• by Chris Mazingo, Principal, McKinsey & Company and Pradip K. Patiath, Director, McKinsey & Company

Large financial institutions often dwarf their regional competitors and pose a formidable competitive threat. Despite their size and scale disadvantages, however, regional banks have an opportunity to fight and win. To do so, they need to concentrate their energy on their local markets and focus on building what we call “local scale.”

Current performance differs dramatically among regional banks—just as it does among large banks globally.1 Understanding the concept of local scale and aligning strategy accordingly could give regional banks a substantial boost in performance. Of course, this would amount to little without the proper focus on execution. The biggest banks may have economies of scale on their side, but a targeted strategy, combined with a local market approach, will enable regional banks to flourish.

Local Matters

The consolidation in the banking sector and the rapid evolution of exceedingly large, national banks has shaken up almost every geographic market in the country. Regional banks have reason to be concerned, as they find themselves competing head-on with one or more banking giants in almost every market within their footprint. Seven of the 10 largest regional banks compete with a large, global bank in at least 85 percent of their markets, with SunTrust and Capital One, for example, encountering the largest banks across more than 95 percent of their footprints.2 Many regional banks may see this as a daunting proposition. The largest banking organizations have enormous national marketing budgets, can lure the brightest talent, and should be able to pass on to customers the benefits of their scale in operations.

Regional bank fears are compounded when one realizes that where the large, global banks compete, they generally become the dominant player. Wells Fargo, for example, ranks in the top three for branch share in 85 percent of its markets, while Bank of America and JPMorgan Chase manage this feat in around 75 percent of their markets. By contrast, most regional banks muster a top three spot in just 40 to 60 percent of their markets.

Despite the competition from the biggest banks, McKinsey research shows that the regional banking model remains robust. However, if they are to thrive, regional banks must be very disciplined both in managing their footprint and ensuring superior execution. Regional banks can excel by delivering a “best of both worlds” strategy, which requires the bank to be deeply embedded in its local communities in order to deliver more personalized service (similar to community banks), while also providing the full product and service suite at a similar price-point to the largest banks. On average, 70 percent of a regional banks’ profits derive from what are essentially local revenue streams: retail accounts and local and regional businesses. In other words, the more “regional” they can be, the more they appeal to their most critical customer base.

Not all regional banks are equally successful, however, at least as measured by bottom-line financial returns and stock market perception. Looking at recent historical performance of the largest 20 publicly traded U.S. regional banks with greater than $25 billion in total assets3 shows that while on average these banks have a price-to-book ratio of 1.3 and a return on equity of 8.7 percent, there is a wide-range of performance. The best performing five institutions have an average price to book ratio of 1.8 and return on equity of 11.7 percent, as compared with the remaining institutions’ average of 1.1 and 7.7 percent, respectively.4 The outperformance of the best firms is driven by a clear strategic focus and effective execution.

Managing the S-curve

In order for a best-of-both-worlds strategy to be effective and for regional banks to have the opportunity to bring these local skills to bear, they must first build critical mass in their core markets. Without critical mass, regional banks will struggle against their larger competitors, continually lagging in deposit share and remaining an also-ran in the market.

Critical mass, in this context, is based on the relationship between the share of branches and the share of deposits in any given market. Plotting branch share against deposit share for all banks in a market inevitably shows that the greater the branch share, the greater the deposit share, but the reality is more nuanced. We analyzed over 250 major counties in the United States and found that an S-curve relationship exists in over 80 percent. We define critical mass as the area on the local market S-curve where a certain level of branch share begins to yield disproportionate returns in terms of deposit share (Exhibit 1).

Although S-curves can vary in shape and slope, the underlying structure of most curves is similar to that shown in the exhibit. When a bank has low branch share in a given market, it is likely to see lower marginal returns and punch below its weight in regards to deposit share. When it has reached momentum branch share (the left-hand border of critical mass), it can enjoy increasing marginal returns. As a bank reaches the inflection point on the curve where the rate of deposit share growth begins to slow, it is likely to be a leading player in that market. Eventually, the rate of deposit share growth begins to slow as expansion continues and a bank reaches saturation point. At saturation point, no matter how many more branches a bank adds, the impact on its share of deposits will be very small.

