Client Centricity E-Book

Jan U. Hagen

• Herausgeber: Murmann Publishers
• Kategorie: Geisteswissenschaft
• Sprache: Englisch
• Veröffentlichungsjahr: 2015

Seitenzahl: 364

Beschreibung

The financial market crisis has brought the very business models of many banks into question. What lessons should banks take from these events? What consequences will the industry have to face when dealing with clients? These questions are at the center of this book, with contributions from renowned experts and examples from theory and practice. Client commitment – the pursuit of pure customer focus – has become a success factor in many areas of the banking industry. This book sheds light on the theoretical aspects of client commitment and shows how its various facets are being put into practice.

Leseprobe

Jan U. HagenUlrich Schürenkrämer

Client Centricity

Foreword

Since the financial crisis, the role of banks has increasingly been called into question by the general public, and there have been doubts as to banks’ benefits to the real economy. The financial industry must take a proactive and constructive approach to this debate. After all, it cannot sustainably prosper while operating in a parallel world. Even more than industrial companies, banks depend on the trust of the societies they operate in.

In this light, the book’s authors make a very useful and welcome contribution to this debate. In a variety of articles, they clearly demonstrate that financial institutions must build their business around their clients, placing them at the center of what they do, whether in retail and commercial banking, wealth management or investment banking. They show that assessing, assuming, and diversifying risks are central to modern banking and that this is how financial institutions serve the real economy and create value.

Now is the right time to emphasize the importance of a client-centric approach. And this is the reason why the book should attract the widest possible attention and readership – not only in the financial sector, but also far beyond.

Frankfurt am Main, December 2014

Jürgen Fitschen

Introduction

The idea for Client Centricity emerged from our participation in the conception and implementation of an executive education program by ESMT European School of Management and Technology. Focusing on relationship managers in classic corporate banking for Deutsche Bank AG, the program encourages them to adopt a new mindset for embracing long-lasting customer relationships based on true partnership rather than specific products.

While defining and discussing the content of the program, we noted the lack of any comprehensive study examining customer relationships in the banking sector. As a result, we decided to compile some of the core program content and create a book providing an overview of fundamental aspects of the customer relationship. A crucial element of the program was shared experiences between managers from banks and medium-sized enterprises; therefore, it made sense to maintain this format in the book. Consequently, the authors featured in this book are all experts from the banking and academic sectors.

The articles in the first part of the book concentrate on theoretical aspects of the customer relationship. The relationship between advisor and customer is analyzed from a psychological perspective. A further article examines factors that limit the extent to which we can measure the success of customer loyalty activities. The significance of client business for long-term success in the banking sector is also highlighted in the context of risk factors. The theoretical section starts with an analysis of the strategic components of customer orientation.

The second part of the book focuses on putting customer orientation into practice. Numerous examples from various areas of banking reveal opportunities to build up a sustainable trusted partnership.

The focus here is on strategy, structure, and systems that consolidate customer loyalty across all sections of the business. Deutsche Bank is presented as an example of this. Features include an analysis of relationship management in corporate banking, an outline of how a relationship manager can develop into a client advisor, and how the quality of the relationship is a relevant aspect of management in corporate banking. In addition, we take a closer look at the success factors in retail banking. With the aid of several practical examples we explore the importance of emotional intelligence when dealing with customers. Lastly, we take a look at a special segment of the banking market, that is, microfinance.

Our thanks go first and foremost to the authors, who were prepared to share their extensive knowledge in this book. We must also thank numerous members of staff from ESMT and Deutsche Bank AG: Angelique Esnault for coordinating the project; Benjamin Didszuweit, who provided valuable encouragement particularly in the early stages of the project; and Andreas Schellenberg, Michael Kühn, and Rayk Heidamke, who each played a crucial role in shaping the ESMT program Certified Client Advisor.

Berlin and Munich, December 2014

Jan U. Hagen

Ulrich Schürenkrämer

Strategic Customer Orientation Martin Kupp

Many banks are trying to intensify their focus on the customer. They are keen to find out as directly as possible from customers how they can improve their products and services and gain their customers’ trust. Whether Deutsche Bank, Commerzbank, or HypoVereinsbank, banks are making an effort to integrate customers early on in the product development process, get to know them better, and find out what they expect of bank products and services.

