RETAIL BANKING Americas DIGEST

Volume III – Summer 2013 RETAIL BANKING Americas DIGEST

IN THIS ISSUE

1. small business baNking Challenging Conventional Wisdom to Achieve Outsize Growth and Profitability 2. Financing Small Businesses How “New-Form Lending” Will Reshape Banks’ Small Business Strategies 3. Enhanced Performance Management Driving Breakthrough Productivity in Retail Banking Operations 4. Innovation in Mortgage Operations Building a Scalable Model 5. Chase Merchant Services How Will it Disrupt the Card Payments Balance of Power? 6. The Future “Ar Nu” What We Can Learn from Sweden About the Future of Retail Distribution foreword

Banking is highly regulated, intensely competitive and provides products that, while omnipresent in consumers’ lives, are neither top-of-mind nor enticing to change. These factors drive the role and form of innovation the industry can capitalize on. In traditional business history – the realm of auto manufacturers, microchip makers, logistics companies and retailers – the literature rightly hails disruptive, game-changing innovation as the engine behind outsized profits for the first movers. In banking, such innovation is very rare.

Disruptive innovations of the magnitude of the smartphone or social networking grab headlines, but are hard to leverage in the banking industry. There are simply too many restrictions on what banks can do, and too much consumer path dependency, to place all the shareholders’ chips on disruptive innovation plays.

Instead, successful banks develop and execute strategies around less “flashy”, dare we say, small-scale innovation that can still reap outsize returns for their shareholders. This issue of the Oliver Wyman Retail and Business Banking Digest takes a closer look at some key innovation opportunities available to banks today, including: •• Paths to success in small business banking through new form lending and other challenges to conventional wisdoms •• Process redesign opportunities triggered by advances in mobile technology, as in mortgage, or through performance management techniques •• Learning from innovation abroad This eclectic list illustrates one of the greatest benefits to small-scale innovation – there is always room for incremental upside. Each effort, executed effectively, will drive additional gains, while affording the flexibility to react to new opportunities. Additionally, such innovation can be a key move in the game of “strategic chess”, such as the recent Chase/Visa partnership announcement (explored in this digest), which their competitors must now respond to.

I hope you find these articles thought provoking.

Michael Zeltkevic On behalf of the Retail and Business Banking Practice Table of contents

1. Small Business Banking 4 Challenging Conventional Wisdom to Achieve Outsize Growth and Profitability The SB segment has long presented a significant opportunity for US banks. However, strategies that meet small business needs, create differentiation and maximize potential economic returns have proven elusive. While many banks have settled back into conventional strategies, challengers to these standards can define a break-out strategy that gains material share from competitors and delivers higher growth and higher profits.

2. Financing Small Businesses 11 How “New-Form Lending” Will Reshape Banks’ Small Business Strategies “New-form lending” is a new approach to small business financing that will satisfy an unmet need for short-term cashflow financing for SBs. New-form lending relies on the analysis and ongoing monitoring of daily cashflows to assess and control risk. This is a major profit opportunity that can also help improve traditional loan underwriting processes by lowering unit costs and improving risk differentiation.

3. enhanced Performance Management 16 Driving Breakthrough Productivity in Retail Banking Operations Years of relentless focus by retail banks on improving the efficiency of the operations function have left few residual opportunities to drive transformational savings without diluting service quality. By developing a new way of measuring employee productivity and compensation, Enhanced Performance Management (EPM) fills this gap by dramatically increasing employee throughput, while simultaneously improving risk, quality and the client experience.

4. innovation in Mortgage Operations 21 Building a Scalable Model The last 20 years have seen a number of innovations in the design of mortgage origination processes. Looking ahead, however, we see three factors converging that will now provide both the opportunity and the forcing mechanism for institutions once more to rethink their approach to mortgage originations, driving fundamental progress in the core operations of the business.

5. cHASe Merchant Services 28 How Will it Disrupt the Card Payments Balance of Power? In the current power play between issuers, networks, and acquirers, JPMorgan Chase has taken a first step towards creating a new 3-party network with Chase Merchant Services. This paper explores how this will impact Chase’s competitors and its customers (merchants and cardholders), as well as the networks themselves.

6. The Future “Ar Nu” 33 What We Can Learn from Sweden About the Future of Retail Distribution With high mobile and internet banking adoption, low branch traffic and heavy use of electronic payments, Sweden and its banks provide invaluable insight into the future of retail banking. This article explores the factors that enabled Swedish banks to accelerate evolution and evaluates what one can learn about the future of US retail distribution and how to enable a smooth transformation. 1. Small Business Banking Challenging Conventional Wisdom to Achieve Outsize Growth and Profitability By Anna Epshteyn Whitney and Tim Spence

Boasting a base of more than 20 MM potential customers1 The sector is also resilient: in the face of recent economic with a broad range of financial services needs, the Small turmoil and uncertainty, 73% of business owners told Business segment has long presented a significant us that their firms were either “very” or “reasonably” opportunity for US banks. Recent Oliver Wyman research profitable, while 75% described them as being in and analysis2 suggest that the SB sector produces $14 BN “established” or “growth” mode. of after-tax profit and $10 BN of after-tax economic profit3, annually – nearly 15% of the total US financial However, strategies that meet small business needs, services economic profit pool. create differentiation and maximize potential economic

Exhibit 1: Small Businesses are heavy users of financial services

PRODUCT USAGE RATE EMPLOYER SMALL BUSINESSES 100%

80%

60%

40%

20%

0% CD Any Any svcs loan loan ACH Wire lease Payroll Money market deposit deposit Savings Remote HY Sav/ Any loan Any card Checking Merchant Mortgage payments Store card Other loan Auto loan/ Equipment Credit card Operational Charge card

Deposits Cards* Loans Payments & Treasury Services

* Card consists of cards used solely for the business; 44% of SBs are also merchants (accept cards) Source: 2011 Oliver Wyman Small Business banking survey

1 ~20% of small businesses in the US have at least one employee in addition to the 3 “Economic profit” is the profit after tax earned by the bank over-and-above the owner. Source: 2007 Census. required rate of return on capital held against the risks of the business; it is worth 2 A 2011 survey of 5,000 small business owners, from which we estimated the noting that today, most of this profit comes from high-balance checking accounts profit to banks from these businesses’ product and service usage. and high-volume merchant services accounts – and not from small business loans.

Copyright © 2013 Oliver Wyman 4 returns have proven elusive. Following the financial Exhibit 2: Profit contribution of small business crisis disruption, the market has largely settled back into customers ranked by relationship profit competitive equilibrium, with many banks – and their CONTRIBUTION TO TOTAL SB PROFIT advisors – allowing a set of conventional wisdoms to constrain their thinking as they craft their strategies. A 73% bank willing to challenge these conventional wisdoms, Oliver Wyman believes, can define a break-out strategy that gains material share from competitors and delivers higher growth and higher profits. 21% 11% What are the conventional wisdoms restricting banks’ 6% 3% 1% strategic thinking? We see five: -2% 1. SEGMENTATION: “The size of the business is the -13% best indicator of needs, profit potential, and sales and service approach” Top 10%

2. RELATIONSHIP COVERAGE: “Assigning percentile percentile percentile percentile percentile percentile percentile percentile th th th th th th th th Bottom 10%

relationship managers is an effective means to 80 70 60 50 40 30 20 10 attract new businesses, deepen relationships and decrease attrition” Source: 2011 Oliver Wyman Small Business banking survey 3. CHECKING: “Offering ‘free checking’ is a table- stakes competitive requirement” Oliver Wyman research validates the notion that larger 4. SMALL BUSINESS LENDING: “Credit process streamlining is the key to improving profitability and businesses are more likely to be profitable. However, expanding SB lending” it also reveals two interesting findings that averages disguise. Firstly, 20% of businesses (the high value 5. NEW REVENUES: “Expanding into new service areas group) generate 95% of total segment profit. More is the best path to increasing fee revenue” surprisingly, more than half of the high value group have annual revenues less than $1 MM. Oliver Wyman research and analysis suggest that some of these conventional wisdoms are wrong, and others only half-right. Worse, they disguise powerful Exhibit 3: Annual revenues of the most new insights that banks can leverage to upgrade profitable small business relationships performance substantially. Let us examine them TOP 20% OF ALL SMALL BUSINESSES one-by-one. BY PROFIT CONTRIBUTION $5-10 MM <$249 K 14% 6% $250-500 K 1. Segmentation: is revenue 7% size all we need? $500 K- Conventional wisdom places a great deal of weight on $1 MM 14% business size. For example, most banks use it to dictate how they organize, what prospects they target, and what products and delivery models they employ. Businesses that are larger, the rationale follows, will carry higher $2-5 MM $1-2 MM 30% 29% deposit balances, have greater credit appetites, and need more complex payments solutions, thus making Note: Payroll businesses only them more profitable relationships. Source: 2011 Oliver Wyman Small Business banking survey

Copyright © 2013 Oliver Wyman 5 These small, but high-value customers – who “fly under the Oliver Wyman research and analysis suggest the current radar” of purely revenue‑based segmentation – present a model is not delivering. As illustrated below, while significant untapped opportunity. Banks that embrace a businesses with RMs have slightly deeper relationships, profit‑centric view and develop the supporting analytics the added breadth does not compensate the bank for could re-focus their new customer acquisition efforts to the significant added expense. Further, customers with target only the most profitable prospects. And, because RMs exhibit higher, not lower attrition rates. the average profitability of the high-value group is 3‑4 times the market average, these banks could spend much There are several factors that may contribute to these more on the sales process and account-opening offers to unexpected outcomes: entice the high-value group to switch. Similarly, the profit- •• First, many banks expect branch management to centric view could be employed to re-focus cross‑selling provide SB relationship management, but it receives and relationship retention efforts (fee waivers, priority low priority in the context of other responsibilities service) within the existing customer base. •• Second, some RMs do not develop much of a relationship with business owners: in our survey roughly one in five SBs with an assigned RM could 2. Relationship coverage: not remember the RM’s name How does it add value? •• Third, we have found that even successful dedicated SB bankers can lower the retention rate for SBs, Conventional wisdom dictates that banks should assign in this case due to their own turnover. SB bankers dedicated relationship managers to increase growth change jobs more frequently than the “natural” rate and profitability of their small business customer of SB attrition, and, in doing so, these bankers take base. Most banks deploy dedicated SB bankers or their best relationships with them. Hence, high RM specially‑trained branch managers in high‑opportunity turnover actually accelerates SB attrition trade areas in an attempt to achieve these gains, asking •• Finally, RMs are expensive; with a typical “loading” them to manage a “book” of 75‑150 relationships. of 100 businesses, each RM will probably have only The logic is that these individuals can build industry two or three hours a year of client “face-time” but and local‑market expertise and provide the superior must add at least $1,000 of pre-tax contribution per service necessary to attract, deepen and extend small business just to cover his/her fully-loaded cost business relationships.

Exhibit 4: behavior and profitability of sbs with and without rm coverage

CUSTOMERS WITH RMS MAINTAIN SLIGHTLY DEEPER RELATIONSHIPS… …BUT ARE LESS PROFITABLE… …AND ARE MORE LIKELY TO SWITCH

1.9 7.3% $1,670 $1,450 1.6

3.7%

Has a RM

Doesn’t have a RM Products with primary bank Average post-tax economic profit* SBS switching primary banks

* Payroll businesses only Source: 2011 Oliver Wyman Small Business banking survey

100%

80%

60%

40%

20% Do not know first name

0% Know first name Under 250 K 250 K-499 K 500 K-999 K 1 MM-1.9 MM 2 MM-10 MM

* Payroll businesses only Source: 2011 Oliver Wyman Small Business banking survey

To improve the returns from relationship management way to “easily free”4 for many institutions, the working assignments, banks could: assumption remains unchanged: attract the relationship •• Assign local RMs to high-profit accounts or prospects with no monthly maintenance fee and generate revenue only; measure and compensate RM performance through upselling, cross-selling and/or item fees for based on the incremental value they create activity in excess of the included transactions and/or •• Redesign RM job responsibilities to focus on skills cash deposits. and activities that make a material difference to clients, eliminating fulfillment-related activities that Our recent research and analysis suggest banks should could be handled less expensively and with lower not compete on price, regardless of what competitors opportunity cost in the back office; increase account choose to do. The connection between market share and loading accordingly revenue production is tenuous. As Exhibit 6 shows, the •• Experiment with a team-based or “virtual RM” model majority of small business free checking relationships to serve less valuable or lower‑opportunity small generate minimal revenue and a significant portion of business clients those will be loss-making on a marginal cost basis. •• Invest in building stronger institutional ties with Three factors explain why banks are generating so the business owner, to mitigate the risk that he/she little revenue from such a significant percentage of the would follow the RM to a different bank customer base: 1. In our experience, more than half of SB free checking 3. Small business checking: accounts will contain an average balance less than To fee or not to fee? $5,000, providing limited interest margin

Conventional wisdom holds that if even one bank in a given trade area offers free checking, all banks will be forced to follow suit. Although “totally free” has given 4 “Easily free” connotes accounts whose fees are waived through simple, easy-to- qualify means that the vast majority of small businesses would meet. Examples would include very low minimum balance requirements and waivers for opening one or two additional products where debit card, online statements and/or other no/low revenue options.

