PERSONAL FINANCIAL SERVICES

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For many players, bigger prots hide weaker positions Who will be the discount stores, warehouse clubs, and category killers? Capturing 1,000 pieces of information per customer

Lenny Mendonca Gordon D. McCallum

prots at banks, brokers, insurers, and mutual fund sellers are in for a shock. Despite their outstanding performance, these institutions now face unprecedented challenges from a completely new breed of competitor, leaving them with the daunting task of having to remake themselves around the needs of customers. It will not be an easy process. Yet there are models for this remaking and they can be found in an industry that has recently sufered some of the same structural upheaval that nancial services is about to sufer: retailing.
HOSE REJOICING IN A DECADE OF RECORD

Take department stores in the late 1980s and 1990s. Ater long years of prosperity, these broad-line retailers, with high cost structures and little-to-no product diferentiation, were targeted by a series of focused competitors with bare bones cost structures, including warehouse clubs, category killers, and specialty chains. History was much kinder to those that anticipated this trend and adapted, improving the quality of their assortments while simultaneously driving down operating costs and improving asset eciency. Other illuminating examples of retail businesses transforming and reinventing themselves can be found in the gasoline industry and in discount store and fast food retailing. In the gasoline industry, the OPEC crisis forced major oil companies to rethink the conguration of their distribution networks gas stations. In general merchandise and grocery retailing, discount stores grew rapidly at the expense of competing formats by ofering wider assortments at lower prices in convenient suburban locations. In the fast food industry, leaders have had to develop new formats to reach customers in diferent places and on a range of occasions, in a market oversaturated with both competitors and outlets.
Lenny Mendonca is a principal and Gordon McCallum a consultant in McKinseys San Francisco oce. Copyright 1995 McKinsey & Company. All rights reserved.

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What has all this got to do with personal nancial services? For a start, traditional strategies stemming from geographic dominance, regulated prots, limited customer choice, and protection from competition must be jettisoned. Today, like retailers before them, personal nancial services (PFS) companies must begin to deliver distinctive products and services to well-dened sets of target customers, even if that means cannibalizing existing business. What is more, supporting these new oferings will require massive upgrades in infrastructure and skills. Like successful retailers, PFS companies must: Find the right number and type of diferentiated distribution formats, both physical (usually fewer) and electronic (usually more). Obsessively focus on costs and operational eciency and pass on as much of the savings as possible to consumers. Master information-based sales and marketing to pinpoint customer needs and purchase occasions. Launch loyalty programs to retain core customers. Merchandise creatively, whether products are branded, private label, or a mixture of both. Foster a company-wide culture that encourages entrepreneurialism, testing, and learning. Devise information and incentive systems that mirror the new competitive reality. This is all quite new and challenging to even the most sophisticated PFS companies. Perhaps it even seems a bit unnecessary in the light of rosy recent history.

Deceptive success
Over the past ve years, everything seems to have fallen into place for US PFS companies. Household assets have swelled from $8.5 trillion to $14.9 trillion, driven by real gains in household wealth, tax changes encouraging retirement saving, and a robust stock market. Mutual fund balances grew at nearly 14 percent per year on average, partly thanks to population growth of 1.7 percent, and partly because of the wealth of an aging population and the savings habits of the baby-boom generation. Albeit more slowly than assets, household liabilities grew as well, from $2.5 trillion to $4.1 trillion, primarily as a result of expansion in home mortgages prior to the 198990 recession. Household net nancial wealth rose from $6 trillion to $10.8 trillion, an average annual increase of just under 10 percent.

