Rewriting the rules in retail banking

Four important trends are changing the terms of success in retail banking. Banks need to act now to develop new skills.

Retail banks have long competed on distribution, realizing economies of scale through network effects and investments in brand and infrastructure. But even those scale economies had limits above a certain size. As a result, in most retail-banking markets, a few large institutions, operating at similar efficiency ratios, dominate market share. Changes to the retail-banking business model have mostly come in response to regulatory shifts, as opposed to a purposeful reimagining of what the winning bank of the future will look like.

Retail banks have also not kept pace with the improvements in customer experience seen in other consumer industries. Few banks stand out for innovation in customer interaction models or branch formats. Marketing investments have traditionally focused on brand building and increasing loyalty: a reputable brand stood for trust and security and became a moat, providing protection against new entrants to the sector.

Today, the moats that banks have built are more likely to restrict their own progress than protect them from attackers. Four shifts are reshaping the global retail-banking landscape to the point where banks need to fundamentally rethink what it takes to compete and win. This should be an urgent priority for banks. The pace of change will likely accelerate, with a select set of large-scale winners emerging in the next three to five years that will gain share in their core markets and begin to compete across borders, leaving many subscale institutions scrambling for relevance.

Four shifts are reshaping retail banking

Over the next three to five years, we expect a few players to emerge from the competitive scrum to gain dominant share in their core markets and possibly beyond. These firms will have taken bold and decisive actions to capitalize on the following shifts that are reshaping the industry. In some cases, these winners will be incumbents that build on an already significant share; in others, they will be institutions newer to the banking industry, which use their agility, strategic aggressiveness, and sharp execution to attract customers.

1. The traditional distribution-led growth formula no longer applies

Until the financial crisis in 2007, a retail bank’s total share of deposits was tightly linked to the size of its branch network. Over the past decade, this relationship between deposit growth and branch density has weakened. Deposits at the 25 largest US retail banks have doubled over the past decade, while their combined branch footprint shrank by 15 percent over the same period. This reverse correlation is even sharper for the top five US banks—while reducing branches by 15 percent, they increased deposits by 2.6 times (Exhibit 1). While there have been previous periods of branch contraction, they were clearly tied to economic downturns; this most recent wave of retrenchment has persisted through a period of robust economic growth.

Retail-banking branch networks are contracting across Europe, North America, and the United Kingdom (Exhibit 2), although the pace of change varies considerably between regions. Those that are ahead of the curve have reduced branches by as much as 71 percent (Netherlands). Banks in North America and Southern Europe are reducing branches and growing digital sales at a more gradual rate.

The rate of branch reduction is often tied to customer willingness to purchase banking products online or on mobile devices. Eighty to 90 percent of banking customers in the Nordics, for example, are open to digital product purchases for most financial products, compared to 50 to 60 percent in North America and Southern Europe. While customer willingness to purchase products via digital channels varies, however, the common thread is that in all markets this readiness is far ahead of actual digital sales and will require banks to catch up to consumer needs and expectations. Within any specific market, of course, there are banks that have acted swiftly to adopt digital and remote as their main channel for interactions; these banks are pulling away from the pack and have taken decisive actions on several fronts:

  • Set a bold aspiration for sales/service channel mix. Banks must do more than react to shifts in consumer preferences—they need to set aspirational targets for sales and service across channels. Some customers will self-select into digital channels, but banks can do more to encourage less motivated customers to make the shift. Banks in markets like the Nordics and the United Kingdom have reduced the number of customers using branches by up to 60 percent by focusing on how to serve the heaviest branch users effectively through other channels.
  • Use advanced analytics to reshape the physical footprint. Optimizing the branch network requires a deep understanding of consumer preferences in every micromarket, and of the economics of making changes at the branch level. Leading institutions are using combinatorial optimization algorithms to optimize the net present value (NPV) of the network based on granular customer data on characteristics such as digital propensity, willingness to travel, needs based on transaction patterns and branch usage, and the size and space/format of branches.
  • Develop cutting-edge digital sales capabilities. Achieving meaningfully higher levels of digital sales requires sophisticated digital marketing and an understanding of how to optimize each stage of the funnel. Most consumers already seek information on financial products on digital channels, but few institutions are highly effective at converting these inquiries into digital sales. Leading banks use first- and third-party data (for example, geospatial, browsing behavior), a robust marketing technology stack (such as 360-degree view of customer, omnichannel campaigns), and an agile operating model (for example, cross-functional marketing war rooms). With these elements in place, progress can be rapid; a North American institution tripled annual online product sales in 12 months.

