Financial Services SPRING 2012 RETAIL BANKING AMERICAS DIGEST IN THIS ISSUE 1 US MORTGAGE FINANCE • JAMES WIENER, MICHAEL ZELTKEVIC 2 MOBILE PAYMENTS • ANDY DRESNER, CHAITRA CHANDRASEKHAR 3 C LIENT EXPERIENCE • JOE FIELDING, KENAN RODRIGUES, MICHAEL D’ESOPO 4 US CONSUMER CREDIT SCORE MIGRATION • PETER CARROLL 5 RELATIONSHIP PRICING • INDERPREET BATRA 6 B RANCH FLEXING • SUMIT SAHNI, PAUL MEE, AARON FINE, MASSIMO TESSITORE TABLE OF CONTENTS 1. US MORTGAGE FINANCE 1 What should the future look like? James Wiener, Partner and Head of the Americas Public Policy Practice | Michael Zeltkevic, Partner and Head of the Americas Retail and Business Banking Practice The financial crisis exposed fundamental deficiencies in the US mortgage finance system. This article explores the set of options faced by policy makers for driving the evolution of the single-family home finance landscape and outlines the importance of clearly defined objectives in this redesign. 2. MOBILE PAYMENTS 7 Aligning strategy with opportunity Andy Dresner, Partner | Chaitra Chandrasekhar, Consultant Mobile payments are widely expected to become much more prevalent in the next few years, which will cause global players to examine their strategies and invest in new initiatives. This article describes the opportunities and threats for banks in both developing and developed markets, and how quickly change may unfold. 3. CLIENT EXPERIENCE 13 From strategy to execution Joe Fielding, Partner | Kenan Rodrigues, Senior Manager | Michael D’Esopo, Partner, Lippincott Recent economic times have reshaped the attitudes and needs of retail banking clients and catalyzed a significant and measurable negative customer sentiment towards the industry. This article describes the “client experience” – and why banks’ increased focus on it is critical in today’s marketplace. It also shares a structured approach for designing and implementing an improved client experience, with efficiency and profitability in mind. 4. US CONSUMER CREDIT SCORE MIGRATION 20 Observations and implications for credit risk management Peter Carroll, Partner A customer’s score can vary significantly across time due to a number of factors. This article discusses the effect of score change on default probability, score migration patterns and predictability, and the implications of such changes on customer credit risk management. 5. RELATIONSHIP PRICING 25 A strong lever to deepen customer relationships – if used wisely Inderpreet Batra, Partner Customers who have more products with an FI – and thus deeper relationships – are shown to be more valuable. This article argues that instead of offering traditional price discounts to help deepen existing relationships, a relationship pricing approach should focus on customer relationships where incremental value can be derived and leverage both price and product offerings to drive desired behavior, as the end goal. 6. BRANCH FLEXING 28 An agile approach to cost management Sumit Sahni, Partner | Paul Mee, Partner | Aaron Fine, Partner | Massimo Tessitore, Partner Instead of simply cutting branches, retail banks must develop a more flexible operating model to manage against topline and cost objectives. This article describes different strategies of “branch flexing” and shows that unlike branch closing, branch flexing keeps the focus on preserving the sales and service experience for a bank’s best customers. 1. US MORTGAGE FINANCE WHAT SHOULD THE FUTURE LOOK LIKE? By James Wiener and Michael Zeltkevic INTRODUCTION originations are funded by Fannie Mae, Freddie Mac, and the FHA/VA. In February of last year, the Treasury The cataclysm of 2008-2011 exposed fundamental laid out three options to significantly reduce the role of deficiencies in the US mortgage finance system. government in the mortgage market2 by phasing out Economic growth and financial stability require Fannie Mae and Freddie Mac. The options maintain that a comprehensive redesign of all aspects of the the government’s role should be limited to oversight financing of single-family home purchases. A new and consumer protection, targeted assistance for approach should be driven by a coherent set of policy lower-income homeowners and renters, and support for objectives, including: market stability under severe stress. • Stability of the overall financial system The mechanics of the redesigned role are where the • Explicit government support for low to moderate three options differ. The Treasury’s plan to phase out income borrowers the GSEs is meant to encourage more private sector • Privatization of risk taking outside of low to moderate involvement by increasing guarantee pricing to reflect income borrowers the same capital standards as private institutions, • Enhanced protection for consumers primarily banks. This would encourage GSEs to pursue The new architecture will also need to address the large additional credit-loss protection from private insurers, size of mortgage outstandings relative to the aggregate adjust conforming limits on loan size and minimum banking balance-sheet, changes to the risk profile of down payments, and wind down investment portfolios. 