to make to absorb losseson nonperforming loans. They will need tolower costs by $45 billon by 2012 to regainreturns on equity that prevailed in 2007.

Source: Bain retail banking survey

Retail bank client Net Promoter® Score

�75

�50

�25

0

25

50%

Bank A Bank B Bank C Bank D Bank E Bank F Bank G

Current NPSSpring 2008 NPS

252 146 14165 222 335 257N=

Figure 3: Industry turmoil has put customers “in play”

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For the financial services sector as a whole,cost reductions on the order of 9 percent to15 percent will be needed to bring costs inline with lower revenues. Much progress hasbeen made, but there is still a long way to go.

Conventional approaches are apt to fall short.As they enter a period of higher capital costs,more stringent regulatory oversight andpinched profit margins, companies will needto rethink their business models to succeed.By homing in on core business activities wherethey can exploit competitive advantages, tomor-row’s winners will burrow deep into theirorganizations to identify and strip out theproduct, process and organizational complexityembedded in their businesses.

The cost of complexity was especially insidiousfor financial services companies during thepast expansion, in part because it was all but invisible and grew without restraint.Companies slipped into a trap of addingproducts and services that piggybacked onexisting offerings and modestly increasedcustomer support to serve the new accounts.But the apparently low incremental costsproved deceptive because they masked thesteep, hidden systemic costs that built up inunderlying processes. Now, with customers’appetite for variety sated, many financialservice providers find themselves strugglingwith a huge overhang of complexity and allits costly consequences.

What to do? Cutting structural costs deeplywhile simultaneously strengthening customerloyalty is a big challenge for any company to pull off. Trying to root out complexity byparing back on product offerings or shuttingdown business lines, for example, does noteliminate the need to continue to serve accountsheld by legions of legacy customers. But thechallenge is far harder for financial servicesorganizations that continue to add complexity,

as many are still doing in response to marketpressure to reduce their perceived risk bydiversifying. In fact, what’s called for intoday’s straitened times is to focus clearly onthe few competitive battlefields where thecompany determines it is best able to compete.

Service companies that succeed in tacklingcomplexity start with a blank sheet of paper.They begin by calculating what their coststructure would look like if they were to offerjust one product—the stripped-down “ModelT” approach. Then, they cost out each newproduct variant as new features are addedback in. Companies that put themselvesthrough this exercise typically find that costsdo not rise in a linear fashion but ratherjump sharply at break points where addedcomplexity starts to strain against capacity.Knowing where those break points occur—and how to avoid them—can spell the differ-ence between healthy profitable growth andsubpar performance.

Some pioneering banks in Europe and in fast-growing emerging markets are putting thisinsight to work by fundamentally rethinkinghow to operate their branch networks morelike retailers to boost customer traffic andradically reduce costs. Applying a concept wecall light-retail banking, they are strippingbranches of costly transaction-processingactivities, shrinking their footprint andconverting branches into attractive boutiquesthat focus on product sales. Construction and operating costs for a compact bank“store” are less than one-quarter of those of a standard branch. Several U.S. retail bankshave begun applying light-retail principles totheir branch networks, but most still need tointegrate the approach more completely withthe services they offer online and with theirback-office customer-support operations toachieve the full potential of the new approach.

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The second critical step for wringing outcomplexity is to zero in on what customerstruly value. Working with clients from a varietyof industries, Bain has discovered that typically5 percent of a company’s products can accountfor up to 95 percent of its sales.

Finally, organizations determined to steerclear of complexity remain perpetually vigilant.Customers and competitors don’t stand still,and as financial service companies race toinnovate, the likelihood is high that complex-ity will creep back in. Smart companies avoidthis by putting safeguards in place to keeptheir business model simple. They raise thehurdle rate any new product or service mustclear before it is added to the portfolio. Andthey “prune the garden” by eliminating orstreamlining an existing product when a newproduct is added.

Capital management: Recognizehow risk affects profitability

The fundamental blind spot at the heart ofthe financial services sector meltdown hasbeen an institutional and systemic failure toassess risks properly and put safeguards inplace to control them. Poor risk managementled banks and other financial companies tomiscalculate their true profitability and, as a consequence, to commit scarce capital to devel-oping and marketing the wrong products, andusing the wrong incentives to reward “success.”

For many companies, the source of the prob-lem has been to run their businesses payinginsufficient attention to their true risk-adjust-ed economic profits. Economic profit beginswith the net after-tax accounting profit butthen critically adjusts for the amount andcost of the equity the company commits toput at risk. Thus, when measured on a risk-adjusted basis, the economic profits associat-ed with a given product, customer segmentor market will likely be significantly lower

than accounting profits—potentially turningan activity that appears to kick off healthyprofits into a money loser.

While the big financials services companiesdid try to account for risk and capital costs inthe period leading up to the credit meltdown,most failed to factor it appropriately intotheir decision-making processes. In somecases, information remained bottled up in thefinance department and did not reach business-unit heads who tried to optimize gross revenuesor other performance measures. In otherinstances, they may have made their estimationsbased on faulty assumptions. For example,banks did recognize the need to adjust forrisk the capital they committed to underwritingmortgages, but their formulas massively under-estimated how big that risk could be in a scenario where housing prices collapsednationally, leading homeowners to default inunprecedented numbers.

Clearly, a more realistic appraisal of risk and amore integrated approach to managing capitalneeds to play a much more prominent role intoday’s more sober times. As they recalibratetheir expectations going forward, for example,financial service companies are taking arenewed interest in attracting plain-vanilladeposits as a surer source of stable funds tosupport long-term asset growth.

Financial services companies that respond tothe painful shift in profit pools by taking onthe hard work to strengthen bonds of trustwith loyal, more parsimonious, customers,squeeze complexity out of their core businessesand do a smarter job of managing scarce capital may not get the quick earnings kickthe sector once enjoyed through leverage andby embracing risk. But they will surely earn a sustainable competitive edge that their lessfocused rivals cannot match.

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Notes

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