In response, Commerzbank set up a 40-member-strong Customer Advisory Council in 2009, elected for three years. It is the job of this council to integrate customers’ ideas and suggestions into the services offered by Commerzbank. This move generated a good response, with around 5,400 customers applying to be on the council in 2008. The council members report that their suggestions for possible new products or ways to resolve existing problems are very much welcomed. The Customer Advisory Council consists of private and business customers. The members were selected to ensure that the council represents a range of ages, professions, and regions.

However, customer councils are by no means a new idea in banks or, indeed, commercial and service companies. Deutsche Bahn, the supermarket chain Penny, and the airport operator Fraport all have such councils. For around 20 years, Volksbank Freiburg has been using customer councils for market research and gathering feedback about new products and services. Postbank set up its customer council “60plus” back in 2005 to give greater weight to the needs of older customers. In addition, the Easy Credit customer council was launched at the end of July to make consumer credit even more user-friendly for customers.

Before any targeted discussion on strategic customer orientation, we must first clarify what we understand by customer orientation, what it is to achieve, and which operative and strategic measures can be used to encourage it.

Mechanisms of customer orientation

Companies can apply measures for boosting customer orientation to try and achieve a whole range of goals. Put into rough categories, we can identify three separate areas associated with this:

• Developing new products and services that are relevant to customers.• Increasing resale rates and stabilizing and expanding business with existing customers.• Driving internal change in which customer requirements play a greater role in shaping corporate culture.

This all revolves around the idea that increased customer orientation can also increase customer satisfaction and loyalty. Since the mid-1990s, numerous analyses, including those by Manfred Bruhn, University of Basel, and Christian Homburg, University of Mannheim, have shown that customer satisfaction and loyalty play a central role in a company’s success. At the heart of these studies lies the confirmation/disconfirmation paradigm (C/D), which states that customer satisfaction results from a comparison between the actual experience of using a service and a specific standard. If the service meets expectations, we talk about confirmation. If the service exceeds expectations, the customer experiences positive disconfirmation and his satisfaction levels are higher than with confirmation. If the service does not meet expectations, however, we talk about negative disconfirmation, which goes hand in hand with lower levels of satisfaction. It is important to note here that the comparison is based on the customer’s perception of the service, not on an objective assessment. This can cover various dimensions of the product or service, such as functionality, form, services accompanying a product, interaction between customer and provider, delivery process, or direct customer contact during the purchasing process.

While customer satisfaction puts a bank on the road toward profitability, it is not enough in itself. Customer satisfaction is simply an appropriate means of increasing customer loyalty and influencing customers’ price behavior. It has a positive effect on customer loyalty, which is then reflected in repurchases, additional purchases, and positive word-of-mouth advertising.

There are three main ways to explain the loyalty of satisfied customers:

• Satisfied customers remain loyal to their provider because this minimizes the risk of receiving poorer products or services from a different provider.• In addition, satisfied buyers tend to make repurchases because this allows them to validate their own behavior and thus avoid any potential dissonance involved in buying from other providers.• Last, but not least, satisfied customers are more loyal because customers interpret their own satisfaction as a reward for their choice of provider and are keen to maximize these rewards.

While we can assume a fundamentally positive correlation between customer satisfaction and customer loyalty, there is also evidence that the effect satisfaction has on loyalty varies with different customers, products, and markets. There are certain products and customer segments where we can see a progressive relationship between customer satisfaction and customer loyalty. This is often true of products with a high level of customer participation. For example, we can assume that additional services offered in the private wealth management sector lead to greater customer satisfaction and also greater customer loyalty.

Figure 1: Relationship between customer satisfaction and customer loyalty (Source: based on Homburg/Giering/Hentschel 1999, p. 185)

Figure 2: Relationship between customer satisfaction and customer loyalty (Source: based on Homburg/Giering/Hentschel 1999, p. 185)

With other products (often commodities, or products that can be compared easily), there is a zone of indifference within which an increase in customer satisfaction has no – or only very little effect – on customer loyalty. It has been shown that additional services, such as discounts when paying for gas with a debit card issued by a specific provider, do increase customer satisfaction. Yet they actually have very little influence on customer loyalty. Outside this zone of indifference, customers react more strongly to efforts to increase customer satisfaction. In this situation, we talk about a saddle-type curve between customer satisfaction and customer loyalty. Figures 1 and 2 show examples of these two relationships between customer satisfaction and customer loyalty.