3 mortgages housed in the regulated financial system, and In February, the FHFA (conservator of the GSEs) had challenges in the current model for mortgage servicing. taken first steps in this direction through its three- pronged strategic plan: Build – lay the framework for the A central element of any redesign will be a re-conception secondary market; Contract – reduce the dominance of of the role of the government-sponsored enterprises the GSEs; Maintain – continue the offering of foreclosure (GSEs1) – Fannie Mae and Freddie Mac. Currently, alternatives and fostering credit availability. the overwhelming majority of US mortgage market 2 Department of the Treasury and Department of Housing and Urban Development, “reforming America’s Housing Finance Market: A Report to Congress” (Feb 2011). 3 Federal Housing and Finance Agency (FHFA), “ A Strategic Plan for Enterprise 1 For simplicity, we will use the term “GSes” to refer exclusively to Fannie Mae and conservatorships: The next chapter in a Story that needs an ending” Freddie Mac. (Feb 2012). Copyright © 2012 Oliver Wyman 1 In this paper, we examine the options for the future of THE FUTURE OF THE the GSEs and make recommendations for the design of a SECONDARY MORTGAGE new US mortgage finance system. These include: MARKET: WHAT ARE • Design of a new risk intermediation structure to provide liquidity and efficiently transfer risk to the THE OPTIONS? capital markets In the current model (Exhibit 1), the GSEs, by • Explicit guidelines for risk taking within the regulated standardizing mortgage terms, have created a valuable financial system source of capital markets based funding. In doing so, they • Creation of a centralized registry for all mortgage transferred interest rate risk from borrowers to investors liens with names of the servicer (one of the under-appreciated aspects of the current GSE • Changes to servicer compensation to an activity model is the efficiency of pricing the 30-year prepayment based model option to the borrower). As Exhibit 2 illustrates, US • Harmonization of regulator and investor servicing mortgage assets are far too large to be funded on bank guidance and modification programs balance sheets via deposits. Accordingly, any proposal for • Greater clarity on reps & warrants risk and the future of mortgage finance needs to maintain a vibrant servicing liabilities role for capital markets funding. EXHIBIT 1: OVERVIEW OF CURRENT CONFORMING MORTGAGE MARKET MODEL AND ROLE OF GSES PRIMARY MARKET SECONDARY MARKET A CORRESPONDENT FANNIE OR FREDDIE ORIGINATOR BORROWER Potentially via broker Warehouse Floor of loans to Investment Market trading line of credit be aggregated portfolio Sales of MBS with MORTGAGE BANK C B credit guarantee Agreement to buy (e.g. TBA loans at specific price market) Originator Securitizer & guarantor INVESTOR Delivery of loan pools (servicing retained) Collections/ Scheduled Aggregation modifications Primary Master P&I payments servicer servicer Monthly payments D Serving standards SERVICING Contractual Claims payments MORTGAGE INSURER for high LTV KEY VALUEADDS OF GSES TO MORTGAGE MARKET PARTICIPANTS A Borrowers: Mortgage products with desirable features (long term, protection from inflation, no prepay penalties) through efficient pricing of credit risk and management of prepayment risk B Originators: Standardization of underwriting standards, pipeline hedging, massive driver of added funding C Investors: Protection from credit loss, increased liquidity through TBA market and investment portfolio activities D Servicers/collections: Standardizing of protocols Copyright © 2012 Oliver Wyman 2 EXHIBIT 2: US MORTGAGE OUTSTANDINGS VERSUS ensuring today’s levels of market liquidity would COMMERCIAL BANK BALANCE SHEET COMPONENTS, require a government backstop. YEAR-eND 2011 4 The government’s role would be that of a reinsurer $ TN of last resort. It would charge a fee for its role and it would be called upon only once considerable private 14 guarantor capital had already been consumed. 2.5 12 In the rare event of private insurer failure, the 1.3 10 $1 TN government should have some flexibility to adjust Other assets fees as appropriate to offset losses and maintain 8 2.9 zero taxpayer loss over a reasonable time horizon (as Cash 6 the FDic does). The government’s main role during 11.1 10.2 4 Securities times of calm would be the oversight of private 7.3 mortgage