We offer our thoughts on the pressures and trends affecting the financial services industry, and how retail financial service organizations can drive value and compete in their shifting business environment.

As we all know, growth is hard to find, revenue is under intense pressure, and the cost of doing business continues to increase. Four forces are shaping this reality: the economic climate, with high levels of unemployment, low interest rates, and a feeble housing market; consumers, who are borrowing less; regulators, who are both curbing fee-based income and increasing the cost of compliance; and technology, which is enabling nontraditional, low-priced competitors in areas such as payments.

Since the financial crisis, many in the industry have assumed or just hoped that these revenue challenges would be a cyclical phenomenon. But there is a creeping realization that this is not the case. It’s our belief that a structural, secular shift is under way; the industry is transitioning from a high-margin business to a lower-margin one.

As significant as these secular shifts are for profitability, they are not the only forces reshaping the retail banking environment. Over the next five years, we expect that two megatrends will force retail financial institutions to rethink their operating models: digitization, which is de-integrating the front- to back-office value chain; and consumer expectations, which are relentlessly rising. Banks will need to invest in these technology advances — specifically, cloud computing, analytics, broadband, and social tools — to meet customer expectations, which are increasing as innovative nonbanks step into the space and solve common, long-standing customer “pain points.”

To navigate this difficult environment and position themselves for future growth, leaders of retail financial institutions need to answer five critical questions:

1. How are we going to compete in this new customer demand–driven environment?
With limited avenues for growth, the banking sector will be hypercompetitive for the next three to four years. In this environment, it’s critical for each bank to be very clear on how it will compete and win in the market. We believe that the winners will retain their profitable customers and capture a bigger share of their wallets. Adroitly targeting specific customer segments, creating products that go beyond deposit and checking accounts, and delivering those products through highly competitive (physical and virtual) sales forces will be competitive necessities.

As the banking value chain rapidly digitizes, banks will need to raise their game in technology and partnering to differentiate themselves. Specifically, banks need to significantly improve the user interface/customer experience by leveraging analytics in the front office and partnering with retail and technology firms to personalize offers, market to customers, and build loyalty.

2. What capabilities do we have to build?
Banks have traditionally focused on financial management, human capital management, risk management, operations, IT infrastructure, and acquisition and integration capabilities to differentiate and win in the market. The financial crisis and the current competitive environment are quickly making these capabilities table stakes. For a sustainable “right to win,” banks must pursue differentiating capabilities.

Investing in certain capabilities will allow retail financial services companies to address four common customer pain points that have dogged the industry for years: Dealing with a bank is complicated and time-consuming; the customer receives impersonal treatment and little recognition; the customer is not in control or empowered to make decisions; and the customer gets no help engaging with friends and family on financial matters. By providing better solutions, banks can improve their ability to demonstrate value to consumers, which is essential for increasing pricing power and acceptance.

Four capabilities that banks can develop to address these pain points and outperform competitors are seamless multichannel experience (deliver an end-to-end customer experience); analytics-driven decision making (drive fact-based decision making and anticipate customer needs using deep insights from customer data); customer-focused value proposition (deliver highly tailored product and service offerings that include standardized and individualized solutions); and internal and external collaboration (work across organizational boundaries to deliver enhanced customer experience).

3. How fast can we and should we drive out costs?
Those who believe that the industry’s current challenges are cyclical will drive out some costs while maintaining the same operating model. On the other hand, for those who believe, as we do, that a secular shift is under way, a more aggressive approach is necessary. Investing in the new capabilities will be expensive, and funding will need to come from wringing costs out of the operation. Banks will have to continuously focus on expense control — on how work gets done as well as what work to do — using lean and technology-enabled process redesign to build more flexible, responsive operating models.

In the process, banks should take advantage of emerging technologies to drive out complexity and improve the customer experience while also reducing costs — recognizing that these seemingly divergent objectives can now be simultaneously achieved. Structural adjustments to the operating model will be required to capture scale and bring variability to cost structures through consolidation and outsourcing. A more granular assessment of costly multichannel distribution networks will reveal where expense is not creating value. In addition, banks have to become nimbler and reduce bureaucracy in decision making by optimizing their organization structure through a reexamination of roles, spans of control, and management layers.

4. How can we get short-term revenue?
Given the challenging revenue climate, most banks are tempted to raise fees on customers to compensate for the shortfall. But imposing new or higher fees without extreme care is a recipe for trouble. First, and perhaps most obviously, higher fees risk alienating customers. The industry’s attempt to raise debit card fees offers indisputable proof of this danger. The outcry was intense, from consumers and politicians.

The inclination to raise fees can also reveal a narrow, transactional view of the interaction that too often fails to take into account the value to consumers. Additionally, it overlooks existing and emerging ways banks can — and will need to — make money in coming years. Banks often provide skills and information to customers, particularly in commercial and small business sectors, as bundled add-ons or even as loss leaders. Yet some of these can be “unbundled” in a way that provides value to customers and more effectively monetizes the bank’s existing capabilities.

For example, banks could aggregate information for the marketing and sales efforts of middle-market and small businesses; leverage deep financial and operational risk management expertise for middle-market and small businesses; offer white-label analytics for other financial institutions and business-to-consumer companies; or perform white-label outsourcing and transaction processing services.

Banks need to evaluate these ways to create new revenue streams by leveraging their existing information, expertise, and distribution capabilities and assets. Companies ranging from Amazon to American Express to GE to UPS have converted capabilities originally built to drive core businesses into new revenue sources. In these times, every bank should be doing the same.

5. How do we sustain the change?
Long-term success is achievable only if the changes adopted by the organization endure. Our experience shows that there are four pillars to sustainable transformation: senior direction and sponsorship, with a focus on augmenting capabilities in concert with cutting costs; ongoing performance management, including a shift in efficiency philosophy toward one that emphasizes continuous improvement; redesign of core processes via strategy planning and investment prioritization to address sustainability requirements and track progress; and leadership behavior to ensure that leaders set the right example and close skill and competency gaps.

Tackling these five critical questions won’t be easy. But we believe that banks that make the effort will more clearly see how to cut costs and where to invest for growth, positioning themselves to outperform in the years ahead.

We hope you find these thoughts helpful as you consider your strategy for 2012, and we would be happy to discuss our perspectives with you in further detail.

download Financial Services - Retail Banking Industry Perspectives for 2012 (97kb, PDF) >