2. Customer experience is beginning to generate meaningful separation in growth

Across all retail businesses—including banks—customers now expect interactions to be simple, intuitive, and seamlessly connected across physical and digital touchpoints. Banks are investing in meeting these expectations but have struggled to keep pace. Many are hampered by legacy IT infrastructures and siloed data. As a result, few banks are true leaders in terms of customer experience. Even for institutions ahead of the curve, typically only one-half to two-thirds of customers rate their experience as excellent.

The impact of this less-than-stellar performance is measurable. For example, McKinsey analysis shows that in the United States, top-quartile banks in terms of experience have had meaningfully higher deposit growth over the past three years (Exhibit 3). The few “experience leaders” emerging in retail banking are generating higher growth than their peers by attracting new customers and deepening relationships with their existing customer base. Highly satisfied customers are two and a half times more likely to open new accounts/products with their existing bank than those who are merely satisfied.

These experience leaders are adopting tactics pioneered by digital-native companies in other sectors such as e-commerce, travel, and entertainment: setting a “North Star” based on proven markers of differentiated experience (for example, user-experience design, carrying context across channels), redesigning journeys that matter most for digital-first customers and not just digital-only customers, and establishing integrated real-time measurement that cuts across products, channels, and employees. These banks know that customer experience is not just about the front-end look and feel, but that it requires discipline, focus, and investment in the following actions:

  • Focus on the journeys and subjourneys that matter. The relative contribution of subjourneys (such as app downloading; activating account) in determining overall customer experience varies considerably. In fact, ten to 15 subjourneys have the biggest customer-satisfaction impact for most products and should thus be the first priority. For instance, when opening a new deposit account, the researching options subjourney has eight times the impact on customer satisfaction than other account-opening subjourneys, on average. For banks, the key is to prioritize these high-impact subjourneys and systematically redesign them from scratch—a process that can take about three to four months and result in at least a 15 to 20 percent lift in customer satisfaction.
  • Change the way you engage with customers. Experience leaders understand that digitization is not just about creating a cutting-edge online and mobile experience, and that satisfaction is shaped by customer experience across channels. The experience should be seamless, especially on journeys that are more likely to take place over multiple channels, such as new account opening, financial advice, or issue resolution. One wealth manager equipped its frontline relationship managers (RMs) with robo-advice algorithms that are in sync with what customers see on the self-directed channel—and provided the RMs with daily and weekly next-best-action recommendations to nudge their clients. Banks need to deploy these tools broadly and empower their frontline staff to play a more consultative role that blends human and digital recommendations. They will also need to revisit how these employees are incentivized, shifting to a longer-term view of relationships and profitability rather than just product sales.
  • Translate data into personalized products and real-time offers. The amount of data available on individual customers or prospects has exploded in recent years. The challenge is to convert these data into actionable nudges and highly relevant offers for customers that are delivered at the right moment. Credit-card companies have long offered discounts on specific spending categories or with specific retailers. Today, they can improve loyalty and share of spending by providing location-specific offers right when a customer enters a coffee shop, movie theater, or car dealership. South Africa’s Discovery, as an example, is launching a bank with product features that are informed by behavioral science and incentive-design research.

3. Productivity gains and returns to scale are back

Larger retail banks have historically been more efficient than their smaller competitors, benefiting from distribution network effects and shared overhead for IT, infrastructure, and other shared services. Our analysis of over 3,000 banks around the globe shows that while there is variation across countries, larger institutions tend to be more efficient both in terms of cost-to-asset and cost-to-income ratios. However, beyond a certain point, even larger institutions struggle to eke out efficiencies or realize benefits from scale.