Customer orientation in developing new products and services

For some years now there have been claims that companies should orient their innovations more strongly to customers. In 2002, the INSEAD business school in France evaluated 100 new product innovations from 30 international companies. Three types of innovation were identified:

• The first were straightforward copies (me-too product);• The second involved only marginal improvements to the existing product;• The third featured a real innovation that significantly increased the value of the item for customers.

While 86 percent of the innovations fell into the “me too” and “marginal improvement” categories, the “real innovations” generated 38 percent of the additional sales achieved and as much as 61 percent of the profits gained from all innovations. These innovations stood out due to their high degree of customer participation. They were able to pick up on real or latent customer needs and transform these into new products and services. The important thing here is to identify customer needs and communicate these within the company.

One company that is regarded as highly innovative because of its focus on customer orientation is 3M. Founded in 1902 in Two Harbors on Lake Superior as the Minnesota Mining & Manufacturing Company (3M), it initially focused on manufacturing sandpaper. After a fairly modest start, the company underwent rapid growth thanks to two customer oriented innovations for the automotive industry – waterproof sandpaper (1921) and masking tape (1925). Following the Second World War, 3M opened a series of production facilities in the U.S. before expanding into Canada, Mexico, France, Germany, Australia, and the U.K. in the 1950s. In 1951, the American Institute of Management named 3M “one of the five best-managed companies in the United States.” Nowadays, the company employs more than 7,000 technicians and engineers worldwide, working on 45 different basic technologies for six business sectors. 3M holds over 25,000 patents. Over 30 percent of its global sales come from products developed in the last four years.

In a bid to create new products based on customer requirements, the research and development department of 3M focuses on customer needs instead of working mainly on research into new materials, technologies, or processes. The company systematically identifies and utilizes lead users in its development of “breakthrough” innovations. Lead users are those individuals whose needs exceed the requirements of the mass market. These users expect an innovative solution to deliver particularly high benefits, no matter what form these come in. They also tend to be discerning potential purchasers interested in the technical aspects of the solution. 3M worked closely with the Massachusetts Institute of Technology (MIT) to develop a process in which teams consisting of four to six members of a company’s research and development, production, and marketing departments worked on such innovations.

The team members began by identifying important trends in their market, then used these to derive potential new markets and, finally, the associated innovations. For example, a team representing an automotive supplier might be tasked with developing a new braking system for passenger cars. They would start off by identifying technological trends for brakes and thinking about potential technical solutions.

In the next step, they would broaden their focus and speak with external experts to complement the knowledge already present within the company with additional sources.

This information forms the basis for the third step – identifying the lead users. When identifying this group, it is important for the team to look beyond its own sector, preferably using experts from their own industry as intermediaries. Discussions with car brake experts could, for example, reveal that other sectors, such as the truck and aviation industry or the military, are also examining the subject of rapid braking. As the demands made on brakes in these sectors will be disproportionately higher than for cars, we can assume this might throw up some interesting proposals for solutions.

The fourth and final step involves developing market-ready concepts. At 3M, this usually starts with a two- or three-day workshop that brings together the lead user team from the company’s own industry, industry experts, and lead users from other sectors. The aim is to filter out and refine three or four of the many options available, choosing ones that, based on the company’s own challenges, promise a high level of customer acceptance at a reasonable cost.

At 3M, the company’s own experts and its customers thus serve as the starting point for identifying lead users who will help to develop innovative products. This concept has become so successful that 3M has now set up a Lead User Process Center of Excellence that shares knowledge about the process with all units.

Another example of new products and services designed to fulfill customers’ wishes is Q110, Deutsche Bank’s “branch of the future” in Berlin. Since opening in September 2005, Q110 has attracted more than one million customers and visitors. The branch is a sort of central laboratory for innovations. It is a place for testing innovations for products, processes, technologies, or marketing strategies. The tests take place in a controlled environment so that customers’ reactions can be observed and evaluated, and products can be developed and adapted. The customer lies at the heart of this laboratory of innovations; ideas that are tested successfully here can then be implemented in over 1,000 other branches.

One such innovation is the new “VorsorgeApp” pension app for the iPad, which is used in customer consultations. Customer information is entered directly while the customer is present. This is then used to calculate the customer’s own personal pension needs. This process raises awareness of any potential gaps in pension provision and can open the door to further consultation.

“Digital signage” is another innovation being tested in the Q110 branch. Customers use this “interactive shop window” to source their own information using a labeling system for Deutsche Bank’s investment products, for example. Seven simple symbols provide clear guidance for customers on the risk and investment grade of a specific product. Customers can navigate their own way through the app. Integrating smartphones allows customers to transfer the selected information to mobile end devices.