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At commercial banks, fees for deposit products grew by an average of 4.5 percent per year; even more signicantly, other fees, particularly mortgage renancing fees reported as part of noninterest income, rose by 7 percent annually. Spreads on credit products also escalated, with 7 percent annual increases for credit cards and 8 percent for unsecured personal loans. Loan loss provisions fell by 10 basis points, from 57 to 47. Over the same period, directly incurred operating expenses remained at. All told, prots in the PFS industry have leapt by 158 percent over the past ve years, from approximately $38 billion to $98 billion. And the future looks bright. The pie is getting bigger. According to recent research by the McKinsey Global Institute, US household net nancial wealth is likely to increase by $6 trillion, or approximately 50 percent, from 1990 to 2000 as the popuProts in the industry have leapt lation grows and ages, boosting the number from approximately $38 to $98 of net savers.* In addition, the baby-boomers are likely to continue to earn and save more than their parents. They will also inherit huge wealth as their parents generation passes on. At the corporate level, the melting away of the depression era regulatory system will permit industry participants to look outside their traditional business for growth. The picture is one of solid foundations and good cause for optimism or so it would appear.

billion over the past ve years. And the pie is getting bigger

Hidden trends
In fact, the recent boom in PFS prots is masking subtle but unmistakable negative trends in the industry. Strange though it may seem, during this period of record rises in earnings, many traditional players money center banks, super regionals, giant life and property insurers, old-line brokers have actually seen their competitive position decline. Yes, demand for PFS products (particularly in asset management) will probably continue growing as the population ages and the baby boom generations borrowing needs decline but spreads on many products have already started to narrow with rising interest rates. Yes, the industry has consolidated during the past ve years, apparently reinforcing the competitive advantage of big regional players and segment dominators but with the rolling-back of interstate banking regulation, the imminent repeal of other restrictions (perhaps including Glass-Steagall), and recent court decisions encouraging cross-segment competition, this advantage may prove illusory. Consolidation will continue until national
The Global Capital Market, McKinsey Global Institute, Washington, DC, November 1994.

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players emerge and new segments based on customer need and product economics replace the old segments banking, insurance, and so on that derive solely from regulation.

Cutting the PFS cake

Product profitability by customer segment, 1993

m ar ke t

Percent

US households 21 Profitability 8 24 33 35 42 25 12

Yes, total prots boomed Deposit Annuities/ Bank but this boom was actually products (25%) insurances (11%) cards* (10%) 11 6 driven by just a few custom25 10 26 32 37 30 17 ers and products (see the 35 36 exhibit). Wealthy and mass auent customers account 35 Mortgages Other credit for only 37 percent of the (20%) products (21%) Investment 4 7 population, but generate products (13%) 18 2 around 75 percent of prots 36 22 42 27 44 in deposits and investments, and 65 percent in insurance 36 32 30 * Includes only Visa and Mastercard and credit. Four main product Includes 1st mortgage, 2nd mortgage, and HELOC Includes auto loan, personal loan, LOC, margin account, and areas mortgages, savings, overdraft protection personal loans and credit, Source: PFS profitability model; PSI; McKinsey analysis and life insurance account for almost 65 percent of total industry protability. A number of companies focusing on these areas have recently emerged, notably Countrywide in mortgages, AT&T, GM, Ford, and many others in credit cards, and mutual fund companies such as Vanguard specializing in high-return moneymarket funds in deposits. Several more product-focused competitors targeting specic segments are likely to join the fray in the next few years. Five underlying trends will drive future prots in the PFS industry, all of them problematic for traditional providers: Intensifying competition. Recent and expected changes to the regulatory framework will continue to foster competition within and across traditional boundaries, beneting consumers but not necessarily providers. In particular, the advent of interstate banking and the sanctioning of acquisitions of (and joint ventures between) traditionally segmented providers like Nationsbank/Dean Witter and Mellon/Dreyfus suggest that competition between PFS providers can only grow ercer. Nonbanks will continue to cherry-pick attractive customer and product segments currently served by traditional providers unless these providers take decisive action. Primary targets will be branch-based and commissiondriven companies such as banks and life insurers, for whom a large percentage of revenue is absorbed by semi-xed costs.