The S-curve of any given market will evolve over time. Not surprisingly, larger and more attractive markets have seen greater competition in recent years, resulting in a flattening of the S-curve. This flatter S-curve makes it tougher for a bank to capture disproportionate returns; that is, it takes more branches to achieve a smaller increase in deposit share. Additionally, changes in market landscape (e.g., through M&A), demographics, or customer behavior can also have an impact on the shape of the S-curve. For example, a large acquisition can lead to the combined entity far exceeding saturation share in a market and thus distorting the S-curve. The curve will usually revert to a more standard (and statistically significant) shape within one to two years, as the new entity stabilizes and the market adjusts.

Interestingly, the growth of online, mobile, and direct banking has not had a substantial effect on S-curve dynamics. Research shows that although the younger generation is less likely to visit a branch to research a new product, 80 percent of 18- to 30-year-olds still prefer to visit a branch to open a new account, which suggests that branches and physical presence will continue to play a key role in bank success.

Tempting as it might be simply to map every market and attack those where a bank has yet to reach critical mass, this would be a flawed approach for regional banks. Spreading investments too thinly across the footprint is always going to present enormous management and balance sheet problems and increases the chances of continuing to play second fiddle to the entrenched larger competitors. Success will not come from casting the net widely, or from targeting seemingly lucrative but competitive markets where a bank has a minimal presence. Instead, regional banks should focus their resources on a set of core, strategic markets that offer the biggest potential for improvement, in order to achieve local scale.

Perhaps the most compelling argument in favor of cementing a regional focus and building critical mass in a series of core markets comes from our analysis of regional banks’ performance against their larger counterparts. When the regional player had a branch share that was at or above the saturation point for the market, it outperformed the large, global bank by approximately five percentage points in terms of deposit share, even when the larger bank itself was also at saturation point. Both banks were among the market leaders, but the regional bank was outcompeting a theoretically more efficient rival. Although a number of execution-related factors likely contribute to this performance, the analysis shows that once a regional bank achieves local market scale, it is no longer at a disadvantage to a large, global bank, despite the latter’s greater access to marketing and resource dollars. We are not arguing that branch investment alone is sufficient for sustainable success, but the analysis implies it is a necessary condition—and one that regional banks need to recognize as they plan their investment strategies.

Revenue and Productivity

As banks reach critical mass in a market, they not only attract disproportionately more deposits, they are also able to generate superior benefits across a number of critical measures of bank performance—including cross-sell, product mix, employee and branch productivity, risk, and pricing. Additionally, building local scale does not just affect the bank’s consumer franchise, it is also heavily correlated with small-business, mid-market and commercial penetration.

Combining the S-curve analysis with McKinsey’s proprietary branch benchmarking survey shows that building critical mass can have significant impact on a bank’s revenue and productivity beyond just direct deposit accounts. If we look at cross-sell rates, there is a striking correlation between the cross-sell rate of non-deposit products and the percent of markets where the bank is in the top three for branch share. This suggests that as banks gain deposit share, they also improve their ability to cross-sell non-DDA products.

This relationship may seem obvious, but it demonstrates the importance of branch presence in building multi-product relationships and increasing customer loyalty. One might think this relationship is driven purely by bank-specific execution, but even for a single bank, cross-sell rates are higher in markets where the bank has a top-three position, versus markets where it is not a leading player (i.e., number six or lower). This suggests that improving cross-selling requires not only a targeted sales program and strong frontline execution but also critical mass in branch share.

One of the most pronounced performance differences between leaders and laggards is in productivity, both at the individual and the branch level.

In our sample, sales of deposit products per full-time employee were 43 percent higher for the leading banks, and deposit product sales per branch were a staggering 109 percent higher. This suggests that leading banks are either able to attract more affluent customers, grab a greater share of a customer’s deposit wallet, attract higher-skilled staff, offer better rates, or, more likely, some combination of all of these. Although some of this difference is probably driven by execution, the sample considered 40 distinct counties, with a number of different banks representing leaders and laggards across those counties. Given the wide variation in market performance and operating styles across these banks, it is fair to conclude that critical mass played a significant role in the productivity variation.