The innovations in Q110 also include specially developed applications for the Microsoft Surface presentation medium. With these applications, financial topics can be presented concisely and managed intuitively in customer consultations. Customers also have access to the new “Mein Zukunftsplaner” application, a planner that helps them visualize their hopes for the future, such as acquiring real estate, and develop an implementation timeline for these plans. At the same time, customers are given information about the financial implications their decisions could have on the potential time of implementation or interest rates, for example. At Q110, the main aim is to start talking with customers. Because this is one way to reveal customers’ existing and latent needs and ultimately transform these into customer-oriented products and services.

Increasing the repurchasing rate is a further element of customer orientation. The aim here is to increase customer satisfaction and loyalty to consolidate internal customer orientation.

Fashion label Zara is one company that is well ahead of the game in this respect. The first Zara shop opened in 1975 in La Coruña, northwestern Spain. By the end of 2010, there were over 1,400 branches in 77 countries with total sales of more than 6 billion euros.

All the branches worldwide have a similar design, with large sales floors, a predominately white color scheme, excellent lighting, and plenty of mirrors on the walls. While competitors like Gap, Benetton, or H&M spend an average of 3 to 4 percent of their sales on advertising, Zara spends just 0.3 percent. Instead, Zara invests in dressing its shop windows and changing them at frequent intervals, sometimes as often as weekly.

Zara describes itself as a fashion follower, not a designer or trendsetter. Rather than predict or even create fashion trends, the company focuses on understanding which fashions and pieces customers want and on supplying them as quickly as possible. The key here is the speed at which Zara collects the relevant information from customers in its branches, processes it, and translates it into fashion garments. Over 200 designers at the company’s headquarters in La Coruña keep a very close eye on the fashion industry, particularly the trendsetters. They go to the big fashion shows, focusing intently on materials, colors, and trends that can be adapted quickly by the mass market.

Just how quickly Zara reacts is illustrated by the announcement of the engagement between Spain’s Crown Prince Felipe and Letizia Ortiz Rocasolano several years ago. The bride-to-be appeared in a white trouser suit. Just under four weeks later, very similar suits were on the racks in Zara. Two years prior to that, Zara stocked pieces inspired by Madonna’s stage costumes. In Europe, these were on sale by mid-July, a mere four weeks after the Drowned World tour started in Barcelona and before it even moved on to the U.S. In the fashion industry, this is an incredibly short reaction time.

From developing a collection to getting it into the shops, the competitors mentioned earlier need a period of up to twelve weeks. That is due in no small part to the fact that these companies manufacture their clothing almost exclusively in low-wage countries in Asia, while Zara’s production operations for the European market are located mainly in Spain and Portugal.

More than 40,000 templates are created annually for the different Zara collections. Because this process is supported by IT, the templates can be rapidly transformed into patterns. Designs are often available in just three colors and sizes. With more than 10,000 new designs each year, Zara manages to change its collection up to 14 times annually. This is significantly more often than its competitors H&M or Gap, which introduce a mere 2,000 to 4,000 new designs into their shops and change their collections only seasonally.

The fact that Zara’s collections change constantly affects customer satisfaction and repurchasing rates in various ways. For one thing, customers visit Zara shops an average of 17 times per year, compared to an average of five visits to H&M, Benetton, or Gap. For another, Zara customers make purchases much more often because they know that the garment will very probably be sold out by their next visit. Frequent changes to the window displays support this trend.

Naturally, data about the garments bought is also evaluated to establish which items were purchased where and when, and in which combinations. But Zara does not rely solely on IT-based data. It also involves employees in the data collection process. There are regular round tables with designers, sales staff, and employees from the production side. Observations made by the fashion-conscious sales staff are particularly useful in helping the design team pinpoint trends from other brands that very fashion-forward customers are already picking up on.

All of this makes Zara a perfect example of how a company can take customer needs – in this case, the desire for fashionable-yet-affordable clothing – and make them the starting point for its own value creation.

Customer orientation for encouraging changes in internal culture

The third objective of increased customer orientation is to initiate and encourage changes to the internal corporate culture. By setting up customer councils and bringing executives closer to the customers, companies can create a culture that is firmly centered on the customer.