SB CUSTOMERS 80% Over 60% of small business checking accounts generate <$25 in revenue 60%

40%

20% Bank 2 example

Bank 1 0% example <1 1-24 25-49 50-99 100-249 250-499 500-999 >1,000 SB REVENUE CONTRIBUTION US$

Source: Oliver Wyman analysis

2. Very few clients generate transaction – or cash versus an account with 100 included transactions, deposit – based incidence fees. For most banks, despite the fact that more than 90% of businesses 90-95% of small business clients will not exceed never exceed the 100 transaction limit the established transaction caps, monthly, 2. Working capital access and protection: Accelerated and less than 5% will order a wire or other fee- funds availability and small stand-by credit lines generating transaction resonate very strongly. In fact, these register as the 3. Despite ongoing efforts, most banks have yet to most powerful motivators of switching and carry crack the code on cross-selling savings accounts, incremental values of $5-15/month. Check payment merchant services, cards and other products that guarantees and fraud protection are also appealing generate real revenue streams 3. Relationship benefits: The presence of relationship Additionally, checking does not need to be free to benefits, whether rewards programs, discounts attract and retain customers. Our research suggests that on loans, savings interest rate bonuses and higher small business owners spend very little time worrying service levels (e.g., 24/7 phone support, dedicated business banker) all are accorded quantifiable about optimizing their financial services costs, and values. Interestingly, business owners appear to that the hassle associated with switching banks greatly consider the presence of these benefits to be more outweighs the potential savings. In fact, more than important than the actual economic value conveyed 80% would stay with their current bank if a $10 fee was imposed on their account. Banks can capitalize on these insights by redesigning their core small business checking offerings, building More importantly, small business owners will pay each product around the preferences of distinct for value where they see it. Having tested dozens of sub-segments and pricing for the value they deliver. potential account attributes, add-ons and service Some may also choose to convert a subset or all of benefits, three areas emerge: their existing free checking portfolios as a means 1. Simplicity and cost certainty: Business owners prefer to generating an immediate revenue lift. While this a single, bundled fee structure over more prevalent approach may result in more modest account acquisition per-transaction pricing models. For example, the and retention rates, it will materially improve the overall average business owner in our research would pay economics of the business and increase the focus on $8/month more to have unlimited transactions, more valuable relationships.

Copyright © 2013 Oliver Wyman 8 4. LOANS: A new process OR Under the traditional credit process, even performing A DIFFERENT NEED? loans originated to address this need would fail to produce an accounting profit. To illustrate the point, Small business owners have long considered access consider a request for a $75,000 one-year term loan. to working capital their most important unmet need. Assuming a 3% interest margin over funding cost, such In fact, in recent Oliver Wyman research, 70-80% of a loan would produce ~$1,225 in revenue over its term. small business owners indicated it to be an important The all-in origination cost per funded loan ranges from consideration in selecting a bank. And yet, while many $900 to $1,800 for most banks, alone, without taking have small business credit cards, auto loans or first into account sales force compensation, credit risk and mortgages, only 15% have an open operational loan or capital consumption costs. Clearly, even a streamlined equipment loan/lease. credit process isn’t a solution. Instead, banks should create an entirely new small Conventional wisdom dictates that if banks make the business working capital loan product category, akin to credit process less painful – whether by streamlining (but not entirely the same as) offerings pioneered over the application process, requesting less information, the past 5‑7 years by firms like Capital Access Network, or making faster decisions – more small businesses OnDeck Capital and Amerimerchant. This new product will respond, increasing origination volumes and, by would be distinct in three ways: extension, profits. 1. Origination: The new loan would be sold to existing Our research and experience suggest otherwise – that customers, primarily via a web‑based interface, most SB owners who value access to credit need using existing data from other bank accounts or something other than a traditional credit line or term- which could be sourced electronically from third loan. Rather, they describe a substantially smaller parties and underwritten primarily on an automated facility designed to address short-term gaps in cash basis, with limited manual intervention flow (in effect, a payables-receivables duration 2. Underwriting: The bank would utilize direct mismatch), generally in the amount of half‑ to observation of real, recent cash-flows from the one‑month’s revenues. business checking or merchant services account to predict future cash flows and, by extension, to determine the ability of a firm to take on credit Exhibit 7: Size of credit line SBs would like to 3. Repayment: Payments would be remitted in small be approved for increments via an automated, daily remittance cycle, as a means of identifying at-risk loans more quickly SBs INTERESTED IN CREDIT WITH ANNUAL REVENUES and smoothing cash flow impact of the new loan on BETWEEN $100 K AND $5 MM the business Over 50 K $5 K and 20% below 21% Oliver Wyman research suggests this new category could produce billions in new outstandings and pre- tax profits. Seeing this potential, American Express and Amazon.com have recently entered the market by making a portion of expected future receipts – Amex $25-50 K $5-10 K card receivables and Amazon Marketplace sales 18% 21% volumes, respectively – available to their merchants in the form of an advance. However, banks should $10-25 K possess an advantage over both, due to insight afforded 20% to them as holders of the primary checking account, thus enabling them to see the full breadth of a small Source: Oliver Wyman Small Business Lending Survey, March 2013 business’s cash flows as opposed to just one slice.

RESPONDENTS FOR SELECT BANKS 100%

80%

60%

40%

20% No

0% Yes Bank 1 Bank 2 Bank 3 Bank 4 Bank 5 Bank 6 Bank 7 Bank 8 Bank 9 Bank 10 <$2 MM $2 MM+

Annual revenue Source: 2011 Oliver Wyman Small Business banking survey

5. new revenues: new •• Product configuration and pricing depress adoption. offerings or new packaging? Banks who exhibit the lowest penetration rates tend merely to have repurposed their Commercial RDC In the face of the declining profitability of core product product structures to SB customers, as opposed to categories, generating new revenue streams has become tailoring specific offerings that reflect their needs a top priority for the banking industry. To this end, and business characteristics some banks have even begun to explore opportunities Payroll, e-invoicing and electronic payments – all of to expand the scope of services they provide to small which provide rich fee income streams – all face similar businesses into other professional services areas, challenges. Targeted marketing campaigns, and including aggregated procurement discounts, marketing refreshed product/pricing plans would help in each services, business transfer services and employee health case, but banks should also develop service packages benefits administration. While one or more of these that incorporate the right mix of these services with may emerge as a new, previously untapped wellspring, the checking account. Our experience suggests more Oliver Wyman research suggests that more immediate than 40% of new customers would opt for a correctly (and much more certain) returns are available via a designed package over a stand-alone checking account, renewed focus on the fee-based payables and receivables without any incremental incentive. services that most banks already offer. * * * * * Remote deposit capture provides a useful case example. Small business remains a big opportunity for US retail It meets a clear need for a significant share of small banks. However, as competition continues to increase businesses – check payments make up 50-70% of for the best relationships within the segment, those who receivables in non-retail sectors – and yet fewer than one abide by conventional wisdom will achieve suboptimal in four SBs make use of it. The issues are two‑fold: returns. Those who challenge it will enjoy outsize growth •• Awareness remains low. A recent survey of small and profitability. business customers at the ten largest banks showed that, depending on the institution, 35-75% of Anna Epshteyn Whitney is a Senior Manager at Oliver Wyman. clients erroneously believed RDC was not offered by Tim Spence is a Partner at Oliver Wyman. their bank

A new approach to small business lending is emerging in cards, car loans or first mortgages, only 15% report US banking. We refer to this new approach as “new-form having an “operating loan” or “an equipment loan or lending”. It is based on a simple but powerful insight: the lease”. That is: small businesses don’t actually have many data in a small business’s checking account can be a strong “small business loans”. real-time indicator of that business’s creditworthiness. Our research also reveals something else that’s curious: We believe that this new approach will rapidly be adopted although only ~15% of SBs have a “small business by all major US banks and become the basis for satisfying loan”, 70-80% of business owners say that “access to what has mostly been an unmet need for short-term credit” is an important consideration to them when cashflow financing for small businesses. Industry-wide, selecting a bank. The majority of these owners seem this could be a $2 BN profit opportunity for lenders. not to want a traditional credit line or term loan. Rather, they describe the need for a line of credit New-form lending will also help improve banks’ traditional that would be available to act as a reserve and buffer loan underwriting processes by lowering unit costs and against occasional short-term cashflow gaps. We have improving risk differentiation. asked respondents to say roughly how large such a line would need to be. In most cases, their answers Finally, new-form lending, by improving the whole translate into an amount equal to between half and one approach to SB lending, will strengthen banks’ overall month’s revenues. For example, businesses with annual value proposition, allowing them to win and retain the revenues of around $500,000 tended to ask for credit most attractive small business relationships. lines of between $20,000 and $40,000. What Research Tells Us About This is consistent with other Oliver Wyman research findings that show how a small business’s average SB Borrowing Needs DDA balance is a reflection of the cashflow and Oliver Wyman research reveals many interesting cashflow volatility that the business experiences. If two characteristics of small businesses and their owners1. businesses have the same monthly average cashflow One particularly important finding relates to small but one experiences more volatility, the second one will business funding: while many say they have SB credit maintain a higher average DDA balance as protection against coming up short when needing, for example, to meet payroll. Dealing with cashflow volatility is a 1 in 2011 Oliver Wyman surveyed ~5,000 SBs including their profitability to perpetual worry for small business owners and in the banks; SBs were defined as “in business at least a year” and “have fewer than 100 employees”; please contact us to obtain a summary. absence of a standby line of credit, they currently resort

Copyright © 2013 Oliver Wyman 11 to various tricks and evasions when faced with a payroll statements, and/or 2-3 years of tax returns. Either to meet or a large bill to pay, and a downtick in receipts. way, these data are essentially out of date by the time Banks have been missing the opportunity to meet this the bank reviews them – and may not have been that need for cashflow volatility protection. accurate to begin with.

The research suggests that most business owners feel a need for a cashflow protection product driven by the New-form Lending to inherent volatility of their businesses’ cashflows. the Rescue? We see a new approach to small business lending Traditional SB Lending emerging in US banking that we refer to as “new- Doesn’t Serve This Need Well form lending”. It is based on the simple but powerful insight that the data describing a business’s cashflows The traditional small business lending model used by can be a strong real-time indicator of that business’s banks does not meet this particular need very well. creditworthiness. One source of data on a small We have known for some years now that banks’ small business’s cashflows can be its merchant services account business loan portfolios are not particularly profitable. (if the business accepts credit cards for payment). The banking industry’s use of economic capital and Another source is the business’s primary checking risk-based measures of return led to the realization that account (whether the business is, or is not, a merchant). small business loan portfolios typically show positive accounting profits but negative economic profits We believe this new approach will rapidly be adopted by “through the cycle”. Further analysis revealed the root all major US banks and become the basis for meeting cause of the profitability problem: the factors that drive the hitherto unmet need for short-term cashflow SB loan economics are unit cost, cost of funds, loan financing described briefly above. It will also provide losses, economic capital, and loan pricing (gross yield). a key underwriting input to banks’ traditional loan Among these, unit cost is undoubtedly the main culprit. underwriting processes and thereby help to lower unit High capital and inadequate loan pricing also contribute. cost and improve risk differentiation (and hence pricing).