Pricing and Risk

In addition to revenue and productivity improvements, McKinsey research suggests that banks with critical mass may also see improvements in pricing and risk. For example, a bank can price more competitively in markets where it has a leading position than in those markets where it does not. Looking specifically at various money market products, the rates were, on average, 10 to 20 basis points higher in markets where the bank did not have critical mass than in those where it did. This difference translated into a $120,000 annual pricing opportunity per branch, or a $6 million opportunity, assuming 50 branches in the market. This analysis implies that as a bank builds presence and scale, it no longer needs to compete as aggressively on price.

Preliminary analysis also suggests that building critical mass can help banks achieve a superior risk selection. For a large regional bank, mortgage delinquency rates were over 500 basis points higher than the top three banks in markets where the bank could not muster better than a top five ranking. This is partly because the leading banks have a better choice of applicants and can more easily pick the best risks. In addition, a regional bank with a strong presence should have better local knowledge of risks than a bank with a far smaller footprint in that market.

Small Business and Middle Market

Building local market critical mass can also have a significant impact on the success of a bank’s small business and middle market banking franchises. There is a strong correlation between branch critical mass and business customer penetration, clearly suggesting that a bank will have greater success—in both small business and middle market— in locations where it has invested in building a significant retail infrastructure. This might seem obvious, but it contradicts the strategies that many regional banks have recently pursued: aggressively investing in middle-market capabilities in locations where they have limited physical scale. Middle-market customer relationship managers rarely sit in branches, so the assumption has been that branch presence was not critical for success.

This analysis suggests that small-business and middle-market customers value local presence as much as retail consumers do and, therefore, regional banks should have a coordinated strategy across their local businesses (i.e., retail, small business, and middle market). These businesses are usually separate entities with distinct growth plans, so this will require more coordination and collaboration across the bank.

What Now for Regional Banks?

It is clear that there are major advantages to being a bigger fish in a smaller pond, despite many banks’ attempts to expand into larger and seemingly richer waters. This insight leads to three major implications for regional banks—each of which should be adapted to a bank’s strategy and position.

First, banks that have extended themselves into new regions or markets should rethink their footprint strategy. As previously mentioned, we estimate that a bank must build at least three to five percent branch share in any market to begin to attract a disproportionate level of deposits and position itself to be a leader in that market. Most regional banks are already in several markets where they are not leaders and therefore need to prioritize investments in locations where they can reasonably reach critical mass. Being lured into, or continuing to invest in, supposedly attractive high-traffic markets that require a huge roll-out of new branches (e.g., more than 20) may turn out to be futile. In considering M&A activity, banks should evaluate the impact of potential purchases or divestitures in light of their impact on their local scale.

Second, regional banks need to take full advantage of their best-of-both-worlds strategy and invest in local specialization and a personalized customer experience. Building critical mass will ensure that regional banks can compete with the largest banks, but local specialization will enable them to win. Unfortunately, over the past few years, many regional banks were captivated with the idea of becoming national players and moved the other way—trying to gain national scale and losing their local touch. Our experience suggests this is the wrong approach. Regional banks should look to their community banking roots when addressing customer-facing activities. Of course, we understand that banks must still operate in standardized ways, with full compliance and efficient processes, but local branches need to be given some entrepreneurial freedom, with the ability to react and adapt to local market needs.

Finally, as banks begin to look to local market S-curves to help drive investment decisions, they should also consider opportunities to move up to the S-curve (as well as to the right). Many banks have a large number of markets (40 to 60 percent is typical) where they are below the S-curve, implying that they are not getting their fair share of deposits based on branch share. This gap is due to poor execution in those markets and suggests banks are not fully capitalizing on their branch infrastructure. Although addressing the execution deficiency can be as simple as adding resources or changing operating hours, it more often requires significant shifts in the mindsets and behaviors of the frontline, which can be a challenging endeavor.

For regional banks, achieving critical mass across the majority of a bank’s footprint should be a long-term objective that drives investment and acquisition decisions for years to come. The benefits are significant, both in terms of individual branch performance and the bank’s ability to compete in a given market. In the interim, we believe there is significant value to ensuring a bank gets its fair share of sales relative to its branch presence, in addition to increasing branch share and achieving critical mass. This requires banks to identify markets where branches are underperforming and to focus on traditional execution levers such as performance management and sales force effectiveness to raise their game. Pursuing this parallel approach of moving both up and across the S-curve will create growth and profitability for regional banks. •