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as sa ff W l ea uen lth t y
94 million $98.5 billion

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as

sm ar M

ke t

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Narrowing product spreads. Recent declines in credit and deposit product spreads are expected to persist as interest rates creep up and then stabilize. Slowing growth in fee increases. Fee increases have already begun to slow on deposit products, and are likely to stabilize or continue declining as more providers introduce no fee or reduced fee bundles of products in the attempt to capture a greater share of their customers wallets. Slowly declining operating expenses. Although product costs for time deposits, mortgages, and instalment loans have risen over the past year, noninterest expense is expected to fall, given providers focus on eciency and the growing use of more cost-efective distribution channels. A core issue will be the pace of capacity reduction as cost pressures persist. Most major product areas have excess distribution capacity that will limit future price increases. Uncertainty over credit and operating losses. The tight lending policies of the early 1990s brought about historically low loan loss provisions. Our base case assumes, perhaps optimistically, that providers will be able to maintain these levels, though admittedly the recent increase in lending may lead to higher provision in future. Given these trends, and despite increased demand for PFS products, prots overall are likely to stagnate or even decline. A base case, constructed using these assumptions, suggests that industry-wide prots are likely to remain at at approximately $98 billion through 1998. More pessimistic assumptions would indicate a decline in prots.

Beyond protability
The implications of these trends go beyond protability into the central value proposition of even the largest and most successful institutions. A core franchise will no longer revolve around the traditional qualities that once made a business successful. In retailing, owning the biggest store in the middle of town with the widest variety of products used to be a winning formula. Not Recent changes to the any more. In banking, serving a broad array regulatory framework will of customers with multiple transactions in a continue to foster competition, large branch now runs the same risk.

No mass

beneting consumers but not necessarily providers

The mass-market retail industry illustrates the danger of getting stuck in the middle. It has undergone radical change in recent years with the introduction of new formats by discount stores, warehouse clubs, and category killers such as Toys R Us, Circuit City, and

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Home Depot. Traditional formats neighborhood grocery stores, supermarkets, general stores, department stores, and hardware stores have been supplanted by new ones with superior economics ofering better value to the consumer. In discount stores, value has been redened as a broad range of items at low prices in easy-to-reach drive-by locations. Wal-Mart emphasizes these qualities not only in its advertising (Always the low price), but also in its store network strategy, efectively blanketing every market in which it operates with a In discount stores, value has series of stores sited conveniently at major been redened as a broad range road intersections. For warehouse clubs, value consists of ultralow prices on all the most popular items, supported by an exciting bare-bones sales environment that makes customers feel they are getting a good deal.

of items at low prices in easy-toreach drive-by locations

With the category killers, value translates into competitive prices on an unbeatable assortment of items in one well-dened category. Shoppers at Toys R Us know they will nd something for their child at a good price, just as shoppers at Home Depot can be sure they will nd what they need to improve their home. While some PFS providers are beginning to experiment with similar concepts, few have developed them far. The deep discount brokerage sector is a reasonable application of the warehouse club concept, but its product ofering is still far narrower than that of a mass market club. Similarly, Charles Schwab has adopted some of the principles of a category killer, with an increasingly broad range of products and convenient access via the telephone and PC. As in retail, when competition intensies and innovative new competitors carve of protable pieces of the business, traditional mainstream providers especially retail banks, life insurers, and securities companies need to develop defensive strategies as well as satisfying their customers at a lower cost. Though many PFS companies have made progress in capturing operational eciencies in the past decade, most are still burdened with costly retail branch networks or commissioned salesforces that absorb a large chunk of prots. Future eciency gains will quickly reach diminishing returns unless there is much more radical thinking on what it takes to acquire, service, and retain core customers. Retail banks need to conduct a deep investigation into the role of the branch as part of an integrated distribution network. Reecting changing

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consumer behavior, this network will be built around cheaper and more efective channels, including direct channels such as mail, telephone, and PC, and lower-cost physical outlets such as kiosks and ATMs. Life insurance companies with expensive dedicated salesforces will have to nd cheaper ways to distribute their products. This will involve making insurance products simpler to understand and sell, and probably improving the net returns of savings-linked products to investors, too. The success of GEICO and USAA in the United States and Direct Line in the United Kingdom in selling auto insurance over the phone demonstrates that creative approaches can and do work.