One company that has been very successful in this respect is DSM. DSM (Dutch State Mines) was founded in 1902 as a state coal mining company. Over the years, it developed or acquired additional fields of business, expanding into fertilizer production in the 1930s and polymer manufacturing in the 1950s, for example. The focus increasingly shifted to material sciences in the 1970s, fine chemicals in the 1990s, and, as of the millennium, biotechnology.

DSM has been listed on the Amsterdam stock exchange since its privatization in 1989. By embracing new technologies and products – some internally and some through acquisitions – DSM has grown enormously and numbered over 23,000 employees by 2009. Just under a third of those were Dutch. Now there are over 200 branches in 49 countries. In 2009, DSM had sales of a good 10 billion euros, with profits of nearly one billion euros.

In the years leading up to the millennium, innovations were the most decisive factor in this success and the rapid growth of DSM. Most of these were generated in the central research and development (R&D) department and then launched on the market by the various business units. R&D was traditionally led by a scientist or technician who, as Chief Technology Officer (CTO), was a member of the board of management. The company’s activities in this field focused primarily on process innovations and ways to improve the efficiency of production. While the decentralized business units were customer-oriented, the culture in central research and development was focused inwards and removed from the customers.

In the period from 2000 to 2006, the central R&D department produced fewer and fewer innovations and the innovations portfolio of some business units threatened to dry up. Among other things, management believed that the problem was attributable to the R&D department’s culture. The CEO at the time, Peter Elverding, set out to slowly change this. To boost customer orientation in the entire organization, and in R&D in particular, he established an Innovation Center (IC) and appointed a Chief Innovation Officer (CIO). By doing so, Elverding made it clear that customer and market orientation were a priority at DSM, and that innovation meant more than just new technologies and materials. Rob van Leen was named CIO. He had joined the company from Gist Brocades, where he was in charge of a business unit. Gist Brocades was acquired by DSM in 1998. Rob van Leen had completed a PhD in molecular biology and a business management degree.

DSM’s central R&D department became part of the Innovation Center, and the existing CTO now reported to van Leen. In addition to central R&D, the Innovation Center was also home to the Corporate Venturing, Intellectual Property, Licensing, Incubator, Emerging Business Areas, and Innovation Services departments.

The new Innovation Center intensified cooperation with the six business units to bring the central research department even closer to customers. There were now regular meetings between staff from sales and R&D, while open innovation processes created opportunities for intensive collaboration with external groups, such as universities, research institutes, and customers.

All of this resulted in tremendous changes in the innovation culture at DSM. An insular, bureaucratic culture with a pronounced focus on technology was transformed into an outward-looking company that put the customer’s needs center stage. Based on products or services developed in each preceding three-year period, sales generated by innovations increased considerably. In 2010, it reached almost one billion euros, accounting for a good 10 percent of the overall sales. The company now launches an average of 60 innovations on the market annually, compared to 25 per year on average before the IC was established. What is more, the intensified focus on customer orientation has seen the success rate of the innovations increase by 160 percent. In 2009, these efforts earned DSM the Outstanding Corporate Innovator (OCI) Award presented by the Product Development and Management Association (PDMA).

Promoting customer orientation within the marketing mix

Customer orientation is achieved through consistent use of the tools in the marketing mix (i.e., product, price, sales, and communication policies) on openly expressed and latent customer demands. As a part of product policy, efforts to customize the portfolio, additional services, and service guarantees present opportunities to increase customer satisfaction. Cars are one example of a high level of customization. In Europe at least, cars in the mid and upper ranges are made according to customer-specific requirements. Each car that rolls off the assembly line has been commissioned by the customer. Because of the large number of different models, virtually no two are identical. The Apple iPhone is another example of achieving customer orientation through customization. Thanks to small programs called apps, users can tailor their cell phone to suit their own specific requirements. As Apple finds out a lot about the user behavior of its customers, it can ensure the next generation of the iPhone delivers what customers want.

Online sales of the 2007 album In Rainbows by British band Radiohead represent an interesting experiment in using satisfaction to determine price. Following the expiry of its contract with EMI, the band took it upon itself to sell the new album online and let customers decide what to pay for it. Although the band never released figures, newspaper reports claimed that the album was downloaded 1.2 million times within 24 hours. In surveys, two thirds of customers said they had paid for the album. The average price cited was 6 pounds, around 40 percent less than the normal price of a CD at that time. In addition, the band received data about the people who downloaded the album, such as age, location, and listening habits. The band used this data and additional surveys to compile the discbox they later released on the market.