Faced with these economics, banks have experimented The idea of examining a small business’s near-real-time over the last 10 or more years with approaches to small cashflows to derive risk insights seems to have originated business lending that are more “consumer-like”. These in the world of merchant receivables financing. Starting semi-automated methods, using credit scores on the 10-15 years ago, firms like Capital Access Network and business or its owner – or both – as key inputs, promised AmeriMerchant emerged to advance funds to card- to reduce those troublesome unit costs but largely did accepting merchants based on an analysis of the patterns not. Why? Partly because banks deployed automated in their monthly charge volumes. Extending that logic, underwriting only for the easy cases (very good and firms like On Deck Capital now use a combination of very bad applicants) and kept the traditional process in merchant-account and/or DDA cashflow patterns to place for applicants in the so-called “grey area”. In the assess a business’s creditworthiness. The wider view end, relatively few loan applications ended up being is rapidly becoming the standard template for “new- decided only via the “automated” path; and so unit costs form lending” and makes this approach work for both didn’t shrink as much as planned. Even the use of credit merchants and non-merchants. scores proved troublesome, in part because the available data on small businesses are simply not as robust and As the merchant receivables financing market evolved, predictive as in the consumer sphere. lenders needed new analytical methods to automate the interpretation of recent cashflow patterns and In fact, data quality has been a perennial problem for make predictions about future receipts. In recent years, banks when it comes to small businesses. The traditional lenders have expanded their models to incorporate underwriting process for small business loans frequently DDA cashflow patterns in addition to – or instead calls for the business owner to provide the bank with of – the merchant account in order to assess a business’s at least two years of audited or unaudited financial creditworthiness. This wider view takes a more complete

Daily loan repayments, fees and interest 3a (for new-form bank loans) BANK

Non-card sales receipts 2a (checks, wires, cash etc.)

PRIMARY BANK (with DDA)

3c 1 Loan advances Deposit the rest of amount after repayment

“NEW FORM LENDER” SMALL BUSINESS

2b Credit, debit and charge card receipts

MERCHANT ACQUIRER/ 3b Daily loan repayments, fees and interest MERCHANT SERVICE BANK (for merchant cash advances)

cashflow picture than merchant receipts alone and almost all other bank lending. The daily remittance cycle more-than-doubles the total market by making financing offers two benefits. First, by monitoring the advances available for both merchants and non-merchants. and payments on a daily cycle, the lender is more on top of things and in a better position to respond to The central premise underpinning this approach is that late payments – as well as to adjust and potentially direct observation of real, recent cashflows provides a increase or decrease the loan or line size. This makes reliable guide to predict future cash flows – at least in the intuitive sense: if a lender is reviewing monthly, weekly near term – and, by extension, to determine the ability of and daily cashflows as a basis from which to infer a firm to take on credit. creditworthiness, i.e., to underwrite a loan, then he would also administer the loan on a daily remittance cycle. A second innovation of new-form lending is the use of a daily remittance cycle to administer the loans. A key early Second, compared with monthly remittance, the use feature of this type of financing was the idea that advances of a daily remittance model helps smooth the cash flow would be repaid directly from the merchant services impact of the new loan for the SB; after all, monthly account. This led to the deployment of daily remittance remittance introduces yet another source of cashflow platforms that could connect directly to a merchant “lumpiness” – and cashflow volatility was the issue services account (or, later, to a DDA account), and process the business owner needed the loan to address in the small loan principal and interest payments on a daily, as first place. opposed to the more traditional monthly, basis. Recognizing the market opportunity, over the last year, In a daily remittance cycle, the borrower accepts a several other lenders have taken innovative steps in this commitment to repay interest and a slice of principal new financing arena. Amex launched American Express in small increments each day over the term of the loan, Merchant Financing, a commercial lending option for rather than the standard monthly remittance cycle of medium-to-large merchants who accept Amex cards

Copyright © 2013 Oliver Wyman 13 that, in effect, provides receivables financing. Amazon As with other types of lending, the ability to generate the also introduced a financing option for merchants who most accurate and reliable models is partly a function sell over its web platform; and Amazon has excellent risk of expertise but also a function of data. Only after analytics that it can deploy against these merchants, accumulating some “bad” outcomes can one develop observing first-hand the ebb and flow of purchase significantly better predictive models. This is a factor that volume and merchant conduct. gives a temporary competitive advantage to the larger, more experienced players in new-form lending. Despite the origins of new-form lending as a merchant financing device, and despite recent innovations that New-form lending can be a profitable new financing extend the device within the merchant space, we believe product that banks can offer their SB customers and that banks, with their extensive small business deposit drive significant improvements in banks’ traditional bases, have a significant information and relationship lending processes and associated economics. It can: advantage in this interesting new arena. Whereas Amex, Amazon and other merchant receivables financing firms Provide business owners with access see only the component of cash flow which flows over to a new kind of short-term credit their platform, the primary checking bank sees essentially they say they want all sales receipts as well as all outgoing payments. Banks, in other words, have a more complete perspective and New-form lending can allow the bank that provides a are not limited to the merchant segment (a little less than business with its primary DDA to pre-approve it for a half of all SBs accept cards). They also already “own” all of standby line of credit suitable for covering episodic and the primary DDA relationships with SBs. short-term cashflow balancing. The amount of such a line or loan could be dynamically adjusted to growth or other changes in the business’s financial status, as Getting Started with continuously revealed through the “pulse” of its DDA cash balances and cashflows. The cost of marketing, New-Form Lending underwriting and administering this new product How can banks interpret their SB customers’ daily category can be a very small fraction of the current costs cashflow data to assess credit-worthiness? Our recent of a traditional line of credit. client experience suggests that various metrics derived Despite the much lower unit costs, banks will need to from 4-6 months of checking account and payments design this product carefully as it will, by its nature, activity prove to be a reliable guide to a firm’s ability generate limited volumes of revolving balances and to handle a given loan amount. What kind of metrics? spreads. For example, if a business with revenues of Things like: daily average balance, balance volatility, $500,000 and a line size of $20,000 took advantage of cashflow volume (in relation to average balance), it every single month for an average of two weeks, then cashflow “lumpiness”, mean and variance of daily it would generate the equivalent of a standing $10,000 receipts, mean and variance of daily outgoing payments, loan. In practice, some businesses might take advantage the “decay rate” of balance after a large deposit, and of the line even less than this. customer mix/revenue concentration. Of course, while these metrics may apply to some degree in any A key part of the product design, therefore, is to get the SB sector, their significance varies according to the fee and rate structures right, with a line commitment fee, specific industry in which the firm operates; the metrics as well as possible draw-down fees, in addition to any that matter most are different for a restaurant than for interest on outstanding balances. Of course, if possible, a manufacturer. the design also needs to avoid a countervailing sense of “nickel-and-diming” the customer.

Copyright © 2013 Oliver Wyman 14 We estimate the US market for this type of standby Where do I get a daily line-of-credit very roughly as follows: remittance platform? Getting started in new-form lending has some practical Potential number of standby lines ~8 MM challenges for banks. One of the biggest is that banks do Potential “equivalent” revolving balances $80-120 BN not have daily remittance loan systems, with relatively 2 Potential additional after-tax profit $1.5-2.5 BN few options for obtaining one. One option would be to create such a system from scratch, but we see few Improve the economics of banks with the appetite for this. Instead, some banks traditional lending have opted to negotiate an arrangement with one of the handful of firms that does have a viable daily remittance The two central principles of new-form lending – the platform. This allows them to get started on the other use of near-real-time, accurate cashflow data, and daily challenges. These arrangements have typically also remittance – can also be used to improve traditional allowed for a way to share SB applicants between the lending procedures. All three of the key cost components bank and the platform provider; since these firms are flagged earlier as problem areas for traditional lending also lenders, the banks often approve and book loans can be improved by adopting (and adapting) these to the higher credit quality applicants while their principles in the way traditional lines & loans are handled. turndowns are re-underwritten by the independent firm. The marketing cost of attracting qualified loan applicants will be significantly reduced through the likely The Broader Impact of mechanism whereby many small business customers will be pre-approved for a “new-form loan” and later New-form Lending “upgraded” when they qualify for a more traditional We have already outlined two important ways in which line that does not need to be “cleaned up” on a monthly new-form lending will improve bank lending to small basis. And from there, successful, growing businesses businesses. But more lending options with better may further qualify for multi-year term loans. economics could turn out to be only part of the overall The cost of underwriting and approval for traditional impact of new-form lending. lines and loans, even when the target SB has not Recent Oliver Wyman research determined that the been a bank customer before, should be significantly majority of Small Business Banking profit currently reduced. Using recent merchant account and/or DDA derives from high-balance checking accounts, merchant data, a bank can generate a more accurate assessment services accounts and credit cards3. The growth of of creditworthiness than it could the old-fashioned new-form lending will certainly add to that profit pool. way, and get to this point much quicker and more The biggest positive impact of new-form lending for cheaply. Of course, the underwriting process will likely an individual bank, however, may not be the profit use additional inputs besides the new-form lending that it adds directly, but the role it can play in crafting emphasis on recent DDA cashflow patterns. But for a winning value proposition that is used to “win over” smaller lines or loans, an adequate assessment of risk high-value prospects in the sales process and protect can be made at low cost, through a combination of new- existing high-value customer relationships against form principles and selected use of traditional credit competitive inroads. scores and tax returns.

The cost of loan administration can also be reduced by Peter Carroll is a Partner at Oliver Wyman. placing traditional lines on a daily remittance basis Ben Hoffman is a Partner at Oliver Wyman. and adopting new-form lending’s more systemic approach to portfolio monitoring and early warning delinquency triggers.

2 This represents an increase in total bank profits from small businesses of 3 See the Oliver Wyman “Point of View” titled “A Profit Growth Strategy for Small approximately 15-25%. Business Banking”.

Introduction to performance. The impact of applying this approach is significant, typically around 20% productivity Retail banking operations covers a myriad of activities improvement1. Importantly, this improvement can be including onboarding clients, decisioning credit, driven rapidly and with few technology dependencies. fulfilling loans and processing transactions among others. Given its increasing scale and scope, the operations function has been relentlessly targeted The case for change for efficiency improvements. Amongst others, Retail banks are increasingly looking for “intelligent” transformational levers such as centralization, cost reduction – methods to trim costs while maintaining automation, process reengineering, outsourcing and or improving service quality and revenues. EPM fits this offshoring have been used to improve the efficiency mold, given its ability to enable doing “more with less”. and effectiveness of operations. As a result of such Banks have traditionally focused EPM-like improvements intense and sustained industry scrutiny, there remain on sales functions given the potential for significant few residual opportunities to drive transformational revenue lift. Conversely, manufacturing companies have savings in operations without diluting service quality. traditionally focused similar performance management Oliver Wyman research indicates that one such improvements on operations functions given the breakthrough opportunity does still exist. The central productivity and quality benefits. We have found that the theme is that of latent productivity. Our studies principles that have worked in both of these situations indicate significant variability in performance across can be combined to improve operations productivity in comparable individuals in operations functions. This the banking industry. variability is often masked and propagated by the lack Moreover, the timing is right for banks to deploy EPM of transparency of results at the individual and team in operations. First, retail banking profit margins are level, and weak alignment between performance and under continued pressure, creating the right impetus for pay. To address this inefficiency, Oliver Wyman has change. Banks are increasingly looking for opportunities developed a solution framework called Enhanced to structurally reduce and variabilize the cost base. Performance Management (EPM), which improves Second, the culture within operations functions has the way institutions manage and pay for productivity. seen a shift. Operations has traditionally been viewed EPM improves productivity by objectively measuring as a back-office, transaction-oriented function. organizational value-add, setting measurable targets However, with operations playing an increasingly for individuals and teams based on opportunity to perform, and explicitly aligning variable compensation 1 After normalizing for other factors.