Retail formats: back to the drawing board

For mainstream PFS providers engaged in rening their core value proposition, a high priority will be to defend their existing position, most of all their expensive, underutilized, and largely undiferentiated distribution systems. Useful models for this transition can be found in gasoline and fast food retailing. Both have experienced upheavals as new formats redened the meaning of customer value.

Out of gas
Gasoline retailing represents an excellent example of an industry that has reinvented itself in the face of major structural change. The retail networks of the major oil companies in the 1960s were large and undiferentiated, ofering a standard format of full-service pumps and a repair/service bay. Margins were stable and unspectacular, with most of the prot generated in upstream production. The oil crisis of the early 1970s rendered this format uneconomic practically overnight. While demand remained constant, margins were squeezed as upstream value shited from the oil majors to OPEC. To make things worse, greater mechanical sophistication and reliability and extended car warranties transferred a large part of the highly protable repair With the category killers, value business from neighborhood garages to means competitive prices on an dealers and specialists. These developments, coupled with changes in regulation permitting self-service pumps, were responsible for the transformation of gas station formats. In 1975, approximately two-thirds of all gas stations were conventional bay stations and one-third were self-service. By the early 1990s, this mix had reversed, with traditional bay stations accounting for less than one-third, and selfservice stations for more than two-thirds, of all gas stations. Reecting this

unbeatable assortment of items in one well-dened category

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change, sales of self-service gasoline quadrupled from 22 percent of the market in 1975 to 86 percent in 1992. While self-service stations are more economical than full-service, it was the realization that gas stations were convenient places for busy people to stop that really boosted the protability of the business. An average gas station could augment its operating cash ow by 50 percent by adding a convenience store, and Few consumers nd using banks even more by adding a car wash as well. By a pleasant experience. This the mid-1980s, one companys other lines attitude must change if banks produced three times more prot per station are to grasp the opportunities than gasoline products. Not surprisingly, stations with convenience stores grew by more than 12 percent between 1983 and 1992. In the past ve years, the rate has been even higher, with Shell, for example, growing by over 45 percent between 1988 and 1992. These changes have created overcapacity in the convenience store market, with dire consequences for the two largest US chains, 7Eleven and Circle K, which both declared Chapter 11 bankruptcy in 199091. Falling sales per square foot mean that the gasoline industry is again experimenting with new formats, fast food in particular. Tests for one major operator indicate that the return on capital for a gas station with fast food could be as much as double that of a convenience store equivalent. The parallels with retail banking are evident. By virtue of their age, many major banks enjoy convenient locations in downtown or suburban areas. Such branches are oten massively underutilized thanks to stang plans developed to improve eciency. Finding protable alternative uses for this freed-up space represents a signicant opportunity. Unfortunately, few consumers nd using banks a pleasant experience. This attitude will need to be changed if bank users are to purchase other products during their visit.

Faster food
Almost all segments of the PFS market are crowded with well-known competitors. Cutting through the clutter to reach consumers will be increasingly challenging. Faced with similar market saturation, fast food retailers have been innovative in expanding the reach of their networks to acquire new customers and capture more of existing customers spending. They have succeeded by developing formats beyond the traditional roadside drive-in restaurants to cater more conveniently for diferent eating occasions. Pizza Hut now ofers small quick-service kiosks at airports, serving mini pizzas to passengers waiting for their planes to depart. It also runs concessions at schools and has started to make home deliveries from special

