Retail Banking Growth Challenges and Creative Solutions

1. February 2019 Mindy Hauptman, Laurent Desmangles, Micah Jindal, and Julie Klein Retail Banking Growth: Challenges and Creative Solutions White Paper

2. 2 Retail Banking Growth: Challenges and Creative Solutions Throughout the retail banking industry, executives are turning their attention to revenue growth. However, we see numerous obstacles to growth that will make it difficult both to acquire customers and to deepen existing relationships. These obstacles include stagnant population growth, intensifying competition, and changing consumer preferences. To address these challenges, leading banks are making use of four primary levers: •• Using advanced data analytic capabilities to create a digital flywheel that optimizes revenue from those customers that seek a deep relationship •• Revamping the product set to expand the revenue per customer •• Exploring options to improve the profitability of transaction accounts •• Engaging in monoline and indirect businesses to penetrate those customers who seek to optimize each product they own. Banks not actively on this journey should embark on a growth program now. They should identify their most critical growth levers, and mobilize a “lighthouse” initiative around a tangible, near-term business goal and a multifunctional team. 2019 could be a pivotal year; now is the time to explore options, set ambitious targets, and rally the organization to strengthen its growth capabilities. Recent trends A decade since the financial crisis, the retail profitability of banks in the United States has at last returned to pre-crisis levels. After years of focus on cost efficiency, bank executives are shifting their attention to revenue in their efforts to create further earnings growth. With three years of positive revenue growth under their belts, they are now cautiously optimistic about their prospects. (See Exhibit 1). Source: Earning Releases, BCG Analysis. Exhibit 1 | Retail bank revenue growth in the United States

3. Boston Consulting Group 3 It needs to be noted, however, that recent revenue growth has in part been the result of improving interest mar- gins. The performance of other revenue drivers has been mediocre. Deposit volume has been a relative bright spot, growing at around 3% year on year for both national banks and regional banks. However, loan volume grew by less than 2% despite favorable economic conditions, while fee revenue declined, as consumers have become increasingly resistant to fees and more astute about ways to avoid them. (See Exhibit 2). Analysts expect net interest margin expansion to slow as a result of rising deposit costs in 2019 and 2020, highlighting the need for banks to improve the underlying dynamics of growth. Looking forward, we see numerous obstacles to growth that will make it difficult both to acquire customers and to deepen existing relationships. These factors, discussed in detail below, include stagnant population growth, intensifying competition, and changing consumer preferences. On the other hand, we believe there are inven- tive solutions for spurring additional demand, as well as for capitalizing more effectively on existing demand. Source: Quarterly earnings releases, financial supplements, 10Qs, BCG analysis. Exhibit 2 | Revenue growth drivers Year Over Year Change Q.3 2017 – Q.3 2018 Nationals Regionals Deposits 3.6% 2.7% Loans 1.4% 1.7% Overdraft, Maintenance, ATM fees as a percent of deposits -2 bps -1 bps Net interest margin 3 bps 10 bps

4. 4 Retail Banking Growth: Challenges and Creative Solutions Challenges to growth 1. Stagnant population growth Throughout the industry, executives are focusing on generating new primary relationships. However, this is un- likely to be a winning strategy for all banks. The number of new households is projected to grow by less than 1% per year through 2025, as millennial and Generation Z households replace Silent Generation and baby boomer households. With such limited population growth, it is difficult to believe that all banks will be able to meet their growth targets through household acquisition alone. (See Exhibit 3). Despite the importance of online banking, customers still cite a lack of physical presence as one of the principal reasons for leaving their bank.1 Such attitudes create a significant advantage to those banks with a larger footprint or to those whose footprints will experience higher population growth. Consequently, regional banks con- centrated in the Northeast and Upper Midwest of the United States, where population growth is expected to lag behind that in the rest of the country, will be particularly vulnerable.2 2. National and non-traditional competition Although revenue grew faster for regional banks than for their national counterparts, the latter are taking advantage of their size and strength to build powerful brands and thrive in an omnichannel environment. The sheer scale of their marketing expenditure makes them the dominant voice in the industry, while their investment in technology is giving rise to high-quality digital experiences that have set the industry bar, even outperforming online-only banks in user ratings.3 Source: BCG interviews with U.S. retail banks, September 2018, BCG analysis Exhibit 3 | Household growth in the United States