This high quality box was special because it contained two additional tracks, a vinyl record, a photo book about the band and the production of the album, concert photos, and a booklet with song lyrics. In this case, the unconventional pricing policy and sales concept helped to launch an innovative product, the discbox, onto the market. This also achieved a higher repurchasing rate. In a subsequent survey, discbox customers said they had downloaded and paid for the album beforehand.

Customer orientation can also come in the form of direct deliveries, customer clubs, inviting customers to visit production facilities, subscriptions, or choice of site. For example, some vineyard owners deliver their wines personally to customers’ cellars. Apart from the fact that customers welcome this service, the vineyard owner also gets a chance to see which other wines are in the cellar, in which volumes, and from which regions. This is all important information that can be used to create customized offers by putting together specific wines or special vintages. It can also be used to develop new wines. This boosts the repurchasing rate.

Customer orientation can also be achieved using the customer councils, the forums, and clubs mentioned earlier, complaints management, and personal communication. Figure 3 shows a selection of options within the marketing mix.

Promoting customer orientation via structures, processes, and systems

Alongside the tools and instruments in the marketing mix, companies can also use structures, processes, and systems to promote customer orientation.

If we return to our previous example of DSM, we see that appointing a Chief Innovation Officer (CIO) and deciding that the Chief Technology Officer (CTO) must now report to this CIO sent out a clear message to the company: Innovation is more than just technology, and it must always be focused on the customer. The company also redefined the processes that are driven by innovation. Some were centralized, such as patenting and corporate venturing, while others were decentralized, such as information gathering and early innovations testing. Processes that require close customer interaction, such as information gathering and testing, were decentralized, while processes requiring no major customer interaction were centralized.

Figure 3: Ways to promote customer orientation within the marketing mix (Source: based on Bruhn 2001, p. 145) policy

Process blueprints are one way to ensure internal company processes are consistently focused on customers. With these blueprints, it is possible to present the entire process and individual process steps chronologically. In addition, they are categorized based on whether the customer is directly involved (line of customer integration), whether the process is visible to the customer (line of visibility), and whether management is involved (line of internal interaction). The aim of such blueprints is to check the efficiency of processes. They can also be a means of initiating communication with the customer or informing customers and employees about individual process steps. As the processes are presented concisely, they can also be checked for customer orientation.

In addition to all this, corporate systems for information, planning, and controlling, must be designed to support customer orientation. Information systems are often the hub of a company’s customer-oriented activities. In the case of Zara, the close links that state-of-the-art information systems create between customers, sales staff, and suppliers are largely responsible for the company’s speed in developing, producing, and distributing new collections. Similarly, at Q110, the primary focus is on rapidly evaluating the customer response to innovations. For that reason, customer-oriented information systems have to fulfill at least three basic conditions. Specifically, these systems must:

• Enable the company to analyze all observations and information.• Implement the results into operational actions.• Utilize the results for communication purposes.

In terms of communication systems, it is important that both internal and external communication focuses on the customer. Most companies concentrate mainly on external communication and neglect the internal side. However, as the examples of DSM and Zara showed, internal communication is crucial, especially when it comes to promoting customer orientation.

Value Creation in the Global Banking Industry – Back to a Client-centric Paradigm Felix S. Fremerey

The market view: a sector in the value trap?

Banks and the application of shareholder value

When the Glass-Steagall Act was finally repealed by the Clinton administration in the late 1990s, the underlying thinking of financial markets and regulators as well as bank managers was simple: global universal banks with broad portfolios would be well-prepared for the future due to enhanced diversification. Furthermore, Basel II strengthened the perception that risk could be adequately measured, reported, and managed (Haldane 2012). The assumptions on risk containment through regulation and global diversification effects did not match expectations. Almost six years after the collapse of Lehman Brothers, the global banking industry is still in a state of disarray.

What one might find interesting is that this ‘overall’ verdict on the financial sector only holds true on an aggregated level. Regional differences are strong, as are differences based on underlying business models. As we show in this article, client-centric banks performed better over-the-cycle, both in terms of profit generation and in terms of risk management, despite the notion that the late 1990s and early 2000s marked a ‘golden age’ of investment banking. It is worth noting that client-centric banks generated more value for investors even before the 2008 crash.

