Retail banking has generated remarkably good profits in recent years for big banks. The UK’s Lloyds TSB, for example, has become the biggest bank in the world by market capitalization, with profits for 1997 forecast at £3.2 billion ($5.2 billion), thanks largely to its focus on retail banking. So high have been the returns that a number of banks for example, Barclays and NatWest of the UK have sold their investment-banking arms to direct more of their attention towards this lucrative sector.
But life for retail banks is about to get a lot harder. A range of non-banking companies, lured by the idea of easy profits, are beginning to move into financial services, often with high levels of success. Technological developments from sophisticated data storage to internet banking and smart cards have robbed banks of their monopoly in transmitting money. At the same time, customers are becoming more demanding and are readier to switch to financial institutions that offer better rates.
This heightened competition is making life difficult for traditional retail banks. They tend to have expensive branch networks and relatively outdated procedures, and their operating costs are usually much higher than their new, more flexible rivals.
What can the big banks do to preserve their market share and stop customers shopping around for cheaper deals? Are the new entrants serious banking contenders that threaten established financial institutions, or merely marketing experiments? One thing is certain: banks that ignore these dramatic changes are taking a high-risk and short-sighted view of their business.
The pace at which retail banking is changing varies from country to country, but common trends are emerging. First, the focus of banking is shifting from transactions towards sales of financial products. This is because, as banks merge, they are increasingly centralizing and streamlining their processes. Second, barriers around banking are being lowered, allowing competitors from other industries to come in and try innovative approaches. Third, the growing variety of delivery channels for banking enables new entrants to thrive.
Until the beginning of the 1990s, nearly every country had a domestic retail banking sector that was separate from its neighbours and dominated by a handful of established banks. In 1980, the big-four high street banks in the UK generated almost 70% of the industry’s profits.
The main exception was the US, where geography and past regulation meant that no bank operated in every state and that most banks stuck to their traditional strongholds. Banks had extensive branch networks where each branch was a miniature bank in itself, with a manager, numerous cashiers and transaction processing operated in the back office.
Customers shouldered the inevitable expense of this unwieldy system in the form of high charges. Faced with bureaucratic errors and lengthy queues for service, customer satisfaction was consistently low, yet people tended to stay with the same bank for life through inertia. Customers could not find out about other accounts very easily, and the process of changing banks was lengthy and complicated. This generally accepted model of retail banking, despite its inefficiencies, existed profitably for many years.
The inherent flaws in this model were exposed once customers were offered new, cheaper and sometimes more pleasant alternatives. Retail banking in the UK faced the first wave of new entrants in the late 1980s when building societies started to offer current accounts. “At the top of every economic cycle there are waves of new entrants who later get burnt by the following recession,” says Gordon Pell, group director of UK retail banking with Lloyds TSB, playing down the competition from other sectors.
Banks had already embarked on cost-cutting after diseconomies of scale began to emerge. The banks had grown bigger over the years, but not more efficient. Europe was particularly overbanked. Since 1985 competitive pressure has caused the number of French banks to halve, while Swedish banks have decreased by over 80%. At this time many countries liberalized financial regulations, triggering a merger and acquisition spree.
Cutting costs
UK banks have cut costs by drastically reducing their bricks-and-mortar operations. For example, the number of NatWest branches has fallen to about 1,750 from a peak of around 3,600 in the late 1980s. The challenge for banks, as banking analyst John Leonard at Salomon Smith Barney puts it, “is to see if they can close branches without losing customers”. Lloyds TSB has 2,800 branches, more than any other banking group in the UK, though 150 branches closed during 1997. More closures are likely to follow when the merger of the two banks, currently undergoing parliamentary scrutiny, is given final approval.