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kitchens that also accept orders to-go but have no eat-in facilities. For those who want a more leisurely meal out, there are still traditional Pizza Hut restaurants with all the usual facilities. Taco Bell, meanwhile, has developed a special format tailored to patrons in inner-city locations, particularly downtown oce districts where there is heavy trac for a few hours every day. These outlets are much smaller than a typical Taco Bell restaurant, reecting the higher rents of downtown sites and the peaks and troughs in customer demand. They also ofer a menu adapted to the oce-based to-go market. Like successful retailers, PFS companies will have to nd new ways of distributing their products. There has already been dramatic growth in alternative channels with vastly superior economics. It is roughly 40 to 50 percent cheaper to process a cash withdrawal at an ATM than at a branch teller window, up to 90 percent cheaper to deal with an electronic payment, and 70 percent cheaper to employ an automated telephone response unit (ARU). Few providers have yet developed a signicant sales capability through these channels, especially for complex products, but things are likely to change rapidly in the next decade with growing acceptance of electronic and remote channels among younger consumers. National Commerce Bancorp and Huntington Bank have already transformed their traditional networks. NCB relies heavily on supermarketbased branches. More convenient for many customers, they are cheaper to operate and ofer an opportunity to reach customers of other banks who might never walk in to a conventional NCB branch. Huntington Bank has been experimenting with video kiosks. Though the results are not yet clear, the concept of a cheap front-end service and sales outlet with access on demand to specialized product expertise is certainly compelling.

PFS companies will have to nd alternative electronic and remote channels with vastly superior economics

Better operations
One of the most powerful lessons learned by retailers in the past ten years has been the importance of world-class operations. This is particularly true in merchandise logistics the process of forecasting customer demand and getting the right product to the right store at the right time. Wal-Mart and The Gap have both made merchandise logistics a fundamental part of their winning strategy. Wal-Mart has a cost structure roughly half that of a typical department store, thanks to its use of geographical scale to maximize throughput at each

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distribution center, its rigorous supplier rules demanding that delivery trucks arrive within 15-minute slots or sufer several hours wait, and its thoughtful partnerships with major suppliers such as Procter & Gamble. This company now has a shadow account team based permanently at or near Wal-Marts premises working to optimize the ow of P&G products through the retailers 2,000 stores. The Gap has tailored its strategy to support the core value proposition of distributing fashionable clothing on a six- to eight-week cycle. A large part of each cycle is initially distributed to stores on the basis of past sales, while a smaller Though it might be obvious portion is held back and then pulled to to front-line employees, the stores according to customer demand. This importance of low-cost, quick system means there is rarely too much service is underestimated by unsold inventory at any one location. Once many senior executives in the store, merchandise that fails to sell as well as expected is ruthlessly marked down week by week in line with predetermined sell-through guidelines, ensuring that oor space is available for the next fashion cycle. Increasingly in retailing, a world-class logistics capability is necessary merely to open the doors. Similarly in PFS, particularly in transaction-intensive areas like deposits, loans, and many personal insurance lines, a low-cost, accurate operating capability is a ticket to play. Since 90 percent or more of all consumer interactions with branches (and more than 75 percent of operating costs) are to do with service, ecient delivery is essential. Though it might be obvious to front-line employees, the importance of low-cost, quick service is underestimated by many senior executives.

Using information
PFS companies have a real opportunity to build on their experience and use the information they possess to strengthen their relationship with customers. Banks, in particular, hold vast amounts of detail about their customers lives: what ATMs they use, what they spend, and where they spend it, month ater month, year ater year. This valuable information is sitting on computer les, waiting to be mined. By capturing and manipulating information on behavior, it is now possible to target customers needs much more accurately to achieve better penetration, deeper loyalty, and reduced cost. The leading direct marketing and publishing companies provide good examples. One catalog businesss response rates are usually two to three times higher for targeted customers than for untargeted mailings. Moreover, retaining existing customers costs only about one-th as much as acquiring new ones, making it much more protable to sell to this group.