5. Boston Consulting Group 5 Consequently, national banks are growing their customer bases more successfully than regional banks. While only accounting for 19% of all bank branches in the country, national banks have been responsible for a third of new relationships in the past year.4 In contrast, the median net household attrition rate for regional banks exceeded the median household acquisition rate by 1.15%. 5 National banks are reshaping the traditional “S” curve, in which banks that have a dense branch network in a market generally attract more than their fair share of deposits. Nationals are succeeding even in those markets where they have a lower concentration of branches, winning a greater share of deposit volume with only mod- est bricks-and-mortar investment. (See Exhibit 4). Incumbent banks are also facing competition for millennial and Generation Z business from challenger banks. These challenger banks have designed customer experiences to cater to the particular preferences of this demographic. They are still small, with the most established challenger banks serving only approximately two million customers, and their ability to generate profits and service customers beyond transactional needs is as yet un- proven. However, they are growing quickly. For example, Chime is enjoying a steady growth of around 150,000 customers per month.6 Moreover, non-traditional players combine low or even zero fees with seamless customer experiences that ap- peal to millennials with low balances and relatively simple financial lives. This reality has placed pressure on traditional banks to offer a similar value proposition, despite the less favorable economics. Finn by Chase and Greenhouse by Wells Fargo are most directly replicating this model, with the offer of no-fee, no-overdraft, mobile-only accounts with integrated personal financial management (PFM) software capabilities. Several regional banks, including Fifth Third and KeyBank, offer similar no-fee accounts with branch access, and almost all offer either a low-fee checkless checking account or a general-purpose reloadable prepaid card. Source: SNL data, BCG Analysis. Exhibit 4 | Branch and deposit shares of national and regional banks

6. 6 Retail Banking Growth: Challenges and Creative Solutions 3. Reduced customer demand and changing relationships Banks are also finding it tougher to deepen existing relationships. The convenience of electronic money move- ment encourages consumers to break up their holdings, selecting the best provider for each product rather than maintain all holdings at a single institution. Furthermore, large segments of the customer base don’t qualify for higher-value products, limiting the potential for add-on sales. For example, 19% of American adults (and 24% of millennials) lack a credit file that can be scored; 30% of those with a file have a FICO score below 650; and 46% of Americans don’t have $400 in savings.7 With income and wealth inequality widening, the proportion of customers owning high-value products has not returned to pre-crisis levels. Only transaction accounts, which are frequently treated as a loss leader, and educa- tional loans, from which most banks withdrew when the government ended guaranteed loan subsidies to private lenders, have seen substantial increases in ownership levels. (See Exhibit 5). It is particularly difficult to deepen relationships with millennials, whose delay in reaching life milestones and student debt burden have restricted product demand and balances in comparison to prior generations. It is un- clear whether these trends will continue, or whether millennials will become more similar to their predecessors as they age. There is also evidence that having a more extensive relationship with a bank is less important to consumers than it once was, and that more consumers are behaving as “product optimizers.” In respect to both invest- ments and loans, Federal Reserve research indicates that the percentage of respondents indicating that they shopped “a great deal” has been steadily increasing.8 Furthermore, monoline and/or indirect providers are gaining market share in virtually every product category. Non-banks’ share of mortgage originations has increased steadily, reaching 64% in mid-2018.9 Captives, dealers, and finance companies financed 47% of auto loans and leases in the second quarter of 2018, whereas banks financed only 32%, down from 35% in 2016.10 The top ten credit card issuers, which operate largely as mono- lines, account for 89% of outstanding balances.11 Fintech lenders account for a third of personal loans, up from Source: Federal Reserve Survey of Consumer Finanaces. Exhibit 5 | Ownership of high-value products

7. Boston Consulting Group 7 less than 1% in 2010.12 The percentage of mutual fund owners who purchased directly from fund providers stands at 36% in 2018, up from 30% in 2014.13 Online-only banks’ share of deposits, consisting largely of stand- alone savings accounts, now exceeds 20%.14 Creative solutions to the growth challenge Despite these challenging conditions, some banks are outperforming growth expectations. The growth of national banks has been highly correlated with overall market growth. However, the relationship between market and bank growth is far weaker for regional banks. Several have delivered deposit growth that exceeds both expectations and their national counterparts, emphasizing that strategy and tactics do matter. (See Exhibit 6). We believe that the following strategies can accelerate bank growth: •• Using advanced data analytic capabilities to create a digital flywheel that optimizes revenue from those customers that seek a deep relationship •• Revamping the product set to expand the revenue per customer •• Exploring options to improve the profitability of transaction accounts •• Engaging in monoline and indirect businesses to penetrate those customers who seek to optimize each product they own. These strategies are not mutually exclusive, and can be executed in combination to boost their effectiveness. Exhibit 6 | Market growth vs individual bank growth