Meanwhile in the US, Chase cut branches in Manhattan last year following its 1996 merger with Chemical Bank. But the US seems to be nearing the end of the consolidation phase, and in this respect is arguably ahead of Europe. Denis O’Leary, executive vice-president and deputy head of consumer banking at Chase, believes that information technology now enables banks to grow both in size and competitiveness. “Economies of scale were elusive in the traditional model, a symptom of weak management. In the technological model, efficiency can be achieved without size being a factor,” he says.
An important development has been the move to centralize transaction processing, which reduces paperwork for individual branches. This can substantially cut staff numbers and costs. Canadian retail banks have pooled their cheque-clearing activities and maintenance of their ATMs. In the UK, two-thirds of NatWest’s branch network has converted to centralized processing and the bank hopes to increase this further in 1998. Royal Bank of Scotland started to move transactions to low-cost processing centres in 1994. However Stuart Sinclair, director of UK retail operations at the bank, thinks that routine transactions won’t disappear from branches altogether. “Banks can’t become too homogeneous,” he says. He believes it is necessary to separate sales and services, but argues that variety and flexibility of function is an advantage banks have over direct providers and they shouldn’t squander it just to save money.
As customers get better access to information on financial services through the media, they are becoming more sophisticated and more interested in finding better value and more attractive banking products.
What the newest providers of financial services, such as telephone banks, internet banks and supermarkets, have to offer is convenience.
They are different from previous waves of new entrants to retail banking, such as building societies, in that they are generally from outside the financial sector. In the US, much of the new competition is from technology companies, but in Europe it is retailers that are entering the business. They are a particular threat because they bring consumer-focused ideas and often strong brand identity, without the high-cost baggage of a traditional bank infrastructure.
Chequebooks at the check-out
Attention in the UK has focused on the supermarket banks that began operating during 1997. The country’s two biggest retailers, Sainsbury’s and Tesco, have gone into partnership with Bank of Scotland and Royal Bank of Scotland respectively. These banks have few branches in England while the supermarkets have few outlets in Scotland, so the banks gain access to new markets without cannibalizing their own operations. The supermarkets also gain access to valuable information on their customers’ spending habits through their bank records.
Sainsbury’s Bank (opened in February 1997) and Tesco Personal Finance (launched July 1997) both combine in-store banking facilities with a 24-hour free telephone banking service. After almost a year of business, Sainsbury’s offers a savings account, two credit cards and personal loans and mortgages, with more services to follow. Tesco Personal Finance offers only a savings account and a credit card, but aims to expand its range this year.
Both banks have used high interest rates to attract accounts. The two pay interest of 6.5% on any balance over £1 ($1.60) compared with an average of less than 2% offered by the big high-street banks. Tesco’s credit card has no annual fee and charges interest of 12.9% for the first six months and 16.9% afterwards, compared with Barclaycard’s rate of 22.9%. By November 1997 Sainsbury’s Bank had attracted over 600,000 customers and £1.3 billion in deposits, and continues to gain over 12,000 new account-holders a week. Since July, 400,000 customers have signed up with Tesco Personal Finance at a rate that caused its systems to struggle to keep up with demand.
But not everyone is impressed. Andrew Blessley, director of marketing and distribution at NatWest, thinks the supermarket banks won’t be able to sustain their popularity. “Once they ease off the rates, the customers will be off,” he warns.
Analysts estimate that Sainsbury’s Bank lost £10 million in 1997; a similar figure is rumoured for Tesco Personal Finance. But Pell at Lloyds TSB thinks the two were expecting some losses. “They regard it as product reinforcement, almost part of the advertising budget,” he says.
Some bankers also express doubts as to whether supermarkets are serious, long-term contenders in the market. “Are they prepared to build real financial services businesses, a process that might take seven or eight years?” asks Pell. And can they handle some of the less palatable aspects of retail banking, such as home repossessions, without it hurting their friendly brand image? “They won’t have the stomach for it in the long run,” says Pell. However, many interpret the fact the supermarkets are offering mortgages as a sign of long-term commitment. “We certainly don’t underestimate them,” says NatWest’s Blessley.