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The top companies in this eld have evolved sophisticated business processes that allow them to respond rapidly to and ultimately predict customer needs. Central to their success is the ability to design campaigns to achieve specic nancial objectives, identify the customers most likely to respond, measure efectiveness, react to customer response by adapting elements of the campaign, and nally capture these results in a dynamic knowledge base. The plunging cost of data storage and manipulation has fostered the development of these capabilities. One direct mail company captures over a thousand separate pieces of data on each customer, ranging from behavioral characteristics (such as categories of clothing purchased and preferred price points) to personal details (lifestyle preferences, family members, and key purchase events like birthdays) and nancial status (payment prole and credit score). This information can be rapidly sorted and prioritized for targeted promotion to customer segments with high potential, allowing the retailer to determine what kinds of catalog to mail how oten. Oferings and credit extensions are constantly adjusted in line with response rates; the best customers receive up to 120 mailings a year. To achieve all this, the company operates three mainframe computers with over 4,000 terminals, and has spent over $250 million on information systems in the past ve years. Such information strategies are generally used to give structure to multiple channels of distribution. Williams-Sonoma and Charles Schwab have combined a selling strategy based on information (via catalogs and telephones/PCs respectively) with a limited number of stores strategically located in the busy downtown districts of major cities. While it is hard to judge just how efective this strategy is, the physical outlets clearly play an important Banks hold vast amounts of role in building brand awareness and detail about their customers encouraging trial, as well as in feeding new lives. This valuable information business into the direct channels. Williams-Sonoma supplemented its original mail-order business with over 200 stores in busy downtown and shopping mall locations. It sought to improve sales by reaching customers who do not purchase goods by post to build an attractive prospecting list for future mail-order business, and to provide a venue for selling more complicated products that need explanation or demonstration. Over 60 percent of total sales now come from these stores.

is sitting on computer les, waiting to be mined

With fewer than 300 branches, Schwab has a national presence and is readily accessible to some 80 percent of the US population. Coupled with heavy print and broadcast advertising, this has won it strong consumer

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awareness in ten to teen years. The companys growth, both in number of customers and assets held, has been impressive.

Looking for loyalty

As industries become more customer focused, they quickly learn that keeping their customers is a great source of prot. Loyalty programs that reward customers for their support have consequently boomed in the past decade, though their success in generating incremental revenue has been mixed. Efective programs share several common characteristics: clear and focused objectives, a sustainable reward scheme that ofers the customer perceived value, an extensive management structure to support and rene the program, and sophisticated information systems to monitor and measure performance. The Neiman-Marcus frequent shopper program, the anity credit cards ofered by companies like General Motors, Ford, and Shell, and some of the better-managed frequent yer programs, such as United Airlines, are examples of successful programs. All these companies recognize that the heavy initial expense of acquiring a new customer makes it vital to maintain customer relationships as long as possible; indeed, excellent marketers view protability on a lifetime basis. Leading loyalty programs ofer at least two tiers of awards, reecting the relative attractiveness of high-value and average customers. NeimanMarcus, for example, ofers In Circle for its top-spending customers and NM Plus for a broader customer group. In Circle has an extravagant seven-tier git The heavy initial expense of structure, ranging from regular mailings of acquiring a new customer makes chocolates to customers who spend over it vital to maintain customer $3,000 per year, to complimentary (and relationships as long as possible oten unusual) international excursions for those spending over $250,000. Customers are ofered special services such as private shopping nights, free git wrapping, and special occasion reminders. The NM Plus program, meanwhile, charges an annual $50 fee (refunded if a customer reaches In Circle status) and ofers a more limited array of git certicates, discounts, and promotional items. In the PFS world, General Motors has adopted a similar approach. Its credit card is a cleverly conceived anity program designed not only to build brand equity and boost car purchases, but also and perhaps more importantly to capture a rich demographic and behavioral prole of existing and potential customers. This information enables GM to understand customer needs in much more detail than ever before and to tailor promotions to diferent customer segments. The costs of the program,