8. 8 Retail Banking Growth: Challenges and Creative Solutions A. The digital growth flywheel The digital growth flywheel (See Exhibit 7) is a virtuous cycle that makes use of advanced data and analytics to: •• Segment the available market in a more insightful way, understanding where there are pockets of customers with unmet needs, resulting in greater acquisition of primary customers. •• Analyze transaction and third-party data to deepen these relationships more effectively, leading to higher profitability per household customer. •• Facilitate earlier detection and management of silent attrition, resulting in increased balance retention. •• Reinvest the resulting incremental profits to improve targeted acquisition and analytic capabilities. We have seen dramatic performance improvements in organizations that have deployed these methods – as much as a 20% boost in acquisition rates, a 5% to 10% increase in revenues from deepening relationships, and a 10% decrease in revenue attrition. At the core of these efforts is more personalization. Through personalization, banks engage with customers as individuals, not just as members of a segment, in order to deliver the right experience, at the right time, through the right channel. Customers experience a tailored set of interactions which demonstrate that their bank understands their needs, in turn building trust and engagement. Consumers are accustomed to such experiences in other industries and are open to similar experiences with their banks. In a recent BCG survey, the majority of respondents said they either wanted their bank to be more like Amazon.com or more like a personal shopper, indicating a willingness to receive relevant, automated feedback and advice about managing their financial lives. (See Exhibit 8). Exhibit 7 | The Digital Growth Flywheel

9. Boston Consulting Group 9 Effective personalization comprises three core elements: •• Customer DNA: a full picture of the customer’s habits, preferences, channel behaviors, transactions, balances, credit score, and propensities, culled from internal systems and third-party sources •• Personalized offering: individualized ”curricula,” experiences with offers and communications in the right sequence, to incentivize specific behaviors desired from the customer •• Recursive learning: a real-time, always-on, feedback loop that retains what has been learned about the customer and others like him. Many bank use cases are similar to those in other industries. The most obvious parallel is the potential to infer customers’ needs and preferences, and deliver timely offers to meet them. Banks can also make use of personalization to improve customer and balance retention. Predicting attrition has often proven to be challenging because models usually only detect those likely to leave the bank when it is already too late to act. However, ma- chine-learning techniques can identify subtle indicators of intended departure far earlier. In banking, the opportunities for personalization go beyond offer-related use cases. Personalization allows dif- ferentiation of the value proposition itself, helping consumers to improve their financial wellness through the use of nudges, low-cost coaching and financial planning-lite. This customer-centric approach is a powerful tool for building trust and overcoming the customer perception that the bank is selling to them too aggressively. While these techniques rest on sophisticated technology, it is wrong to conclude that they are purely digital ap- proaches. Human interaction continues to be more effective for complex sales, service recovery, and financial coaching. Best practice for such interaction demands an omnichannel approach. To be truly effective, staff must be properly trained, personalized information must be delivered to front-end systems, and management processes need to be revised. Exhibit 8 | What customers want from their bank