Copyright © 2013 Oliver Wyman 16 important and visible role in improving the client incentive payout and their real “value-added” experience, the culture within the function has become contribution (which we will define shortly) was nearly increasingly open to change. Third, the systems and non-existent (see Exhibit 2). data environment within banks has matured enough to enable the granular level of performance measurement required for EPM to work effectively. Additionally, Exhibit 2: Performance payout model technology like workflow and imaging enables dynamic capacity management with work intelligently routed OPERATIONS AGENTS based on skill alignment and available capacity. INCENTIVE VS. PRODUCTIVITY Together, these conditions create an environment in ANNUAL INCENTIVE $ which EPM can successfully deliver the direct cost and 10,000 quality benefits the operations function strives for. Different reward for 8,000 same level of productivity The opportunity 6,000 The core issue with most performance management systems in operations is that they try to do too much. 4,000 Take the example of a leading North American bank (see Exhibit 1). 2,000 Same reward across wide range of productivity Exhibit 1: Performance measurement model 0 0 200 400 600 800 1,000 60% 30% 10% AVERAGE CREDITS PER DAY Source: Oliver Wyman analysis Productivity Multiple criteria Client experience >10 KPIs 4 criteria Managers were only using two or three of the available Risk balance 3 criteria five performance bands. There was hesitance to use the highest and lowest performance bands, thereby implying that all individuals were performing at an average level. Everyone in the middle bands received a This bank used a balanced scorecard approach to similar annual incentive, keeping the average employee measure employee performance in operations. The happy but not rewarding outstanding employees illustrated example for a transactional function had for their performance nor providing non-performing three categories of performance – productivity, client employees motivation to improve. Employees with experience and risk balance, with weights of 60%, 30% very different productivity levels got the same reward and 10% respectively. “Productivity” comprised both and, perhaps most importantly, the capped incentive qualitative and quantitative criteria, with the latter structure did not encourage superior performance. including more than 10 KPIs, some overlapping and beyond the direct control of the individual. The “client experience” and “risk balance” criteria were highly The change subjective with no clear linkage to measurable goals. These measures were then somehow aggregated to Oliver Wyman architected an “Enhanced Performance come up with an overall performance rating at the end Management” solution to transform the way of the year, which drove 70% of variable compensation. performance was measured and rewarded at this The remaining 30% was driven by business unit and organization. Enhancing the performance management bank performance. Given this complex measurement model started with a change to the way performance model, the relationship between an individual’s was measured. For each major functional area within

Activity Credits per unit This improved performance measurement model Processed application 30 ensures that individuals focus on value-added tasks, that Reviewed application 10 they work harder and smarter to achieve their hurdle and that there is a direct relationship between productivity Edited application 20 and incentive payout (see Exhibit 4). Individuals who Serviced dealer call 10 do not meet their hurdle get no incentive, while there Errors -30 is significant upside for the best performers. Most importantly, such a reward model does not cost an organization anything incremental for a given amount of

Value-added work performed. Rather, incentive dollars are distributed credits differently to align with individual performance.

To ensure that EPM focuses on team performance Individual Single adequately, the EPM payout model includes a team hurdle Pay-out component, which is measured by aggregating the value-added credits earned by all members on a team. CREDITS HURDLE PERFORMANCE For individuals, a small portion of their overall incentive (say 20%) is driven by the team component. For team leaders, a significant portion of their overall incentive operations, all value-added activities were identified (say 80%) is driven by the team component with the rest and weighted based on relative effort or value. As an driven by higher-order goals, e.g., performance of the example, within a transactional group focused on loan entire department or function. This team component fulfillment, a “credit grid” was designed depicting each ensures that individuals are motivated to collaborate value-added activity performed by the group and the with their peers and team leaders are rewarded based on credits associated with each activity (see top half of the aggregate performance of their teams. Exhibit 3) based on relative effort. In this case, “processed applications” is assigned a value of 30 credits while “reviewed applications” is assigned 10 credits since the Exhibit 4: Enhanced performance former activity takes about three times as long as the payout model latter. Importantly, errors are also on the grid and are OPERATIONS AGENTS assigned negative credits. This ensures that due attention INCENTIVE VS. PRODUCTIVITY is paid to service quality in a model that motivates faster ANNUAL INCENTIVE $ throughput. At the end of each measurement period, an 10,000 Significant upside for individual’s credits are summed and then compared to a high performers pre-decided hurdle for that same measurement period 8,000 (see lower half of Exhibit 3). 6,000 The difference between credits accumulated by an individual and the hurdle become the “value-added” 4,000 credits, which are then converted into an incentive payout using a fixed, pre-assigned dollar value per 2,000 No incentive if hurdle is credit. For example, let’s say Employee A worked not met 8 hours in a day, has a hurdle of 500 credits and achieved 750 credits. Employee A earns 250 value-added credits 0 which are converted into an incentive payout at say 0 200 400 600 800 1,000 AVERAGE CREDITS PER DAY 10 cents per credit, which translates into $25 in earned Source: Oliver Wyman analysis incentive for that day. Employee B may be on a part-time

Copyright © 2013 Oliver Wyman 18 Exhibit 5: EPM framework by activity E ciency Mix of e ciency Eectiveness focused and eectiveness focused TRANSACTIONAL RISK BASED CALL BASED PROCESSES OPERATIONS OPERATIONS EXPERT SERVICES Definition Highly codified, Repeatable processes, Client facing phone-based Ad-hoc services which are repeatable, predictable, however, risk judgment activities that are outcome oriented and less controllable processes required which impacts somewhat routine based routine, limiting the predict- predictability but need to be flexed based ability and controllability on client situation at the unit level

Throughput

Quality

Risk Performance Client experience management dimension Relative focus of dimension is low Relative focus of dimension is high

The example just described is for a transactional function of 20+% in pilot groups across transactional, risk and call- in operations, where throughput is the key measure based operations within 6 to 12 months of implementing of productivity, subject to a certain minimum quality EPM. The jump in productivity is driven by a combination standard. Oliver Wyman has developed EPM models of two factors. First, EPM enables improved visibility for risk-based, call-based and expert-based operations and understanding of performance by measuring true functions (see Exhibit 5), each varying slightly to organizational value-add. Second, EPM ties compensation emphasize the performance management dimensions directly to performance, thereby creating the right most critical for that particular function. motivation for team leaders and individuals to improve their productivity. Additionally, we have observed that As an example, risk-based operations like adjudication EPM-driven productivity lift is consistently accompanied or fraud emphasize risk as the foremost performance by a parallel improvement in quality, with the best management dimension, with quality, client experience performers typically making fewer errors than before. and throughput being additional but secondary Team management also improves, with team leaders elements. Similarly, call-based operations such as becoming more engaged with their team and using inbound contact centers focus primarily on the value-added credits as an objective way of discussing client experience and throughput, the idea being individual performance while highlighting opportunities that performance for individuals in these functions for improvement based on learning from the best. should focus on ensuring a positive client experience on every call while maximizing the number of calls The team component of EPM also creates the right handled. Expert services include head-office functions incentives for team managers to keep the capacity of or more knowledge-based activities like business their teams aligned with volumes. Situations of over or architecture or program management. The EPM under-capacity compromise the opportunity to earn model for expert services is not as formulaic as the value-added credits. This creates the right “tension” in other categories given the broad and unpredictable the system for team managers to make the appropriate nature of the underlying activities. EPM tries to strip capacity management decisions keeping in mind the out subjectivity and behavioral elements and instead, overall productivity of the team and the available or focus on measurable and controllable outcomes. expected volumes. The impact More broadly, EPM also serves as the foundation for other structural improvements. For example, the The impact from transitioning to an EPM model is productivity lift observed within the bank via EPM significant. We have observed productivity improvement can be extended to outsourcing firms that provide

2-3 months 2-3 months 4-6 months

PHASE 1 PHASE 2 PHASE 3 DEVELOP FOUNDATION AND DESIGN DEPLOY PILOTS EXPAND AND MATURE

Governance and executive steer

Foundation Program expansion

Pilot design

Operational readiness/ communication Pilot implementation

operations services. Banks can push third parties to enable a transition to EPM. Once pilots are designed and conform to the same productivity standards as in- underway, the positive results from pilots typically build house operations functions and can also variabilize the momentum required for EPM to be implemented their third party spend by paying on a per transaction across the organization. The program expansion phase basis, based on EPM-generated productivity standards, can be realized fairly quickly as long as the program is instead of a per person basis. Additionally, EPM serves resourced appropriately. Of course, the entire journey of as the driving force to re-think and streamline the EPM needs to be enabled by strong governance and top- organization structure in operations. By deploying a down steer from executives, which helps critically with consistent performance management model across change management. each activity bucket, EPM enables resource sharing and organizational synergies, pushing banks in the Importantly, EPM can be implemented with little to no direction of organizing “like” functions together. technology change. The key information requirement for EPM is tracking of individual and team performance, which typically leverages existing performance Implementation management systems and reports. Implementing EPM is an eight to twelve month journey for most banks. Assuming an operations headcount Conclusion of a few thousand employees spread across multiple locations and sub-functions, the best way to initiate an Operations continues to be scrutinized for cost and EPM program is to develop a foundation (i.e., current service improvement opportunities, however few state assessment) while concurrently designing pilots to residual opportunities remain. EPM fills this gap by test EPM in a few functions (see Exhibit 6). dramatically increasing employee throughput, while simultaneously improving risk, quality and the client The foundation helps create a compelling case for experience. Organizations that have embraced EPM change by demonstrating the variance in performance have witnessed a 20+% improvement in employee across comparable individuals and highlighting the productivity. Most importantly, these benefits have been overall misalignment between productivity and pay. realized rapidly given that for most organizations, EPM has few dependencies on new technology. Pilot design focuses on developing an EPM model in a few functions or sub-functions that are relatively high Amit Bhandari is a Partner at Oliver Wyman. on the maturity curve, i.e., their leaders welcome the Kenan Rodrigues is a Partner at Oliver Wyman. change and the basic foundational data exists to quickly

INTRODUCTION most prominent of these – automated underwriting (e.g., Fannie Mae’s Desktop Underwriter®), barcoding/ Taking the long view over the past 20 years, the mortgage indexing electronic documents, e-signatures, automated industry has made tremendous advances in operations valuation models, MISMO standards – have resulted in and technology, raising the bar considerably from significant improvements to both customer experience its highly manual starting point in what nonetheless and operations productivity. continues to be a people-led, paper-intensive business. More recently, however, the industry has been hit by But realizing these types of advancements is incredibly a double distraction that has caused progress to stall: complex and resource intensive. Since 2004, the swamped by the after-effects of the “great recession” (in industry has been in a continual state of flux – first with the form of persistently elevated foreclosure volumes and the housing bubble, then with its after-effects, stricter a barrage of recent regulatory changes) and struggling underwriting standards, a fast-changing regulatory to keep pace with continued high volumes of refinance landscape and historically low interest rates. In this applications. These two bodies of work have consumed environment, most lenders have focused on survival the bulk of both managerial and workforce capacity more than on innovation. However, a confluence of across the industry and have made it largely prohibitive three factors is now providing the right environment for to pursue any significant fundamental operational lenders to reinvest in innovation and improvement. enhancements over the past few years. Looking ahead, however, we see three factors converging that will now 1. THE RECENT DISTRACTIONS OF provide both the opportunity and the forcing mechanism ELEVATED FORECLOSURES AND for institutions once more to rethink their approach to PERSISTENTLY HIGH REFINANCE VOLUMES mortgage originations, driving fundamental progress in WILL SUBSIDE the core operations of the business. This paper explores The combination of a surge in non-performing loans both why we believe these factors have set the stage for and a prolonged refinancing boom has kept the a new period of innovation in mortgage origination and industry working flat-out over the last five years. The what we see as three key themes of the coming redesign. latest forecasts from MBAA, the IMF and the GSEs, however, all point to a decline in refinancing volume of SETTING THE STAGE FOR A NEW as much as 70% in the next two years. This decline in PERIOD OF INNOVATION industry activity levels is part of the inherent cyclicality of the business. As such, we expect most management The last 20 years have seen a number of innovations teams to recognize the forthcoming activity lull as a in the design of mortgage origination processes. The window of opportunity—rather than a persistent “new

1 4 FAMILY MORTGAGE ORIGINATIONS $BN 4,500 9%

4,000 8%

3,500 7%

3,000 6% Forecast 2,500 5%

2,000 4%

1,500 3% 30-yr FRM 1,000 2% Refinance 500 1%

0 0% Purchase 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Mortgage Banker’s Association Forecast, Feb 22, 2013 normal” – allowing management finally to allocate 3. THE MARKET WILL SHIFT TOWARD attention and resources to making real underlying PURCHASE MONEY MORTGAGES, business improvements. CONFRONTING LENDERS WITH STEEPLY ESCALATED CONSUMER DEMAND AROUND EXPERIENCE QUALITY 2. DEADLINES FOR IMPLEMENTING COMPLEX REGULATORY REQUIREMENTS The decline in refinancing volume over the coming WILL LOOM period also means that the market will shift to being purchase money dominated for the first time since A barrage of recent regulatory changes have made 2008. In this environment, lenders will find it much the workload for each loan originated higher than more difficult to generate new business. In “refi boom” ever. Failure to achieve timely compliance with these periods as we have experienced over the past several changing standards, of course, comes with potentially years, many originators operate at maximum capacity. debilitating operational risk and expense. Over the They may even turn business away at the margin by coming period, lenders will devote an increasing number holding pending applications in a production queue of resources to operational compliance. And while the long enough that the applicant goes elsewhere, or by pace of change may slow, one of the lessons learned pricing uncompetitively. In a purchase money market, from this period has been that lenders’ operating models however, volume is scarce and event-driven; each need to be flexible enough to accommodate a wide loan must be won in open competition, often based variety of process changes and to be able to assimilate on reputation and word-of-mouth recommendation. these changes seamlessly, without reliance on ever- A refinancing transaction is essentially financial in increasing headcount. The non-discretionary nature of nature, but a purchase transaction is one in which compliance should serve as a catalyst for innovation in borrowers are more emotionally engaged. If the process changes that will not only address the regulatory lender does not deliver a high-quality experience, requirements currently on the table, but will also better borrowers will be upset and may both go elsewhere prepare lenders to adapt to additional changes that may and create negative word-of-mouth for the lender, arise in the future. at a time when exactly the opposite is needed.