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in the form of rebates and operating expenses, are far outweighed by prots generated both by the card itself and ultimately by car sales. Another important element in successful programs is their extensive use of cross-marketing to maximize brand reach. Several leading consumer brands are currently collaborating in an attempt to capture a dominant share of the purchases made by their most protable customers. This approach is most evident in Given the undiferentiated the travel industry, where airlines, car rental service and low switching costs companies, and hotels are closely aligned in retail banking, loyalty with one another. Given the small perceived programs can be key in longdiferences in this industrys service oferterm customer retention ings and the low switching costs for most regular business travelers, loyalty programs can be key in long-term customer retention. There are clear parallels in retail banking, where churn rates in the consumer checking business remain high because of undiferentiated service and low switching costs. The best anity programs are supported by sophisticated information systems capable of performing several functions simultaneously: capturing POS transaction data, tracking points earned, issuing cards and awards, and handling customer queries and complaints. Programs also provide managers with a rich information base to help them direct and develop their business. Zeller, the Canadian retail chain, uses demographic information from its Club Z applications, nancial data from credit applications, and customer purchase behavior from specic transactions to shape its product assortments and promotional programs. The economics of anity programs need careful modeling. One European airline that was considering introducing a new frequent yer program took nearly a year to research the key design elements. Not only was it concerned with the programs mechanics and operating costs, but it also wanted to ofer something core customers would value, without it incurring huge liabilities for the future. It was also keen to avoid a situation where it surrendered potential revenue without achieving any noticeable increase in passenger trac because its program was matched by competitors, resulting in little diferentiation and questionable protability.

To brand or not to brand?

Which parts of the value chain to emphasize and develop and which to subcontract is still understood better by retailers than by the PFS industry. Issues include the merchandise mix, the balance between branded and private label goods, and the relative emphasis placed on manufacturing and distribution. These issues are likely to come to the fore as leading PFS

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providers develop strategies that leverage their scale or skills. To date, most have created brands via integrated in-house networks combining manufacturing and distribution. Such an approach is rare in retail, where only a handful of companies manufacture and sell their own brand exclusively. Even companies, such as The Gap and the UKs Marks and Spencer, that ofer what appears to be 100 percent Investment houses may question private label merchandise, rely on a large the merit of servicing their own number of external suppliers to help in accounts if specialist rms are designing and manufacturing to their needs. able to do it more cheaply Instead, the retail industry has disaggregated around entities that bring to bear specic expertise: designers provide creativity, manufacturers focus on driving down costs (which is why many apparel factories are based in Asia) and increasing exibility to reduce lead times, and distributors emphasize store siting, logistics, and in-store service. As the PFS industry evolves, it is likely to disaggregate in a similar fashion. In the mutual fund industry, Schwabs One Source and Fidelitys Funds Network have provided some smaller fund management businesses with heavyweight marketing and distribution muscle at relatively low cost, freeing them to focus on their own expertise in stock picking. This approach has also arrived in the stock research industry, where smaller brokers can buy the research of the top Wall Street rms. It is occurring in credit cards, too, with several specialist rms now handling such functions as payment processing and merchant card acquisition. This trend is likely to spread still further. Retail banks will have to reexamine the value of developing their own investment capability to manage in-house mutual funds, and securities and investment houses may question the merit of servicing their own transaction accounts if specialist rms are able to do it more cheaply.

Test, test, test . . .