10. 10 Retail Banking Growth: Challenges and Creative Solutions B. Revamped product sets With the total population expected to remain relatively stable, banks need to look at how additional products or expanded eligibility for existing products can enhance revenue per customer. While household penetration by banks is nearly universal, 19% of households that have a bank account also use an alternative financial provider for transactional or credit services. Contrary to conventional wisdom, many of these households are solid- ly middle class, including more than 20% of households with an annual income between US$50,000 and US$75,000, and, perhaps more importantly, 39% of Generation Z and 33% of millennials. 15 These consumers generate substantial revenue outside the traditional banking system. Estimates for this revenue are as high as $173 billion annually, 84% of which emanates from credit products.16 In the past, credit risk and potential regulatory and reputational risks have discouraged banks from lending to these customers. How- ever, advances in alternative underwriting techniques, the upcoming inclusion of deposit account, rent and util- ity payment data in credit scoring, and a softening regulatory stance toward small-dollar credit are improving the risk environment and making the pursuit of these revenue streams a more attractive proposition. In the fall of 2018, US Bank became the first large bank to re-enter the small-dollar credit space with its Simple Loan product. Various fintechs, such as Petal and Deserve, are analyzing cash flow and bank transaction patterns to underwrite credit cards for consumers who would not qualify based on their credit scores alone. There are also potential opportunities for new product concepts which can meet the needs of important customer segments. While it may be too soon to completely understand the financial needs of Generation Z, it is clear that millennials face some unique financial challenges. For example, they tend to have high levels of student debt, leading to debt-to-income ratios (DTIs) that don’t comply with qualified mortgage rules. They also participate widely in the gig economy, causing income volatility that defies traditional budgeting guidelines. They receive fewer direct deposits from employers, a key driver of customer stickiness and often a route to free transaction accounts. Meanwhile, their credit files are often thin, rendering them ineligible for traditional lending products. These challenges faced by millennials open the door to new product concepts. For example, several lenders provide student loan refinancing, and Fifth Third’s Momentum app rounds up debit card purchases and applies the difference to customers’ student loan balances. Some are addressing income volatility with smart automatic transfers that are triggered by cash flow patterns rather than by static rules; or by issuing credit cards or loans that allow for several penalty-free skipped payments each year; or by providing direct deposit customers with early access to wages that are earned but have not yet been paid. Other lenders are helping customers to build their credit files without incurring undue risk through secured credit cards or other credit-building loans. While a few banks have taken steps in this direction, fintechs are responsible for much of this innovation. Mu- tually beneficial partnership opportunities may arise, with fintechs seeking to accelerate growth by accessing banks’ established customer bases.

11. Boston Consulting Group 11 C. Improved transaction account profitability In an environment where there are likely to be more single-service transaction account customers, it will be even more important to find ways to make them profitable. Transaction account functionality has increased ex- ponentially as new, mostly digital, services have been introduced. Early entrants have generally launched valu- able functionality for free, hoping to gain competitive advantage through acquisition or to reduce operating costs. However, time and again, the functionality has been swiftly copied, eliminating the acquisition benefit and creating new table stakes for participants. At the same time, expected cost savings have often been slow to materialize, as the operations supporting past ways of doing business have not been dismantled. Because consumers have come to expect these services for free, it would likely be impossible to begin charging for them without unleashing a backlash. However, there may be potential to generate revenue for new services using a “freemium” pricing model. Under freemium pricing, a basic level of service is provided for free, while additional, or premium, features are then offered for a fee. These fees are often thought to be a fair exchange of value, and so do not raise the same objections as fees that are perceived to be a penalty. Freemium pricing for transaction services does already exist to some extent today. Some banks offer immediate funds availability on check deposits for a small fee. Others provide standard online bill payment for free, but charge for same-day bill payment. This concept could potentially be extended to other services, such as for early access to regularly scheduled direct deposits; or for permission to exceed standard limits for mobile deposits, ATM withdrawals and other transactions; or for the occasional check payment made on checkless checking accounts. D. Monoline and indirect businesses Banks have built monoline businesses for years, most notably in credit cards and mortgages. More recently, banks such as Citizens and MUFG Union Bank have launched national online savings businesses. Similar opportunities may exist for other products. For example, fintechs have demonstrated that student loan refinancing can be a viable stand-alone business. Incumbents such as Citizens Bank and Wells Fargo have similar lines of business, while Fifth Third has partnered with Common Bond to provide these services. Even if these young borrowers do not develop full banking relationships, the lending business can be attractive in itself. While banks may be able sell products that are merely good enough in the eyes of relationship customers, monoline players must excel in those aspects that are most important to product optimizers, whether this be interest rate, rewards, speed, or other elements of the user experience. Given this high bar and the cost of marketing beyond the customer base, banks must be selective, focusing where they can build a genuinely competitive and profitable stand-alone offering. Many of the same growth-related benefits may be realized, with fewer marketing-related hurdles along the way, by engaging in indirect businesses. Indirect auto finance and retail credit card businesses are long established, but emerging consumer preferences are creating new opportunities. For example, Citizens Bank, Regions Bank, and Fifth Third provide point-of-sale financing for products ranging from iPhones to home improvement to bi- cycles, working directly with retailers or through partners such as the fintech GreenSky. While these arrange- ments offer little opportunity for forging direct relationships with borrowers, it is a way to capture the lending balances of consumers who prefer immediate approval and funding, and installment payment terms.