There are multiple reasons for this phenomenon: partially management driven, partially driven by the misinterpretation of risk-and-return by commonly accepted market-driven analytical tools. Interestingly enough, stricter regulation has been under review for some time now, whereas improved and simplified measurement tools like the leverage ratio have not been in the centre of the debate.

Figure 1: Banks underperformed the MSCI World Index in the last decade by about 32%

Figure 1 compares the MSCI World Index to the MSCI World Bank Index for the last 10 years (starting July 1, 2003). Except for the 50 months preceding the collapse of Lehman Brothers in September 2008, the sector underperformed the broader market. Again one should be aware of the fact that this is the “global” picture, which mixes up different banking models and different regions.

The return and “expected return” bias

Simplified financial theory states that taking greater risks should enable banks to extract higher returns, at least in the medium to long term. Taking this theory too literally emboldens managers and financial analysts alike to take on leverage and to enter higher-risk businesses in order to improve the return on equity and the expected future return on equity. This is all the more true as banks – unlike other industries – are de facto protected by their governments in order to avoid bank runs, such as those in the 1930s.

Applying theory to practice, higher amounts of leverage, extreme growth (organically and through M&As), and entering into high-risk businesses stayed at the top of the agenda for management. This is still true, with the exception of businesses that require higher capital allocation under the Basel III rules (McKinsey & Co. 2012).

Does past performance predict the future?

Interestingly enough, the financial literature offers credible alternatives to the simplistic view of discounting linear positive expectations, as Campbell and Shiller demonstrate in their Journal of Finance article “Stock Prices, Earnings, and Expected Dividends” (Campbell and Shiller 1988).

Campbell and Shiller argue that the predictive power for future returns is poor when using short-term dividend outlooks rather than historic dividend payments as an input variable. Especially for periods longer than seven years, the past performance of companies (and therefore banks as well) becomes a very good predictor for the near and medium-term future profitability: “Long historical averages of real earnings help forecast present values of future real dividends.”

This appears to be intuitive, since there is little need for fundamental change if the bank was able to deliver high, stable returns in the past. If “long-horizon stock returns are highly forecastable” (Campbell and Shiller 1988), investors could use this insight to shape and push the bank’s management agenda in the right direction, provided that the returns and associated risks are predictable.

Following a comparable logic, a review of historical returns of banks would likely provide a better outlook than a short-term review that is combined with a strongly “managed” outlook. In the ESMT Business Brief “European Banks – The Way Forward Toward Resilient Business Models” (Fremerey and Hagen 2010), the authors discuss this approach in detail without reflecting upon potential consequences on stock performance.

Adding a tangible risk measure to the debate on returns

Following Haldane & Madouros (2012) in their speech delivered at Jackson Hole, less complex risk measures will be needed in order to make complex risk managerial, transparent and comparable. If one accepts the fact that the return on equity (RoE) and the predicted RoE are key indicators for investor relations and the measurement of success, one needs to add another component on the same aggregation level in order to account for the expected risk associated with the targeted returns.

Value-at-risks (VaR) models translate market risks into risk-weighted asset (RWA) equivalents using probabilities derived from historical data sets and are based on the “normal distribution” of large samples (Authers 2010). Normally, market risk equivalents are added to credit risks and operational risks in order to generate a top-line VaR figure. This becomes highly complex and more difficult to interpret when the proportion of market risk comprises a higher percentage of the total risk.

About 50 percent of the total assets in our 10-year analytic Bankscope data sample from 2000 to 2009 were allocated to market assets and about 50 percent to credit assets. On the other hand, market-risk models allow for a situation in which only about 20 percent of the global RWA stem from market assets and about 80 percent from client-centric loan businesses. Securitization of loans therefore leads to a reduction of RWA but not to a mitigation of the underlying risk.

We propose to add the volatility of the reported long-term returns as a second key figure, which greatly helps in interpreting past and future returns.

Ways to “contain” valuation bubbles

With a tangible, easy to understand risk matrix, the incentive for “cheating” investors will dramatically decrease, giving room for trust-building and the development of stable business models. In this context, growth will remain on the agenda, but leverage to a lesser extent.

It goes without saying that by just looking at the standard deviation of different return figures, such as the operational return, the pre-tax return, or the net return, the risk assessment of a banking stock is not complete from the investor’s point of view. On the other hand, indicators for long-term average figures help to forecast potential bubbles and to avoid getting trapped into them, normally caused by accepting too optimistic assumptions.