Copyright © 2013 Oliver Wyman 22 Furthermore, while lenders have been distracted with swings in workload. This means establishing a more other priorities over the past few years, the world has variabilized expense structure, but it also means having become more digitally connected and huge technology the capability to promptly enact this variabilization to advances in other industries have trained consumers keep cycle times within an acceptable range. to expect very high levels of service and always-on information availability. For example, in many industries, Over time, lenders have worked to improve cycle times consumers can now press a button on a mobile app to and scalability through better use of technology and trigger an agent callback rather than waiting in a call process redesign at the margin. However, lenders are queue. Real-time online tracking tools at FedEx and UPS now re-thinking operations from the bottom up using an let us know the exact status of our packages 24 hours assembly-line principle of breaking work down into its a day and the cab-hailing app, Uber, has taken this base component parts. This approach is well-established one step further by letting consumers view their cab’s in manufacturing, pioneered in auto assembly and now progress toward them in real time. Consumers will now prevalent across industries from technology to retailing. have these kinds of expectations when interacting with Disparate/non-dependent tasks should be conducted in a mortgage lender. Lenders must make the process parallel where possible and like tasks should be clustered easy, be responsive to questions and get borrowers to for efficiency where possible. the closing table promptly. Those who fail to meet these This change in mindset, when applied to loan new standards will find purchase money even harder to origination and fulfillment processes, requires lenders attract than in the past. to fundamentally redesign business processes, roles, The combined effect of these three factors is a tasks and technology in mortgage operations. For compelling catalyst for lenders to re-think mortgage example, mortgage fulfillment has traditionally been operations with the objectives of remaining operationally conducted by a loan processor who serves as the point compliant with ever-changing regulations, raising the person for fielding customer questions, collecting level of customer care as will be required to compete required documents, verifying information, coordinating in the coming environment and improving operational with third parties and preparing the underwriting productivity to minimize impacts on per-unit costs. The package – essentially playing the role of quarterback. The last of these becomes important because the first two, bottleneck for completing fulfillment work is often this if undertaken without efficiency and cost discipline in mortgage processor who is typically handling up to 30 mind, would naturally otherwise be likely to lead to an other loan files simultaneously. In the assembly-line view unacceptable escalation of operating costs. of the world most of these activities can be conducted by members of specialized teams, focusing on a particular sub-set of component activities, many of which can run in RE-THINKING parallel; the processor then effectively becomes a “loan MORTGAGE OPERATIONS coordinator” who focuses primarily on customer contact. At scale, our experience has identified 10+ component With these objectives in mind, leading players are activities in mortgage fulfillment, each of which can be beginning to innovate and re-envision their operations conducted in parallel by specialized teams. This approach around three elements: creating an assembly-line reduces application cycle time considerably while approach to mortgage operations, building cross-channel improving fulfillment productivity by 30-40%. and self-service capabilities and industrializing MIS. Redesigning mortgage operations as an assembly-line A. CREATING AN ASSEMBLY-LINE APPROACH also helps address scalability challenges. Traditional mortgage operations have tried to variabilize their Leading lenders are creating a new, consistently expense structure by laying off and re-hiring employees. speedy, scalable, and reliable end-to-end process, from Scaling operations to meet demand this way is crude application to closing. Possibly the greatest lesson but effective. However, the combination of lagging of the past four years has been that lenders need a indicators and lead time in hiring and training resources production process that is more adaptable to huge creates a substantial time delay before lenders are able

TYPICAL DIRECT MODEL TYPICAL RETAIL MODEL POTENTIAL ASSEMBLY LINE MODEL DISTINCT ORIGINATIONS AND LOAN OFFICER WITH PROCESSOR ORIGINATOR WITH PROCESSING SUPPORT COMPONENTIZED FULFILLMENT

Origination Fulfillment Origination Fulfillment Origination Fulfillment

Customer Customer Customer Customer Customer Customer

Hand-off Hand-off Underwriting Loan Officer Loan Officer Originator Loan coordinator

Originator Processor Closing Underwriting Componentized fulfillment teams VoE & VoI Title

3rd parties Processor Closing VoD Certification Appraisal Underwriting Credit and ID Closing 3rd parties

to flex their workforce. This effect was compounded need to be defined for treatment of most possible after the SAFE Act, which forced lenders to specifically outcomes. Exceptions and escalation need to be routed search for licensed personnel or spend time training and and managed separately. Full transparency is required certifying unlicensed individuals. on both a loan level and process view to identify choke points and manage adherence to service levels. Some The shift towards “componentized” processes greatly new vendor platforms are now specifically designed improves lenders’ ability to enact expense variabilization to enable the assembly-line approach, but lenders and reduce the time delay in flexing capacity. This is will remain responsible for redesigning operations achieved by narrowing the criteria for training and hiring in the manner most suited to their individual needs required for both the loan coordinator and members of and objectives. the componentized teams. For example, whereas the traditional loan processor needs a broad range of both B. BUILDING CROSS-CHANNEL AND technical and soft skills, the assembly-line approach SELF-SERVE CAPABILITIES separates the roles requiring soft skills (loan coordinator) from the technical skills (component teams). This A universal need for all mortgage applicants is to have reduces the typical training time for a new employee flexible and responsive interactions with the lender. The from a few months to a few weeks. quickest way for lenders to frustrate their customers is to make it difficult for those customers to get in While the operational upside to cycle time and scalability touch with the right representative to discuss their is substantial, realizing this model requires significant loan application. The fallback to any interaction has investment and technology prowess. The “brain” of the always been the phone channel, where a customer assembly-line approach is the workflow engine that can dial an 800 number and eventually get someone drives the process and coordinates work. Processes to answer his/her question. While this fallback will need to be fully standardized with clear service level always continue to exist, the expectations of the agreements and turn times. Detailed business rules next generation of home buyers include the ability

HOME & MORTGAGE APPLICATION CLOSING AND FULFILLMENT CHANNEL SHOPPING TAKING POST CLOSING

SUSAN

Susan goes through the entire PHONE loan process exclusively over the Bob receives a phone, just as she could have call updating done for any channel him on the status of his loan Bob goes online at Bob returns home, tracks Bob goes to online WEB home to do more down some missing portal to verify research – gets an information, and picks closing details online quote up loan app online right BOB Bob meets in person where he left off at his with rep to begin in-person meeting loan app; rep sees MOBILE Bob uses mobile Bob’s online quote Bob checks in on his app while looking and mobile history, loan status on the for houses to get which inform his mobile app home-buying tips discussion and advice

IN PERSON

to interact with their lender in the manner of their real-time and re-engineering processes to account for convenience, be it in person or via mobile, internet, new or changed processes. For example, mobile and phone, online chat or even video telephony. This means tablet platforms will need to pull loan and status data building out cross-channel capabilities with seamless not only from originations, servicing and workflow integration into lender processes and systems. systems, but also other bank systems housing customer data (e.g., deposits, cards). Chat functionality will In a few years, these capabilities will likely be considered require a dedicated component team equipped to table stakes, but for now they can differentiate a lender handle questions on any loan file. Settings for customer and the experience it provides the customer. The preference on form of contact need to be customizable best example in this context is QuickenLoans and its and lender agents should honor those preferences, for innovative online and mobile features. Their myQL® example by emailing if the customer prefers email or platform provides a single customer-facing portal that calling if the customer prefers to be called. translates the loan process into a simple to-do list for the customer, with clear real-time status updates and While the customer experience benefit of building integration with their myQL® iOS and Android apps. user-friendly cross-channel platforms is game- While QuickenLoans is one of the few lenders with changing by itself, migrating customer interactions live instances of tools of this nature, development of to alternative channels is also a boon to operationally similar mobile and tablet features are among the top scaling capacity at times of surges or troughs. priorities at many large lenders, with some anticipating Integrating self-service capabilities into these platforms further developments into home-search, advice, reduces the number of phone calls or office visits location-based services, and application taking. for basic functions (e.g., inquiring about status, handing in documents) and, therefore, flattens the Operationalizing these capabilities requires not just relationship curve between loan volume and number building out the cross-channel platforms, but also of resources required to handle that volume. integrating information from lender systems in

• Market share • Volume trends e.g., by product, • Penetration in core customer geography, segment segments • Productivity and utilization • Comparison against peer • Quality institutions OPERATIONAL • Drill-downs e.g., by location, team, process, etc.

• Call quality and service levels STRATEGIC • Industry originations trends • End of call feedback • Macroeconomic indicators e.g., • Regular surveys interest rate, unemployment • Regular focus groups to • Other market events that drive understand big pain points volume changes

• Industry satisfaction rankings FINANCIAL e.g., JD Power & Associates • Cost per loan • Forums and messaging boards • Proﬁt per loan

• CFPB consumer complaints • “Shock” scenarios CUSTOMER

database SATISFACTION • Volume surge/ trough • Margin sensitivity • Employee satisfaction surveys EMPLOYEE • Interest rate sensitivity • Attrition rate by role, SATISFACTION • Other economic indicators geography, etc. • Peer cost and proﬁt per loan • Peer attrition rates • Peer margins • Compensation benchmarking across roles T Example of external metrics T Example of internal metrics

C. INDUSTRIALIZING MIS AND DATA well and what requires improvement. At the same time, new-form operational reporting also provides a “heat Operational excellence is an important driver of map” of where work is flowing versus bottlenecking, economics and competitive success, yet mortgage enabling managers to dynamically reallocate resources leadership teams are being challenged to make the before backlogs can emerge at any given step in right operational decisions with insufficient information. the process. Good MIS has always been important to managing the business in a controlled way, but now lenders have Anticipating when to reallocate resources and having the elevated its significance to “mission critical” status as confidence to do so decisively cannot be underestimated both an early warning indicator of changing market in importance. For a recent client, we explored scenarios conditions and a tool to manage operational risk. At the where a particular operational lever was either pulled on same time, the metrics that must be tracked are more time or delayed and we found that in the scenario where in number and more complex than they were in the the decision was delayed even slightly, performance was old-fashioned world, where one processor saw a loan never able to recover to the level where it could have all the way through from application to underwriting. been had decisive action been taken (even a year past In that world, productivity metrics rarely drilled down the initial delay). to the individual level and floor managers had difficulty knowing who was getting the work done efficiently and MIS needs are not just limited to the operationally- who was lagging. oriented and should not even be exclusively inward- looking. Instead, we see five key dimensions to robust In the assembly-line approach, as processes are future-state mortgage MIS and believe that these componentized across disparate teams (some located should be assembled and tracked dynamically so at third parties and each responsible for only one step in that management has a real-time view across all five a complicated process), accountability is dispersed and dimensions at its fingertips in making key operational nuanced reporting is essential to know what is working decisions. These five dimensions are as show in Exhibit 4.