Few PFS companies today know the real economic returns on their products, or the value added in distribution, or the attractiveness of their products compared with those of competitors. In other industries, the best way to develop a feel for these critical measures is through limited experimental rollouts of new products and services in new channels. This is a vital skill that PFS companies will have to master. The notion popular with retail companies of piloting and testing actually originated in the packaged goods industry. Its benets are

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manifold. Retailers can compress product development and manufacturing cycles, allowing them to prot from fashion trends by getting merchandise into the shops faster, and minimizing the risks associated with betting several months in advance on what will sell. The principle of responsive development and distribution in PFS will grow in importance. In an industry where virtually any product can be copied in a matter of weeks, companies with the ability to test and roll out new product ideas more rapidly than their rivals will maintain a competitive edge. Companies that have created competitive advantage in this way include the apparel chain The Limited and a leading European fashion shoe company. The latter has, like competitors, shited much of its production capacity to Asia, but it has also retained several factories in Europe. Popular items in danger of selling out can be reordered from a local factory for fast delivery, giving the company much greater exibility. The Limited has now cut the time between order and delivery to the point where it is able to design merchandise and distribute test quantities to certain bell-wether stores before deciding what styles to emphasize and what quantities to order. The delay between order placement and delivery has been reduced to between 35 and 55 days, compared with more than 120 for many competitors.

Manage what gets measured

All these steps would be only partly efective without adequate management reporting and incentive systems. The key is to focus on the few measures that really determine success. While these difer from business to business, they should be easy to measure, transparent to managers, and clearly linked to the overall performance of the business and to management compensation. This again is a radical departure for most PFS companies, which have historically focused on such eciency measures as cost to income ratio and transactions per employee. These measures are no longer sucient to identify and Cost to income ratio and evaluate the full range of value creation transactions per employee are no opportunities. As PFS companies experilonger sucient to identify and ment with new formats, develop new sales evaluate opportunities and marketing programs, and roll out new products, a new set of measures will be needed for assessing performance, including sales per square foot, gross product margin, service productivity, customer lifetime value, share of wallet, customer satisfaction, employee retention, defection rates, new product time to market, and sales closure rates. Rarely captured

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systematically by PFS companies today, such data will be crucial to managers operating in the more competitive environment of the future. PFS companies should also make links between measures transparent. Systems should be exible enough to report key measures by product, channel, geography, or customer type, and permit managers quickly to obtain detailed As elsewhere, PFS companies information underlying each key measure. must look outside their industry If a banks sales of Certicates of Deposit for performance benchmarks suddenly increase, for example, a manager should be able to discover whether this growth is due to competitive changes in a local market or to an efective marketing campaign launched by one of the banks distribution channels. An efective measurement system should also be a timely one. Current information is critical to spotting and reversing negative trends and capitalizing on positive developments. Frequently updated information is also an important motivational tool. Last months sales data will do little to drive salesforce behavior; it is already old news. As elsewhere, PFS companies must look outside their industry for performance benchmarks. A direct marketing company may yield the best benchmarks for telemarketing eforts, for example, while sotware companies may supply useful comparisons regarding new product time to market. Benchmarks are essential in developing new measurement and incentive systems. They can also help in setting high aspirations and nding opportunities for improvement. Leading PFS companies are beginning to recognize the challenge they face. If just the ten largest commercial banks were to increase their PFS prots by 15 percent annually over the next ve years, the pretax prot creation required would amount to over $10 billion. This sum is more than double the prots of Merrill Lynch, American Express, and Schwab combined. In an increasingly dicult environment, to win will require new competitive strategies and in an industry with $100 billion in prots, the stakes are huge. The race is on to see who will become the discount store, warehouse club, and category killer of personal nancial services.

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CAN RETAIL BANKS LEARN FROM EACH OTHER? Financial services providers must take better advantage of price elasticities in various segments than they have in the past. Hardly any bank in the world today could claim to be excellent in pricing. Given its impact on prots, the importance of improving pricing cannot be overemphasized. Our analysis of best practice clearly showed that high protability was connected in most countries and most banks with high pricing
Reinhold Leichtfuss and Frank Mattern The McKinsey Quarterly, 1995 Number 1