The search for profitable customers

Knowing the customer has always been a truism for successful community banks. The banks profiled in Project Excellence, KPMG Peat Marwick's survey of top-performing community banks, found a balance between seat-of-the pants and fact-based marketing. Most used more than anecdotal information to understand and market to their customer requirements.

Some were using relational databases for target marketing, some were using publicly available data to segment their retail customer base, and some had very focused relationship marketing efforts to target small-business segments. But, while most were pursuing a relationship strategy, only a few were using customer segment and profitability information to focus their marketing efforts. To stay on or travel the road to top performance, we believe community banks will require a greater understanding of the customer segments within their markets, the needs of the segments they want to serve, and the nature of business and relationship profitability. This understanding should be an integral component of strategic planning, focused marketing, and performance-measurement efforts. We will take a look at how two banks, striving to become Project Excellence banks, have adopted aspects of segmentation and profitability analysis.

Bank A: Focused marketing and risk-based returns

Many of the community banks we work with have increased their assets through acquisition. The reasons for pursuing growth strategies varies from the keen sense that there are real opportunities when the large banks pull out of rural communities, to the determination to remain independent. Many also feel the need to achieve a certain amount of critical mass which they believe is necessary to compete in some business lines such as mortgage, indirect, or small business banking. Whatever the true or underlying reason, banks are seeing the need to use more sophisticated methods for assessing market potential.

One diversified southeast community bank (with a wholly owned mortgage bank) had embarked on an acquisition spree. If a potential location or branch was located along one of two major highways which defined their expansion market, and the price was right, they bought it. Their acquisitions were opportunistic, not reckless. Community bankers, like these, are closer to their markets and intuitively understand the trends in their communities. Their instincts are generally on the mark. However, this bank, like many others, had come to a juncture where their instincts needed to be augmented with solid analytical review of the options.

Their options were simple:

• Be a full-service community bank offering basically the same products in a similar fashion in all of their markets
• Focus on the same customer segments no matter where they lived;
• Develop products and services for those segments
• Tailor their focus to the unique characteristics of each market

They used a building-block process to evaluate their options--looking first at the general economic conditions and then refining their analysis with information about the customer base and their purchase habits. From a general economic perspective, they saw their markets as four distinct types, each with its own characteristics and growth potential.

They then took a closer look at both the customer segment characteristics and the relative profitability of each of the lines of business serving these communities. They didn't want to simply "offer the right products to the right customer." They wanted to develop profitable customer relationships in each of their markets.

About one-fourth of their markets are agricultural. While there may be manufacturing facilities to augment the agrarian base, most are remote plants for companies headquartered elsewhere. They are low-wage, low-skill jobs which are susceptible to closure (classic "stitch-and-sew" operations). The majority of the consumer base could be described as users of the most basic of financial products.

The MSA markets, on the other hand, have a population and economic base as would be expected for medium-sized metropolitan areas. They have a diverse economic base ranging from some of the most sophisticated investors to first-time bankers.

The striking difference between these two markets influenced their decision to tailor their products, services, and delivery channels to each market and not attempt to focus on a particular segment, nor attempt to be a full-service provider in every market. A preliminary segmentation scheme highlighted the different approaches.

EXHIBIT 1: Bank A's Segmentation Strategies
Strategies	Agricultural	MSA (urban)
Product Mix	Traditional consumer bank products	Broader range of products including investments
Delivery Channels	Market anchored with traditional branches Possibility of introducing telephone or home banking	Multiple alternative delivery channels such as: Traditional branches Supermarket branches ATMs Telebanking and home banking
Customer Service	Focus on efficient service delivery of basic products	Focus on relationship building

The other key decision was how to best leverage their most profitable product businesses. Here the bank combined its knowledge about business returns and markets. Essentially, three banking product businesses--construction, residential lending, and middle-market lending--were very strong performers with returns on equity above the bank's average and target returns. The bank will expand delivery capability for these businesses to develop stronger customer relationships in emerging markets and MSAs.

Bank B: The components of customer profitability

If there is a mantra for bank managers, it would be "profitability." Even the smallest community banks are looking at ways to understand organization (line of business), product, and customer profitability. Fortunately, some software vendors have developed or adapted their products for the community bank markets. One such system is being installed by a midwest community bank with assets just under $2 billion.

Typical of others its size, it operated as a series of independent banks. They opted to radically transform their organization from a cluster of community banks to a customer-driven line-of-business focus. This was not a minor undertaking. Their goal was to develop profitable customer relationships within their major lines of business which included commercial, retail, agriculture, trust, and others as defined by their senior management.

It soon became clear that understanding the underlying components of customer profitability was one part of the whole process. To effectively implement the shift to a customer focus meant changing the organization structure, aligning their performance management systems (particularly compensation and incentives) to the new strategy, and creating a sales-based, relationship-driven culture.

This transformation has been a series of decisions followed by an implementation plan for each phase. One of the earliest decisions was that their line of business profitability would be the sum of their customer relationships and products. This required identifying their top customers (their initial determination of "top customer" was anyone with a total relationship above a specific threshold level) and assigning a relationship manager to each.

To align the bank's reward system with its customer-relationship strategy, they developed a score card which explicitly links compensation to profitable customer relationships. Recognizing that long-term profitability is not only a function of today's contribution, but also selling the total mix of banking services and providing high-quality service, the bank's scorecard has three components--profitability, sales, and service.

Full implementation of the systems should be completed within the next few months, so the actual components of their most profitable customers has yet to be determined. What importance product choice, balance, and fees play will be revealed shortly.

When that is finished, they should have in place a new organization, performance management system, and clear profitability reporting by customer and line-of-business to solidify their strategy of becoming a preeminent relationship banker.

Parting shots

The old paradigm of banking was that 80% of the profits came from 20% of the customers. The reality is that for most, it is 130% of the profits coming from this magic 20%. Unprofitable customers erode the ultimate bank profits. Also, we all know that banking is becoming boundaryless. The mega players will be stepping up the ante in terms of targeting some of the community bank's more attractive customers, be they depository or lending, consumers or small businesses. In the future, community bankers will need to be more broadly informed. They'll need to know more about their customers, their relationship service needs, and their profitability to put "boundaries" around the most profitable relationships. The burning question is: "Shouldn't you know who these customers are?" After all, the Omega bank's player knows.

Ultimately, the goal of performance management systems is to ensure profitable growth coupled with top-quality customer service.

Perhaps a better way to put it is that the top-performing community banks balance intuitive knowledge with hard facts--the latest theories with practical solutions. They understand that while segmentation and profitability reporting are needed to better understand their customers and their financial needs, no customer will ever say that they are leaving because "your target marketing efforts were not sufficiently cross-selling those products which fit my current life event." But they will leave because your tellers were rude.