Copyright © 2013 Oliver Wyman 26 Synthesizing across these various dimensions is critical market for lenders, with the keys to success being an to making accurate and timely management decisions operational ability to meet customer expectations in a business that is both operationally-intensive, on the experience, and building a model that is both highly market-driven and subject to intense regulatory practically and economically scalable. To realize this scrutiny. While many will be making investments during end-state, lenders need to define the ideal set of the coming “refi bust” (as often happens), the players interactions between the customer and lender and who currently excel in this area devote considerable derive the operational, technological and organizational resources to the MIS that supports the business and have capabilities required to effect that vision. Achieving fully routinized, and in parts even automated, its impact this re-envisioned state requires time, resources, on decision making. investment, and above all, a commitment by the lender to the strategy in order to reap the benefits. CONCLUSION Samrat Kansara is a Senior Manager at Oliver Wyman. We believe the current environment is opportune for Narayan Nallicheri is a Partner at Oliver Wyman. lenders to prepare for this new normal. Competition Lucia Uribe is a Partner at Oliver Wyman. for purchase money will create a more challenging

JPMorgan Chase has taken a first step towards creating This move has been a long time coming. The payment a new 3-party network similar to American Express and card market today consists of six mega-issuers (JPM, Discover. The new entity, Chase Merchant Services, BAC, Citi, COF, AXP, DFS) processing on four major will leverage the Visa infrastructure, but won’t be networks (Visa, MasterCard, AXP, DFS). subject to Visa rule sets or pricing terms. It will allow Chase to self-settle any transactions executed at Chase Since Visa and MasterCard went public in the early Paymentech merchants using Chase credit or signature 2000s, issuers have gradually lost influence over debit cards – while leaving the Visa network to process the payment card system. The networks have much transactions at merchants who have not signed onto the higher valuations than the issuers, are less exposed to new mini-network. regulation and credit conditions, and have global growth opportunities that the issuers lack.

Exhibit 1: Top issuers and networks relative volume size, affiliation

US Bank Capital One

Citi PNC Credit volume

Total volume Mastercard Visa (credit & debit)

Credit volume JPMorgan Top 7 issuers Chase 3 PARTY NETWORKS Wells Fargo Total volume Top 7 issuers (credit & debit) American Bank of Express America Total volume Discover all issuers (credit & debit)

Note: Volumes represent consumer credit and debit as of 2011 year end Source: The Nilson Report

Copyright © 2013 Oliver Wyman 28 The networks also have pricing power with both issuers Exhibit 2: Spend share of major card issuers and merchants. And when merchants pushed back (Visa/MC only) in court, it is not network fees that were reduced, but interchange – merchants can now deploy surcharges, Issuing share discounts and product discrimination to influence Credit Debit Total Acquiring share* card choice. Furthermore, the networks continually Paymentech JPM 25% 8% 15% 13% commoditize the market by providing Tier II & III issuers (Wholly owned) with functionality that approaches what the mega- JV with FDC BAC 16% 13% 14% 18% issuers spent millions to pioneer. (Minority stake) JV with FDC Wells 4% 11% 8% 4% Much of this came to a head during Durbin (Minority stake) JV with FDC implementation. Issuers expected the networks to share Citi 13% 1% 6% 4% (Minority stake) the Durbin pain in two ways: COMS COF 8% 0.6% 4% <1% 1. Accept that it was in the issuers’ interest to (Wholly owned) Elavon drop the networks’ “affiliated” PIN brands USB 6% 2% 4% 6% (Wholly owned) (Interlink, Maestro) to avoid network-on-network JV with FDC PNC 0.5% 2% 1% 1% interchange competition (Majority stake)

2. Reduce issuer-side processing fees to reflect the new * Some large acquirers are not issuers (e.g., Vantiv, Heartland and GPS). First economic reality Data also acquires under its own brand Source: The Nilson Report Yet the networks dug their heels in to protect their own revenue streams and, in the case of Visa, introduced a new “stealth” debit network (PAVD) that issuers could not opt out of even though it would be more costly to The press release announcing the deal suggests them than “unaffiliated” PIN debit. This was a wake- that Chase aims to improve its positioning with both up call for the mega-issuers that the power balance cardholders and merchants: had shifted to the networks. The only way to gain back •• For merchants, Chase can be more flexible in leverage is to shift volume to the other network. This interchange terms and rules sets – at least as is expensive and disruptive for customers and only a it relates to the volume from Chase-branded handful of issuers took that route. cards. Chase can also develop proprietary data sharing protocols that provide the merchants Enter JPM. Of the major MC/Visa issuers, only Chase is with more customer insights than is possible via a both a scale issuer and a scale acquirer. Most other banks standard network have either small issuing scale or JV acquiring structures •• For cardholders, Chase may offer proprietary deals that limit their flexibility. US Bank has large issuing and from its merchants. For example, by using Chase acquiring businesses, but at only one-fourth JPM’s data to target offers to narrow segments, a merchant issuing scale and one half its acquiring scale. may be willing to offer better deals than it does to the Note that FDC, with its alliances, has over 50% share in general public acquiring and its alliance partners collectively have a The question that arises is how this will impact Chase’s big position in issuing. While FDC could form a club of competitors and its customers (merchants and these JV partners to negotiate a similar deal, this would cardholders), as well as the networks themselves. be complex, given the different equity shares in each JV, and the different mix of Visa/MC affiliations among its partners. Such a club would remain a 4-party network, but with fewer parties on each side – it would lack the nimbleness of a 3-party design.

Copyright © 2013 Oliver Wyman 29 Acquiring impact these SME merchants, a penny per transaction reduction would not be noticeable. Further, selling acquiring to The clearest advantage from this deal accrues to small merchants is as much a function of distribution as it Paymentech, Chase’s merchant acquiring arm. To the is of price. Instead, Paymentech might invest its network degree that Chase is able to offer a lower total cost to the fee savings to pay ISOs an improved “buy rate” and merchant than another acquirer, it will generally win the grab the lion’s share of their sales without any particular contract. Paymentech already has competitive scale and differentiation to the merchant. services, but this is a unique differentiator. Paymentech could also use its new freedom to offer In the POS world, Paymentech could simply charge superior rule sets and pricing policies. One example is a lower network fee than Visa does and outperform eCommerce, where Card Not Present (CNP) interchange all other competitors. Large merchants typically face is substantially higher than POS interchange – even three major components of card acceptance costs: the for merchants with very strong fraud monitoring and acquirer fee of 0.2-1¢, the interchange fee that goes prevention programs. Paymentech specializes in to the issuer and the network fee that goes to Visa or eCommerce and must be very aware of this. A deal MasterCard. The network fee is typically 11bp plus that offers lower interchange on Chase volume to 1.5-2.5¢ which works out to 5-6¢ on the average debit reward higher levels of card security would reinforce transaction and 10-11¢ on the average credit transaction. Paymentech’s position as the acquirer of choice for CNP If Paymentech simply undercuts the network fee by a and put pressure on the legacy networks to reexamine penny on Chase card volume, their average acquiring CNP policies. While this would reduce interchange fee per transaction would be substantially lower than the revenue to the issuing side, eCommerce is still a small market level charge. This leaves interchange unchanged. enough portion of total spend that the tradeoff may be worth it. At “bricks and clicks” retailers, such a Paymentech can also offer this deal on a partial basis. A concession on the “clicks” side may be enough to win merchant could use Paymentech to process its Chase the larger “bricks” business. There may also be areas cards while leaving all other volume to the incumbent like “friendly fraud” where closer collaboration might acquirer (similar to how merchants operate with AXP and result in material reductions in merchant costs without Discover). In this case, Chase reduces its competitors’ reducing interchange at all. volumes and revenues even without winning the entire contract (most merchant acquiring contracts have a carve- Finally, by working directly with merchants in a out for 3-party networks). Furthermore, Paymentech gets closed loop, Chase can develop analytics that provide to integrate with these merchants, making it easier to merchants with greater insights into customer behavior. displace the incumbent the next time the contract comes Issuers like Chase have data on customer spend and up for bid – such transition costs are one reason large demographic profiles that merchants lack. Using these merchants rarely leave their incumbent acquirer. data, merchants can target offers to niches of Chase cardholders. AXP has exploited analytics of this kind This will have different appeal to different merchant historically to justify premium discount rates from segments depending on their payment mix and merchants and there is no reason Chase couldn’t do the geography. Debit-centric verticals, like supermarkets same thing. and gas stations, will have a smaller share of their volume from Chase cards than credit-centric verticals such as The net result could be a large increase in Paymentech airlines, hotels and department stores. Further, low- share at both large and small merchants. At large average ticket verticals, like fast food, already pay low merchants they could win more contracts outright or absolute network fees that would be harder to undercut. take a share of volume at the expense of the incumbents. Finally, Chase’s branch footprint is concentrated in At small merchants they will appeal to the best ISOs certain metro areas, giving stores in those cities a much because they can pay more without undermining core bigger debit impact. economics. These share increases could be highest in verticals with high credit spend and average ticket as The network fee advantage doesn’t help directly with well as debit-centric verticals that are in-footprint for the smaller merchants who pay via a merchant discount. For Chase branch network.

Copyright © 2013 Oliver Wyman 30 Issuing impact Redemption at the POS offers liquidity to the cardholder, but the actual value depends on how many merchants The impact on Chase issuing share is much choose to adopt the mechanism and what exchange rate more speculative. Chase adopts for these redemptions. Historically, points redeemed this way have a lower exchange rate than 1. Chase and its merchants need to find a proposition those redeemed using the standard menu of redemption that leverages cardholder spend and demographics options – and low exchange rates discourage usage. data to make proprietary, targeted offers to their Chase may also need to restrict the universe of joint customers merchants allowed to participate – there simply isn’t 2. The offers have to be differentiated enough – either enough redemption volume to make it material to any from a value or exclusivity perspective – to merchant if it is deployed too broadly. differentiate Chase cards from other cards 3. The offers have to be rich enough so that cardholders In short, the impact on Chase issuing fortunes is use them more than they have used other, less highly contingent on getting enthusiastic merchant targeted and differentiated offers from specialists participation. This will take time and investment by both like Groupon or Cardlytics. Visa and MasterCard are the merchants and Chase. It also requires merchants also moving into this space to adopt unique processes to make offers to Chase cardholders who might account for only 20% of so of Chase was clearly thinking along these lines when it their overall customer base. This is a tall order. purchased Bloomspot recently. Bloomspot specializes in daily deals in upscale venues like restaurants, spas and hotels. This gives Chase an engine for capturing merchant Network impact offers and distributing them to cardholders – and it focuses on just the kinds of merchants that the acquiring While Chase is a winner in this deal, the impact on the proposition will most appeal to. networks is clearly negative.

However, it is not clear how important merchant offers Visa will lose the network fees that merchants would are to either merchants or cardholders. AXP has done ordinarily pay on Chase volume. Chase will likely pay this for a long time, but it is not clear how much of its some fee to Visa for the use of Visanet, but this will no market position among affluent cardholders is due to doubt be much lower than the typical 11bp + 1.5-2.5¢. this rather than its service quality, rewards proposition On the other hand, Chase has committed to migrating and product differentiation (no pre-set spending limit). more of its volume from MasterCard to Visa – this will The effort required to craft and target offers is non- backfill some of Visa’s lost revenues at MasterCard’s trivial and many merchants lack the sophistication to expense. So MasterCard may be the biggest short term take advantage of the rich data that Chase might put at loser here. their disposal. Chase could develop advisory services to work with merchants on this opportunity, but these To the degree that Chase succeeds in growing issuing would only be affordable in collaboration with the very share, both networks will see an absolute reduction in largest merchants. volume over the longer term. Furthermore, there may be merchant pressure to match any interchange or network The other advantage for cardholders is the availability fee reductions that Chase Merchant Services might offer. of reward redemption at the point of sale. Chase To the degree that any other banks form similar mini- cardholders would be able to “pay with points” at networks, the losses will be compounded. selected merchants; this may be combined with targeted offers or it may be a routine payment option.

Copyright © 2013 Oliver Wyman 31 Impact on other large banks No other issuer is positioned to cut a similar deal without further M&A. Citi, US Bank, PNC and Wells all have much BAC is potentially large enough to cut a similar deal smaller issuing and acquiring businesses and would with the networks. But first, they may need to claw back have difficulty monetizing their volumes even if they controlling share in their acquiring JV, so they are at least could cut similar deals. While they might club together a year behind Chase in getting there. Collectively, BAC to do this, it is hard to see how they could deliver the and JPM account for 41% of Visa debit and credit spend, shared network from multiple acquiring arms – and so moving this volume to private mini-networks would even then, would operate on a 4-party model which vastly reduce aggregate network revenues and scale. undermines some of the advantages of such a move. Capital One is particularly challenged as they have material issuing share but almost no acquiring volume. Exhibit 3: Credit card market A logical move could be to align with Vantiv to gain 100% acquiring scale.