We expect this paradigm to change over the next few years, as structural improvements in efficiency ratios and increasing returns to scale enable some large banks to become even more efficient. The reason is twofold: first, advances in technologies such as robotic-process automation, machine learning, and cognitive artificial intelligence—many of which are now mainstream and commercially viable—are unleashing a new wave of productivity improvements for financial institutions. Deployed effectively, these tools can reduce costs by as much as 30 to 40 percent in customer-facing, middle-, and back-office activities, and fundamentally change how work is done. Dramatic change has already taken place in banking sectors such as capital markets, where algorithmic trading and automation are radically changing the talent profile.

The second factor leading to a wave of productivity improvement in retail banking is the shift from physical to digital channels for customer acquisition. Banks with scale—and skills in leveraging that advantage—will achieve customer-acquisition costs of up to two to three times lower than their smaller peers. Their outsized volumes of customer data will lead to better targeting and funnel conversion. As investments shift toward digital channels, the productivity gap between large and small banks will widen.

This dynamic has played out in more digitally mature industries, with firms like Amazon and Priceline acquiring customers at a significantly lower cost than competitors. As in these industries, eventually a limited number of dominant firms will emerge, squeezing out undifferentiated midsize and smaller competitors. There are early signs of this trend: undifferentiated smaller community banks in the US have lost a significant share of deposits over the last two to three years, while the three largest banks have gained share. Of course, scale is not everything. Banks that succeed in this new wave of productivity will also have taken the following actions:

  • Use cutting-edge technology to automate. Over the next few years, banks will increase their use of technologies such as natural language processing and artificial intelligence to automate customer-facing interactions and complex internal tasks.
  • Build and reinforce the brand. With rising digital sales consumers have more choice than ever in selecting a financial-services provider. However, our research shows that across most categories, consumers actively consider only two to three products before deciding on a purchase. So it remains as important as ever for a bank to be part of the initial consideration set. Brands with superior awareness and recognition are not only more likely to be part of the initial consideration set but also achieve higher conversion rates than lesser-known brands when they are considered. A leading credit-card provider in the United Kingdom that invested heavily in brand awareness is now twice as likely to be actively considered—by 17 percent of consumers versus 7 to 10 percent for other brands—and experiences 50 percent higher conversion when considered compared to lesser-known brands.

4. The unbundling and ‘rebundling’ of retail banking

The tight one-on-one retail-banking relationships of old are unbundling. Forty percent of US households today hold a deposit account with more than one institution. It is common to have a mortgage with one bank, an unsecured loan with a different lender, and separate deposit and investment accounts. The banking relationship is fragmenting even faster in countries with higher digital adoption.

This decline of customer loyalty provides a perfect context for firms seeking to enter banking in a selective way—focusing on the most profitable segments. Some attackers have demonstrated that while they cannot compete with incumbent banks’ broad access to customer data, they can compete effectively on customer experience coupled with aggressive pricing.

New entrants in financial services typically begin by focusing on a niche—making either a product- or segment-focused play. Their ambition, however, is often to own the full banking relationship of this segment over time—providing cards, mortgage products, and broader banking services.

The Open Banking movement, heralded by Europe’s second Payments Service Directive and the United Kingdom’s Open Banking Standards, has the potential to accelerate the unbundling of banking in the regions where it applies, leading to increasingly intense competition over the next few years. The requirement for banks to share data and provide access to consumer and small-business accounts through a common framework of application programming interfaces is likely to fuel a wave of innovation and level the playing field for fintechs and technology providers seeking entry through payments or consumer financing.

The trend toward unbundling in financial services is well under way, but where it will lead is still an open question. In industries such as music, television, e-commerce, and transportation, digital distribution led to unbundling that destroyed value for incumbents in the short term; over time, consumers tend to converge on a single provider—often an attacker. In this context, firms that effectively orchestrate platform or ecosystem environments tend to eventually emerge as winners.