12. 12 Retail Banking Growth: Challenges and Creative Solutions Conclusion: Getting started The challenges to sustaining growth are real, but executives should be encouraged to know that there are numerous constructive paths to pursue. (See Exhibit 9). Some will already be confident about which levers offer the most potential for their organization; others will choose to perform a diagnostic to identify the most effective levers. We have also seen organizations succeed with “growth hacking sprints,” which target numerous opportunities in a single market, culminating in a playbook for a full footprint rollout. Regardless of the approach, it is critical to create momentum by setting an ambitious goal (such as onboarding x million new customers over the next year, or reducing attrition by y basis points), and by mobilizing a cross-functional team to achieve the goal. One approach is to assemble a high-functioning multidisciplinary team around a “lighthouse initiative” - one that has substantial impact, senior leadership buy-in, and a high level of visibility, and which addresses key gaps across the organization. While many of the trends discussed in this paper will persist well into the future, 2019 could be a pivotal year. The past ten-year run of improving retail ROA is very mature, and macro-economic headwinds are coming into view. It will be imperative for retail banks to begin taking active steps to assess and shore up their revenue- generating capabilities. Mindy Hauptman Laurent Desmangles Micah Jindal Julie Klein Exhibit 9 | Paths to pursue

13. Boston Consulting Group 13 References 1 2018 BCG Retail Banking Excellence Consumer Survey 2 Weldon Cooper Center for Public Service, Demographic Research Group 3 2017 Magnify Money Mobile App Ratings for Bank of America, Capital One, Chase, Citibank and Wells Fargo averaged 4.34, compared to 4.12 for Discover, First Internet, Bank of the Internet, Simple, Aspiration, Nationwide, Moven, State Farm, and Ally, and 3.72 for BBT, PNC, TD Bank, US Bank and SunTrust 4 BCG Retail Banking Excellence Consumer Survey 5 BCG Retail Banking Excellence Benchmarking 6 American Banker, October 10, 2018, “Chime Grows to 1.7 Million Customers, Acquires Credit Scoring App Pinch”, www.american- banker.com/news/chime-grows-to-17m-customers-acquires-credit-scoring-app-pinch 7 The Consumer Financial Protection Bureau Office of Research, May 2015, “Data Point: Credit Invisibles”, https://files.consumerfi- nance.gov/f/201505_cfpb_data-point-credit-invisibles.pdf; Fair Isaac Corporation, FICO Blog, September 24, 2018, “Average U.S. FICO Score Hits New High”, https://www.fico.com/blogs/risk-compliance/average-u-s-fico-score-hits-new-high/; Federal Reserve Board, May 2018, “Report on the Economic Well-Being of U.S. Households,” https://www.federalreserve.gov/newsevents/pressreleases/oth- er20180522a.htm; BCG analysis 8 Federal Reserve Board, 2016 Survey of Consumer Finances, Estimates Inflations Adjusted to 2016 dollars, https://www.federalreserve. gov/econres/scfindex.htm 9 Housing Finance Policy Institute Chartbook 10 Experian Automotive Finance Trends 11 Value Penguin analysis of SEC filings 12 SEC filings, https://www.valuepenguin.com/largest-credit-card-issuers#outstanding-loans 13 Investment Company Institute Fact Book 14 SNL 15 FDIC 2017 national survey of unbanked and underbanked households 16 Center for Financial Services Innovation, 2017 Underserved Market Sizing Report

14. 14 Retail Banking Growth: Challenges and Creative Solutions About the Authors Mindy Hauptman is an associate director in BCG’s Philadelphia office and focuses on retail bank growth and value propositions. You may contact her by e-mail at: hauptman.mindy@bcg.com Laurent Desmangles is a senior partner and managing director in BCG’s New York office, and leads the firm’s retail banking practice in North America. You may contact him by e-mail at: desmangles.laurent@bcg.com. Micah Jindal is a partner and managing director in BCG’s Los Angeles office. He is a core member of the Financial Institutions Practice area, with a specific focus on retail banking and mortgages. You may contact him at jindal.micah@bcg.com. Julie Klein is a principal in BCG’s San Francisco office focused primarily on financial services. You may contact her by email at: Klein.julie@bcg.com.

15. Boston Consulting Group 15 Endnotes 1 2018 BCG Retail Banking Excellence Consumer Survey 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Weldon Cooper Center for Public Service, Demographic Research Group Boston Consulting Group (BCG) is a global management consulting firm and the world’s leading advisor on business strategy. We partner with clients from the private, public, and not- for- profit sectors in all regions to identify their highest-value opportunities, address their most critical challenges, and transform their enterprises. Our customized approach combines deep insight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable competitive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with offices in more than 90 cities in 50 countries. For more information, please visit bcg.com.