80% Discover Conclusion Amex 60% If the leading issuers do all move to mini-networks, Chase it is hard to see how Tier II/III issuers and acquirers stay relevant. Pure-play acquirers will lose to large 40% BoA merchants on cost and to smaller merchants on Consortium distribution. MasterCard and Visa will have fewer 20% funds to promote their acceptance brands and build MC out their services which are disproportionately 0% Visa used by Tier II/III issuers. Additionally, these issuers will lack the differentiation that comes from ads, Today future Chase offers and POS redemption. This could lead to Bank of America Potential

JP Morgan another round of consolidation on both sides of the Consortium cards business. (other top issuers) Note: Assuming the top 7 issuers break away to set up their own networks Source: The Nilson Report Andy Dresner is a Partner at Oliver Wyman

Significantly reduced profitability and changing At the same time, customer preferences and channel customer behavior have created a clear imperative usage have reached an inflection point. After years of for US banks to change how they approach retail uninterrupted growth, same-branch teller transaction distribution. Charting a new course will be challenging: volumes are declining steadily for most banks. At the the new model must confer the same competitive same time, card-based and other electronic payment advantage that local branch density has provided, methods are supplanting cash and checks, obviating drive a mix of traffic that can be converted into new and the need for a weekly visit. Simple branch service deeper relationships and deliver a superior customer requests have declined similarly, as customers make experience – all while meaningfully reducing cost to use of increased internet and other remote service serve. So, what might the future look like? With high functionalities to resolve their own needs. Finally, recent mobile and internet banking adoption, low branch traffic and heavy use of electronic payments, we believe Sweden and its banks provide a beacon. In this paper Exhibit 1: Online/direct channels will we will profile the characteristics of retail distribution continue to grow in the US Annual transaction volume by channel in Sweden, explore the factors that enabled banks (Disguised client example) there to accelerate evolution, and evaluate what we can learn about the future of US retail distribution. NUMBER OF TRANSACTIONS

US retail distribution: an imperative to change CAGR Branch -4% The impact of the financial crisis and its aftermath on Online/ retail banking economics is, by now, well-understood. Mobile 13% According to our estimates, between 2007 and 2012, as much as $50 BN in annual revenues evaporated due to ATM -6% fee regulation, deleveraging and low interest rates. As a Call 7% result, the branch banking business lines at most large Center banks are operating at efficiency ratios in the 65-75% 2008 2009 2010 2011 2012 range and producing equity returns in the mid-to-high Source: Oliver Wyman analysis single digits. Neither outcome is sustainable.

FOR INDIVIDUAL SWITCHERS* FOR SMALL BUSINESS SWITCHERS†

LOCATION : Branches near the new bank’s where I live or work branch(es) are very convenient

TECHNOLOGY : High quality service impressive online or mobile capabilities

ACCESS TO CREDIT : Fee level and the new bank is structure willing to lend me money

PRODUCT : Low minimum the product has good balance requirement features and pricing

0 20% 40% 60% 80% 100% 0 20% 40% 60% 80% 100%

* Defined as consumers who switched their primary checking account bank within the last 18 months; Consumers are not counted as a “switcher” if their new bank was acquired by their old bank and they did not actively switch banks † Switched primary banks within the last 18 months Source: Oliver Wyman Survey of Consumers (Q1 2012), Oliver Wyman New-Form Lending Survey of Small Businesses (Q1 2013)

Oliver Wyman research confirms that most customers preferences. Finally, there is no beacon of success to now conduct their pre-purchase research outside emulate in the US market. Although most of the largest the branch as well – only 14% of a consumer survey’s banks are experimenting with new approaches, none respondents indicated the branch was their preferred has yet completed a network-wide transformation. research channel, as compared to 61% for the web. So, where can executives contemplating their retail Against this backdrop, there is no question that US banks distribution strategies look for inspiration? We believe must evolve their retail distribution strategies. Recent Sweden provides a glimpse of at least a decade into the Oliver Wyman research and analysis suggests the rewards future of retail and offers important lessons on how to of doing so are great: most banks could at least double complete the transition. their branch banking business line profitability and increase equity returns to above 15%. Retail banking in Sweden: And yet this change will not come without significant risk. Branches (specifically, locational convenience) a decade ahead or an are still the most important driver of primary bank alternate reality? selection (as shown in Exhibit 2), and they generate To the eyes of a US banker, retail banking in Sweden the vast majority of profitable cross-sales. seems a world apart. Internet and mobile banking are Those banks that historically maintained good network nearly ubiquitous – more than 85% of Swedes are active planning and expense discipline simply will not be users of one or both – and have long since become the able to prune their networks significantly without primary method for interfacing with your bank. Swedes putting future sales opportunity at risk. In addition, log in more than ten times as frequently as they use there will be no “silver bullet” solution – winning any other retail channel. Advanced user-friendly “app” strategies will need to address network structure, retail functionality available in Sweden enables consumers to format, process, technology, staffing model and cross- complete a much wider range of financial management, channel integration, and must be flexible enough to information-gathering and payments activities than is adapt to different customer segment and local market possible in the US. In payments, electronic methods

MIX OF CONSUMER PAYMENTS BRANCHES PER CAPITA SWEDEN CUSTOMERS HAVE REPLACED CONVENTIONAL WIDTH INDICATES AVERAGE BRANCH SIZE PAPER BASED METHODS WITH ELECTRONIC TRANSACTIONS BANK Electronic 29% 6 % BANK Card-based 51% 52 %

Paper-based 20% 42 % 1000-1500 sq. ft 2000-3500 sq. ft Sweden today US today Sweden today US today

REMOTE CHANNEL USAGE YEARLY BRANCH VISITS MOBILE AND ONLINE BANKING IS TWICE AS WIDESPREAD SWEDEN CONSUMERS VISIT BRANCHES LESS THAN 5% IN SWEDEN AS IT IS IN THE US AS FREQUENTLY AS US CONSUMERS

Mobile & + Online 40% 20 %

Online only 44% 40 %

+ Neither 16% 40 % Sweden today US today Sweden today US today

Source: Swedish Trade Federation, Swedish Bankers’ Association, 2012 American Bankers Association Guide , FDIC, OECD, Nilson Report, internetstatistik.se, Cisco IBSG Global Research

dominate paper alternatives. Cards are broadly accepted branches4 due to rapidly declining customer demand and heavily utilized – cash represents only 20% of retail (as mentioned previously, check-related transactions are transactions1 – and paper checks have disappeared non-existent). Staffing levels are generally lower and roles entirely from Swedish consumer households in favor of more fluid. Most bankers are “universal” – they switch simple-to-use ACH and P2P transfers2. seamlessly between sales and service – but dedicated to a specific segment. Customer-facing technologies, Bank branches form a much less prominent part of the including self-service terminals, internet and mobile street-level retail landscape in Sweden – there are 35% banking demo stations, video teleconferencing and fewer per capita, as compared to the US – and customer digital merchandising are much more prevalent. A traffic is significantly lower. Over 80% of customers at significant portion of branches serve only small-to-mid- one Swedish bank have not visited a branch in the last sized businesses or mass affluent customers. six months3. In this environment, most Swedish banks employ retail formats and operating models that differ So, is Sweden an alternate reality, or does it provide a materially from the traditional US approach. Branches glimpse into the future of US retail banking? Probably are significantly smaller, many less than 1,500 square a bit of both, but we believe primarily in the latter for feet, and utilize an open floor-plan to encourage casual two reasons. First, the profile of demand for consumer banker-customer interaction. Traditional teller zones financial services in the US and Sweden is sufficiently are uncommon: in fact, the largest Swedish banks have similar to suggest that they should evolve toward eliminated manual cash-handling from 65-75% of their similar end-states:

1 Swedish Trade Federation. 4 bloomberg.com “Swedish Banks Make Money by Saying No to Cash”, 2 Sveriges Riksbank. April 11, 2013. 3 Oliver Wyman analysis; excludes visits to on-site ATMs.

•• Demographics – The Swedish population is •• Long-term savings needs – Structural reforms to the substantially smaller than the US (~3%), but the Swedish public pension scheme have given rise to the countries have similar population age pyramids and same personal savings requirements that exist in the average life expectancies. Average household size in US. Today, a 40 year-old Swede can expect to collect Sweden is 2.0 versus 2.6 in the US. Immigrants are 12- a pension benefit equivalent to 40% of his/her salary, 14% of the total population in both countries. Levels starting at age 65; the equivalent calculation for Social of urbanization are also similar (80%+) Security is 30-35% •• Use of financial services – According to recent studies, Second, the developments that enabled the retail 99% of the Swedish population participates in the transformation in Sweden – the secular shift toward banking system (i.e., owns at least one financial electronic payments and access to/adoption of internet account), relative to 91% in the US5. The 8 percentage banking being the most critical – are already underway point difference is meaningful when scaled to the in the US; structural advantages merely allowed the full US population, but both countries are among Swedish banks to accelerate them. For example, internet the most highly banked, globally. The growth in US access is now near-universal in the US and the gap in general purpose reloadable prepaid cards – nearly online banking adoption – 84% of Swedes use it, versus one in five unbanked customers used one in 60% of US consumers – is closing quickly. Similarly, the 2011 – will continue to erode this gap voluntary shift from paper to electronic payments is well •• Household balance sheets – In both countries, total underway. While over 40% of US consumer payments household debt-to-income ratios are at or above are paper-based (compared to just 20% in Sweden), they 100%. Thanks to recent deleveraging in the US, DTIs have been declining at 2-3% YoY in the US for the past are actually higher in Sweden. Homeownership rates 5 years. At the current pace, the US would reach parity are 60-65% in both countries with Sweden within a decade.

5 Demirgüç-Kunt, Asli, Thorsten Beck, and Patrick Honohan. 2008. Finance for All? Policies and Pitfalls in Expanding Access. Washington, DC: World Bank.

Copyright © 2013 Oliver Wyman 36 Exhibit 5: Sweden’s top banks dominate the retail banking market PRIVATE MARKET DEPOSITS PRIVATE MARKET LENDING TOP FIVE PLAYERS CONTROL OVER 80% OF TOP SIX PLAYERS CONTROL OVER 80% OF CONSUMER MARKET DEPOSITS CONSUMER MARKET LENDING MARKET SHARE MARKET SHARE 25% 25%

20% 20%

15% 15%

10% 10%

5% 5%

0% 0% SEB SEB SBAB Nordea Nordea Swedbank Swedbank Sparbankerna Sparbankerna All other banks All other banks Handelsbanken Handelsbanken

Source: Swedbank Annual Report 2012

What structural advantages enabled Swedish banks to •• Cultural dynamics – While harder to pinpoint, recent accelerate these trends? We see three: studies by the World Economic Forum identify •• Favorable competitive market structure – Following Swedes as being among the earliest adopters of new a wave of consolidation in the 1990s, there are only technologies, globally, which would suggest that the 36 chartered commercial banks in Sweden (versus population may generally have been more willing more than 6,000 in the US), and the four biggest to try out new remote/self-service banking options. banks dominate the retail banking market. As a The legacy of socialism may also have contributed result, Swedish banks were able to operate in concert indirectly to the willingness to accept institution- to accelerate changes in customer behavior (i.e., led change eliminating paper checks and, now, cash) •• Government infrastructure investments – Sweden What can Sweden teach has made a number of significant public investments us about the future of US to spur internet access and personal computing availability. The government adopted a formal retail distribution? “broadband policy” in the 1990s and has since So, what can the Swedish paradigm teach us about the aggressively subsidized broadband deployment. future of retail distribution? We see five lessons, which Similarly, until 2009, the “home-PC” policy enabled we will explore in more detail below. employees to lease and/or purchase computers from their employers on a pre-tax basis, substantially 1. Transformation will not lowering the cost of home computers6. As a result, mean commoditization computing and high-speed internet connectivity was The Swedish market suggests that competitive diversity available to the majority of the Swedish population at will survive, and even thrive, as the retail model evolves. a significantly earlier date Universal banks, traditional community banks, small-to- 6 The subsidy was a concept called “home-pc” where employees could rent a medium enterprise and affluent segment-focused banks, computer from the employer with the cost deducted from the gross salary (rather than net), typically over a 3 year period. This was phased out over 2007-2009. internet-only banks, consumer finance specialists and

REMOTE BANKING Skandia SPECIALIZED SELF SERVICE Direct bank Avanza Bank Direct bank

Virtual Ikano Bank Direct bank Nordnet Direct bank S E B 170 branches 59% cashless JAK Nordea 28 branches MODELS 304 branches Swedbank 47% cashless

Segment focused 317 branches 30% cashless Commercial bank Sparbanken 1826 Handelsbanken 20 branches 461 branches Savings bank 2% cashless Sparbanken Nord Community TRADITIONAL BANKING 16 branches RELATIONSHIP BANKING Co-operative bank Mass market Subset Niche (HNW) CUSTOMER FOCUS Note: Data from 2011 Source: Swedish Bankers’ Association

non-bank alternatives all exist, and have proven capable Could large US banks undertake similar consolidation of delivering above-hurdle returns. Given its sheer size programs? Although many metro markets may be as of the US, we believe the US market may support even much as 20% over-branched7, we believe the organic greater strategic diversity. consolidation opportunities are limited for most banks.