Another high-profile new entrant to the UK retail banking industry is Virgin. Not content with airlines, cinemas and cola, in October 1997 entrepreneur Richard Branson launched Virgin Direct Personal Financial Services. Its centrepiece is Virgin One, a new product that combines cheque, credit-card and mortgage accounts in one, with a single interest rate (currently 8.2%). This operates in partnership with Royal Bank of Scotland, and Stuart Sinclair of the bank predicts that Virgin One is “going to be very big”. “It’s incredible value, everything you borrow is at mortgage rate,” he says. During the pilot phase the account was available only to existing Virgin Direct customers, but since the end of January it has been open to the wider public.
It is not clear whether Virgin One, although innovative, is a product with mass-market potential. “It’s not for everyone,” concedes Sinclair. The account is aimed at the affluent and financially astute, possibly with an irregular income such as the self-employed and those with bonuses.
Paul Duffin, general manager of banking and savings at Halifax, wonders whether consumers will like the idea of having all their eggs in one basket. “People would prefer to feel that they are £2,000 in credit with a separate £50,000 mortgage, rather than £48,000 in debt,” he says. He also wonders whether mortgages will damage the brand when the economic environment is less favourable. Pell at Lloyds TSB is scathing about Virgin One. “It’s a total non-event,” he says.
Another interesting question is how the introduction of the single currency in Europe will affect retail banking.
One thing it is likely to do is increase cross-border retail banking, something which is still rare, although not unknown. For example Svenska Handelsbanken, the biggest bank in Sweden, is also successful in Norway, Denmark and Finland. Germany’s Deutsche Bank has 300 branches in both Italy and Spain, and intends to expand into France. Citibank of the US, though, is the only bank attempting to do retail banking globally.
Emu will eliminate most remaining barriers to entry between banking markets in Europe. This will intensify competition, but most bankers are doubtful that cross-border retail banking will take off, since there are still great advantages for a bank operating in its domestic market.
“Each country has its own quirks and difficulties,” says Sinclair of Royal Bank of Scotland. Language, cultural and geographical differences won’t be eliminated by the single currency and customers will continue to favour banks that use their own language and are close at hand. But in time these barriers will diminish and once customers get used to technology and remote banking, cross-border banking may boom. “In banking it rarely pays to hurry, and banks must be prudent about expanding outside their home countries,” says Lars Gronstedt, executive vice-president in charge of business development at Svenska Handelsbanken.
Blessley at NatWest is also cautious about expansion into Europe. “Our experience has not been wholly satisfactory. As a bit player you get the scraps off the table,” he says. NatWest has shut down its operations in France, Italy and Belgium among other countries to concentrate on the UK market.
Emu will bring both opportunities and threats. Banks have to identify where they can beat the existing domestic providers, and where competition from foreign banks could threaten their own businesses. “If you’re good, there is at least as much opportunity as risk in Europe. The UK market does not represent any easy pickings,” says Sinclair of Royal Bank of Scotland. The German credit-card market, although more developed than a few years ago, is seen as a fruitful sector for foreign companies. Santander Direkt, a subsidiary of Banco Santander of Spain, is the largest provider of credit cards in Germany and the UK’s Barclaycard is also a major player. Any countries where banking still follows the traditional model (overbranched, old-fashioned, high cost) may have cause for concern, as domestic banks will find it hard to compete with cheaper rivals. “For example, many German and Italian banks should be worried,” says Gronstedt at Svenska Handelsbanken.
Dial-a-banker
But the greatest potential for cross-border banking lies in technology, such as the internet and telephone banking, which makes national boundaries irrelevant. One of the main trends is the move towards a choice of channels, or “multi-optional banking” as Germany’s Bayerische Vereinsbank dubs it. Telephone banking has grown rapidly in the past decade. A pioneer was the UK’s First Direct, an independent unit of HSBC’s Midland Bank, set up to offer an alternative to branch banking. Banking is conducted through a 24-hour telephone service which has never closed since it was launched in 1989. By 2000, First Direct aims to have over a million customers. “The first bank to recognize the trend towards direct banking was Midland with First Direct,” says Eugene Lockhart, president of global retail banking at Bank of America, who worked for Midland at the time First Direct was set up.