Provided that a bank shows a poor track record in the last three years, even over longer periods (normally removed during the strategic planning process), the only logical consequence and valid option for managers aiming at creating value is to deliver credible “hockey stick” type outlooks of three to five years. These outlooks tend to be “risk free,” in the sense that they normally contain no deviations, or changes that are too small to create volatility, so they are linear and positive. Finally, it is up to financial analysts to make fair judgments on the credibility of the planning, but normally the consensus is built around the outlook given by the bank. In other words, medium-term outlooks systematically overstate realities and thereby ignore the cyclicality of the business. This reflects a similar bias on the gross domestic product (GDP) outlook, too. Figure 2 illustrates the issue.

Figure 2: Dominant planning and IR logic leads to the creation of bubbles

One could expect that with consistent reporting of the expected returns, in combination with expected return deviations, the building of bubbles could be at least partially reduced. Graham and Dodd (1934) proposed to “shift the original point of departure (…) from the current earnings to the average earnings, which should cover a period of not less than five years, and preferably seven to ten years.”

We are not stating that fundamental, long-term returns predict the future for all companies in all situations, but their predictive power is stronger than looking only at “forward guidance” provided by the management.

Expected effects of the new paradigm

The proposed simplified risk-return paradigm would – independent from adjustments on the regulatory level – improve the development of client-centric business models from the market side. Furthermore, it would partially bridge the existing “complexity gap” opening up between risk managers, general managers, institutional and retail investors.

Figure 3: Resilient banks out-performed the MSCI World Index by 25% in the last decade

Figure 3 illustrates the market effects that “stable” or “resilient” business models have on global banks. With the brief interval of the “systemic risk” crisis in the aftermath of the Lehman Brothers collapse, one can see that the banking sector remains an attractive sector for global investors.

The index shows the performance of the 15 most resilient global bank stocks. The ones that were in the 10-year period before the selection demonstrated the most attractive balance between high returns at the lowest relative risks measured by the volatility of the RoE. Over the cycle, the performance of the resilient banks is 25 percent higher than the broader MSCI World Index, and about 57 percent better than the benchmark MSCI World Bank Index. These differences should prompt bank managers and investors to rethink the value debate again.

The management view: how bank managers best create value

Identification of value position

When discussing risk-return differences with international bankers, it is quite common that factors outside the managerial space are used for explaining current and past performance deviations. The most popular ones are macro developments (such as changes in interest rates, F/X, GDP growth, etc.) and tighter regulation.

The consequences and imperatives of the “market view” on bank management are fundamental. Provided that stable, client-centric business models create higher and more consistent total returns, the first priority would be to identify the actual value proposition of the bank relative to its peers. This is comparably easy to achieve by taking the public domain return data of the competitors and computing them against one’s own risk-return position. It is more difficult, however, to implement a management agenda that is able to move one’s own position toward the efficiency curve. With “efficiency curve,” we describe the optimal balance between risks and returns relative to the portfolio of global banks in the sample (as illustrated in figures 6 and 8).

Assessment of drivers: growth

In line with strategic management literature (Elsas, Hackethal & Holzhäuser 2010), creating growth in the last decade has been the strongest driver for achieving resilient business models – and therefore better value generation.

Figure 4: RWA growth dynamics lead to higher average returns over longer time periods

We measured the growth rates of both total assets and RWAs in our long-term risk-return matrix. Figure 4 illustrates the effects of RWA growth dynamics on pre-tax returns. The 60 percent of global banks in Q3–Q5 were able to grow their RWAs by at least 9 percent annually. This group’s average pre-tax RoE generation was more consistent, despite the need to raise more equity to cover such RWA growth.

Figure 5: Stronger RWO growth dynamics limit the risks of the business model, too

In order to cope with the risks associated with double-digit RWA growth, one should take a careful look at the impact on the risk position over the economic cycle, as shown in figure 5.

RWA growth, both organic and through M&A, not only enhanced returns but also stabilized the generation of returns, the latter although not dramatically.

The group of banks that were unable to generate growth or that had poor growth rates on average added the most risk – a reflection of the management tendency to seek high-risk investment strategies when the basic business model fails to attract clients. It might not be surprising to learn in this context that banks from the eurozone represented the majority in the lagging group, whereas banks with exposure to emerging markets dominated the high-growth quintile Q5.

Overall, however, the assessment on the positive impact of RWA growth does not deviate much from general strategic management theory. The overall effect could be plotted in a risk-return portfolio view, as shown in figure 6.