2. Transformation will mean (limited) Exhibit 7: For Sweden, transformation branch consolidation meant consolidation Swedish branch networks contracted From 2008-2011, after a decade where the number of materially (2004-2011) branches per capita in Sweden was relatively stable, all but one of the largest Swedish banks meaningfully NUMBER OF BRANCHES PER 100K ADULTS reduced their branch networks. Overall, branches 23.1 8% drop in branches per capita declined by 8%. To put this in context, a 22.9 22.9 23.0 22.8 in 7 years proportional effort in the US would result in more than 9,000 branch consolidations and closures. 22.2 Speaking with the executives who oversaw the network 21.7 reduction for one of the earliest movers, it is clear that 21.1 the process was challenging. 2-for-1 consolidations (i.e., shuttering two locations in favor of a new, centrally located branch) proved much more successful than outright closures, which resulted in attrition as high 2004 2005 2006 2007 2008 2009 2010 2011 as 70-90% in instances where only one bank closed its branch in a local market. Overall, however, the Source: Swedish Bankers’ Association programs delivered meaningful channel profitability improvements and Swedish retail efficiency ratios were 7 baird Equity Research, D. George, “Is It Time to Rethink Branch Banking already envy-inducing. Strategies?”, Sept 2012.

Greeter Self service machines (e.g., deposits) Entrance

Service pods Waiting area

Internet access terminals Open office Meeting room

For example, in two recent research examples, potential •• Branch network designs will become less monolithic branch consolidation candidates totaled no more than and more tailored – Most banks will move away 5-10% of bank networks. To start with, to maintain from the traditional, homogenous “model branch” satisfactory CRA ratings, most banks must exempt a network model toward a more tailored, site-specific material share of their least profitable branches from structure. Individual locations will receive different any optimization program. In addition, branch real treatments and staffing levels based on the local estate ownership rates are significantly higher in the US market opportunity, mix of customer segments than they are in Sweden (where the large banks lease they serve, and proximity to other, larger locations. the majority of their retail square footage), limiting the More segment-specific branches – or “branches banks’ flexibility to execute 2-for-1 consolidations or at within branches” – will be built to serve only small least delaying the ability to realize fixed cost savings. businesses or affluent customers (at one leading Most importantly, given the number of competitors in bank in Sweden, 15% of branches serve only small- most metro areas who meet the minimum “locational to-medium businesses and another 30% serve only convenience” threshold, it is a virtual certainty that the affluent) at least one competitor will maintain or expand its •• Branches in general will become much smaller and presence in an effort to capture market share from those more flexible – We expect the average branch footprint who contract. That leaves in-footprint, merger-related to fall by as much as 50% (from 3,000 ft2 to closer to consolidation and outright market exit as the most 1,500 ft2) as there is less (or no) need for a large (or viable levers to eliminate the remaining 10-15% of excess any) teller zone, lower staffing levels and more cash branch capacity. We expect to see a good deal of both in handling automation reducing back-office space the coming years. needs. Floor plans will need to become more open and flexible to encourage more non-transactional banker- 3. Transformation will mean customer interactions and to allow for more site- retail format and operating specific staffing. Specific tactics that are commonplace model innovation in Sweden: 24-hour access ATM vestibules at the Whereas we expect the decline of total US branch entrance, larger windows and limited architectural counts to occur more slowly than many have forecast, space dividers (a less material security risk if manual as simple teller transaction volumes continue to decline, cash handling is automated or eliminated), open pods the Swedish experience suggests that branch formats and private meeting rooms in place of assigned offices and operating models will evolve radically. Many of the and dedicated demo-stations to showcase internet, changes will be instantly visible: tablet and mobile app functionality

Copyright © 2013 Oliver Wyman 39 •• Customer-facing technologies will become much 4. Transformation will require a new more prevalent – In high-transaction locations ATMs sales paradigm and assisted self-service technologies will replace Retail sales models employed by the largest Swedish tellers to handle the majority of simple transactions. banks share three common characteristics which differ Video teleconferencing will provide on-demand materially from their US counterparts: access to mortgage, small business and investment sales specialists in locations that could not support •• Swedish branches originate a much more balanced such expertise otherwise. Video-tellers will provide mix of deposits, lending, payments and investments human support outside open hours. In Sweden, some product sales, where US branches tend to be much locations have been replaced entirely by ATM and more deposit-centric self-service only technologies •• Swedish banks employ far more dedicated affluent •• Branch staffing levels will decline and the use of and small business sales forces, where these are “hybrid” or “universal” job families will increase – As served primarily by personal bankers in many overall transaction volumes decline and an increasing US banks share are fulfilled via self-service technologies, •• Swedish banks have moved toward a more required branch staffing levels will fall significantly. integrated, outbound sales model, where the majority To enable smaller numbers of staff to handle peak- of US branch sales arise from in-bound foot traffic volume sales and service times, more banks will (e.g., teller referrals, lobby intercepts, in-branch design and deploy hybrid “teller-seller” or “universal merchandising and other related programs) banker” job families. Any remaining non-customer On the first two of these, the transition is already well facing activities will be shifted to lower-cost back- underway inside most of the largest US banks; the third office resources. Some of the capacity freed up will may be more disruptive. At many US banks, in-bound be reinvested in resources focused on high value traffic constitutes more than 95% of branch sales, new segments, or other specialists relationships and cross-sales. As branch traffic declined In total, we estimate that adopting a Sweden-like branch in Sweden, the banks there experienced first-hand that operating model could produce run-rate savings of this model simply could not create enough activity at the 25-30% of retail operating expenses. Effecting this “top of the sales funnel” to perpetuate their historical transformation across a large legacy network will growth. Now, according to one of the largest Swedish not be easy, but our experience suggests it can be banks, well over 75% of new sales are initiated through achieved in time – and be accretive in each period. In outbound activity. cases where leases expire or real-estate can be sold, To prepare for this paradigm shift, US banks will need to outmoded legacy branches can be replaced entirely invest in building more integrated, information-driven, with the new format(s). For branches where neither exit outbound sales capabilities, in parallel with any efforts option is possible, or where a superior new location is to reduce branch traffic. Using Sweden as a guide, such not available, traditional teller zones can be retrofitted capabilities would include: with new technology, and low-cost environmental elements can be deployed to repurpose or conceal •• Advanced customer segmentation and unneeded floor-space. New roles and staffing levels targeting – Moving from simple wealth or can be introduced in almost any circumstance, and demographic segmentation to incorporate current Oliver Wyman experience suggests that in most cases profitability, preferences and potential lifetime the headcount-related savings are sufficient to self- value; developing predictive analytics to identify finance critical, related capital investments. In some profitable cross-selling opportunities and changes in cases, there may even be opportunities to monetize attrition risk excess square-footage by sub-leasing it to other financially-oriented firms (e.g., insurance brokers, local title agents, accountants) or making it available to customers or community groups.

US TODAY SWEDEN TODAY FUTURE US

Booked Walk-in Sales Booked Walk-in Sales meetings Service-to-sales hand-offs meetings Service-to-sales hand-offs

GENERAL SALES REMOTE SALES SPECIALIZED REMOTE SALES REPRESENTATIVES SUPPORT BRANCH BANKERS REPRESENTATIVE

•• Better integration between sales and that the experience design for each task is intuitive and marketing – More direct-response and internet as user-friendly. Examples of advanced mobile functionality a percentage of total marketing spend, integrated in Sweden include: campaigns that include marketing (e.g., media buy, direct mail) and sales (e.g., a follow-up call) Exhibit 10: Transformation means components and more consistency of message across multi-channel experience innovation service channels

•• Phone-based meeting booking support for branch Tap here sellers – e.g., dedicated contact center teams to pre- Thai restaurant $20 Gallery Q SEND qualify leads and set appointments, which the local Cafe branch sales personnel can fulfill $20 RECEIVED PAID

5. Transformation will require GPS AUGMENTED P2P NFC substantial investments in internet REALITY PAYMENTS PAYMENTS and mobile banking Compared to their American counterparts, Swedish banks possess significantly more advanced internet and mobile banking capabilities. Each of the largest Swedish $ banks offer dedicated “apps” for mobile and tablet $ formats and support all of the most prominent operating systems. In general, the breadth of functionality is much PFM INVOICE/ MOBILE ONLINE greater than what any individual US bank offers today BILL PAY WALLET MEETINGS and Swedish banks have invested significantly to ensure

Copyright © 2013 Oliver Wyman 41 Exhibit 11: Mobile technology in sweden •• New talent to fit new roles/capabilities – Strong outpaces the US branch and regional leadership were the key catalysts for change, and not all of the legacy leaders were Financial/ Balance checks Shake your phone to get a good fit for their roles. One of the largest banks account balance information management actually “re-appointed” all branch and regional Personal Financial Single view of all financial Management holdings, whether with the manager positions as part of the transformation. (PFM) bank or another provider ~60% of legacy branch managers were re-hired, but Standard Device-specific rendering (e.g., the majority of those were placed in new branches. functionality schedule bills, make transfers, execute trades) The remainder of positions were either promoted or Payments P2P transfers The six largest banks formed hired from the outside a joint-venture, Swish, to offer real-time P2P funds transfers •• Customer communication – Executives identified proactive communication and education as the ACH/Bill pay Take a picture of a bill, and the app pre-populates payment factors that most strongly influenced customer 8 information and remits funds acceptance of the new model. Having branch Mobile payments The largest banks have been staff assist customers in navigating new branch at the piloting QR-based technology point-of-sale in conjunction with Seamless, technologies and demonstrate internet/mobile a Stockholm-based mobile payments firm (a number of capabilities was particularly important in changing major merchants, including customer behavior McDonalds, have recently signed on) •• Strong top-down support and dedicated project Information “Augmented Point your phone camera in leadership – Banks with the most successful gathering reality” branch any direction and the mobile experiences heavily engaged the executive team locator app will show the location and distance of branches within the in shaping the strategy, structure, business and field of vision people decisions; they also established a small, dedicated project team with clear governance and decision rights While some of this functionality may not prove essential, the lesson for US banks is clear: if the goal is to migrate low-value activities to lower-cost channels, the If this is the future, when will perception of capabilities, and especially ease-of-use, it arrive and what is it worth? will be critical to increasing adoption. While it is highly unlikely that the US market will follow the 6. Transformation will require an same development curve, or arrive at precisely the same integrated effort, new talent, and end-point, Sweden provides interesting insights into the substantial customer communication future of retail banking and important lessons on making the transformation smooth. Further, given the pace of When reflecting on the factors that influenced the change in the market, the economic imperatives and long success (or failure) of their transformation initiatives, lead-times associated with a change of this magnitude, executives at Swedish banks highlighted four critical we do not believe banks can afford to wait to set their success factors: strategies once a “future standard” emerges in the US. •• Approaching the transformation as an integrated change effort – Since the key elements of the While the transformation may be challenging, the prize retail transformation were all heavily inter-related, is certainly attractive: on a run-rate basis, we believe the banks that approached transformation as most banks could double the profitability of their retail an integrated program enjoyed substantially franchises, return efficiency ratios to their historical better results than banks who attempted to make levels and boost returns-on-equity to more than 15%. changes piece-meal

8 The way invoice payments work is through a combination of a standard identifier (known as the OCR number) and a company routing number tied to the Siddhesh Karmali is a Senior Manager at Oliver Wyman. company’s banking account (known as a giro transfer number). Through the mobile app, the customer scans a long line of text containing the OCR number, Tim Spence is a Partner at Oliver Wyman. amount and giro transfer number which auto-populates all payment information.

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Copyright © 2013 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.