The formula has been widely copied. European examples include Bank 24, set up by Deutsche Bank in Germany, Santander’s Open Bank in Spain and Paribas’ Banque Directe in France.
In the US telephone banking is estimated to be about 50% cheaper to run than branch banking, as a result of the low cost of calls. Most American banks now offer a full telephone banking service and are investing heavily in technology. Chase receives 150 million calls a year to its hi-tech call centre in Jericho, New York. Further growth is expected. “It is still an under-used channel and the systems are getting smarter and smarter,” says Blessley at NatWest.
The fashion has also taken hold in emerging markets. Bank Tiara of Indonesia recently introduced 24-hour telephone banking, and banks in Turkey and Slovenia are keen to follow.
Computer banking, either through the internet or using proprietary networks, is a small but rapidly growing distribution channel. Security First Network Bank, the first internet-based service, has been operating from Atlanta in the US since October 1995. It holds 12,000 accounts and claims to be the only bank to have customers in every US state. The bank has also worked to improve the security of internet transactions.
Although operating costs are low, Security First Network Bank was expensive to set up and has made substantial losses. The bank is now up for sale; whether it will thrive in the future or be looked back on as a interesting experiment remains to be seen. Most major banks are setting up their own electronic services, but internet banking is most advanced in the US and in Scandinavia. Sweden’s Svenska Handelsbanken has gained 13,000 internet customers since it set up on-line banking in mid-1997; it is adding about 200 new accounts each day. New York research company Faulkner & Grey estimates that there could be as many as 7 million internet banking customers worldwide by the end of 1999.
An important development in the US has been trials of web-television, an interactive system that combines television and personal-computer technology. A normal television screen is converted to an internet terminal, and a remote control is used to choose options. This technology has been used for both on-line banking and home-shopping.
Another technological innovation that will affect retail banking is the smart card, which contains a microchip instead of the usual magnetic strip. One of its features is that it can be used to carry electronic cash. Value is stored on the card from a customer’s bank account and can be spent on low-cost purchases such as newspapers and bus fares, removing the need for small change. The two major electronic cash cards are Visacash, operated by Visa International, and Mondex, now controlled by MasterCard but developed by NatWest and Midland in 1990. Visacash is being tested in the UK in Leeds and in Manhattan in the US .
So will we become a cashless society? The consensus answer is no, although most banks and retailers would favour smart cards since cash is the most expensive form of payment for them to process. Humans remain psychologically attached to the idea of cash. “We are handling more cash than ever before,” says Pell at Lloyds TSB.
Despite these technological innovations, few bankers believe that the branch network is dead. Even the direct banks, such as Security First Network Bank, are opening branches to attract more customers, confirming the sales advantages of direct personal contact. Sinclair at Royal Bank of Scotland is resolute about the need for face-to-face customer service and predicts the number of RBS branches will expand rather than contract. “There is a rediscovery of basic truths in retail banking,” he says. “The future doesn’t lie in a channel, it lies in excellence.”
Burkhardt Pauluhn, member of the divisional board at Deutsche Bank in Germany, agrees that branches still make a lot of sense. The main challenge, he believes, is not reducing the number of branches, but “reshaping and remodelling while retaining good customer service”.
Blessley at NatWest has a clear vision for the branch of the future: “There will be less need for the old mausoleums and a move towards bright colours, sofas, TV for the kids, coffee,” he says.
So what is the key to successful retail banking in the next decade? O’Leary of Chase thinks he knows the answer to think laterally. “You must think outside the nine dots, think differently,” he says. “Anyone who thinks traditionally in this business is going to be food for the sharks.”