The history of the music industry over the last 20 years provides a possible model for how things will go in banking. Until the 1990s, music distribution was dominated by stores selling tracks that record companies “bundled” onto albums. In the early 2000s, digital distribution, especially via iTunes, radically reduced distribution costs. Consumers could now “unbundle” albums by purchasing individual tracks online; not surprisingly, many record stores went out of business. Over the past few years, however, we have seen a “rebundling” in the form of the streaming playlist. Streaming services are now the dominant distribution channel, with a few large players such as Spotify and Apple emerging as winners. The success of these platforms is based on their ability to create highly personalized bundles based on consumer needs and preferences, and a superior interface without the friction of purchasing tracks individually. Leaders have created significant value for consumers by using customer data and insights to deliver a superior experience, rather than by manufacturing the underlying product.

If we apply this scenario to banking, winning firms will be those that leverage superior access to customer data to provide truly differentiated and cutting-edge experiences—potentially extending beyond financial products and services. To do this effectively, banks will need to retain privileged access to information about consumers’ sources and use of funds, especially through payments and transaction activity. Banks that rebundle effectively will use this data to deliver compelling and integrated experiences that provide seamless funding, investment, payments, and money-movement capabilities. The bottom line is that in order to reverse the unbundling of financial services, banks need to make it worthwhile for consumers to have a relationship with one institution; they need to deliver not only simplicity and convenience, but also superior value. Only a few banks in each market are likely to be able to succeed with this strategy.

Already, large technology firms such as Amazon are extending into parts of the financial-services value chain, starting with areas where they have a data advantage such as payments, short-term financing for purchases, and working-capital loans for merchants on their platform. To counter the unbundling of their most profitable products, banks need to develop capabilities that few currently possess, and follow the lead of successful technology platforms:

  • Retain superior access to data on transactions and financial behavior. As vast amounts of data are captured by tech firms on consumers’ behavior and preferences, one of the last bastions of valuable information is data on transactions and financial behavior. To retain unparalleled access to this data, banks will need to continue to own the transaction layer, giving them a full view of inbound and outbound activity, to form a complete picture of consumer balance sheets. Historically, this required a bank to be a customer’s primary checking-account provider; over time, we expect that institutions could do this without necessarily owning the checking-account relationship. In some cases, payments or transaction providers could see a significant share of customers’ spend volume. Financial aggregators may also be in a position to capture a broad spectrum of customer activity and use it to build an analytics advantage.
  • Leverage insights to develop innovative products and features. The traditional suite of products that financial institutions offer has remained largely unchanged over the past few decades and is often structurally hard to change given how banks are organized. More nimble firms will be able to leverage insights to create unique offerings—for example, cash in a checking account could automatically be optimized for return based on financial behaviors and spend patterns without needing to ring-fence and transfer it to a separate high-yield deposit or brokerage account.
  • Extend beyond purely financial services and products over time. There are a couple of clear benefits that financial institutions are likely to have relative to ecosystems being created by large tech firms. Superior access to financial information enables them to create faster and more precise offers for big-ticket products that have financing needs associated with them (such as homes or cars). For these types of products, banks could be well positioned to own the full customer journey, including the browsing experience and the transaction. One Northern European bank has developed a mobile app that integrates house searches, booking viewings, budgeting, transactions, and help with setting up a new home (for example, utilities, appliances, and renovation).

Retail banking is at an inflection point, and we expect the pace of change to accelerate significantly over the next three to five years. Success will require clarity in direction, and speed and agility in execution. Retail banks that capitalize on current shifts in the market will emerge with a winning position in their core markets and begin to compete across borders.

This article is an edited extract from the full report, Rewriting the rules: Succeeding in the new retail banking landscape (PDF–680KB).

About the author(s)

Vaibhav Gujral is a partner in McKinsey’s New York office, where Nick Malik is a senior partner; Zubin Taraporevala is a senior partner in the London office.

The authors wish to thank Ashwin Adarkar, Jacob Dahl, Filippo Delzi, Miklos Dietz, Dave Elzinga, Darius Imregun, Somesh Khanna, Marc Levesque, Alejandro Martinez, and Robert Schiff for their contributions to this article.

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