• by John Beran, The Beran Group and Hugh Gallagher, First Manhattan Consulting Group

Regional banks benefit from many of the advantages of larger banks. They also benefit from many of the advantages of community banks. The corollary: challenges of both large and smaller banks overlap in the mid-sized tier.

Given this multitude of variables, the unique task for regional, mid-sized banks is to formulate an appropriate growth strategy that differentiates between what they can do and what they must do. Customer expectations in payments will continue to increase as technology advances and innovations proliferate. Finding the “just right” efforts in payments will allow regional banks to flourish at the middle-of-the-road scale and offset heightening pressures on their business models.

Regional Banks: The Best or Worst of Both Worlds?

Over the past 20 years, the competitive landscape for small, medium, and large banks has shifted considerably. During this timeframe, we’ve seen the emergence of large, global banks, while many regional banks have disappeared, often through consolidation. This trend, in turn, has had implications relating to scale. Scale affects many aspects of a bank’s ability to compete, most notably in buying power, cost of operations, ability to innovate, and brand power. Credit and underwriting power is another key advantage of scale. An institution’s ability to lend on a scale that does not require bank syndication facilitates the ease with which commercial borrowers may obtain credit and limits the need for multiple banking relationships. The ability for the largest banks to advertise and market on a larger or national scale enables significantly more exposure on a per-dollar basis. Analyzing banking industry spend on marketing and advertising illustrates the buying opportunity the largest banks have due to their geographic coverage and brand awareness. In 2013, the four largest banks in the country spent a combined $6.16 billion in total marketing including dollars spent on advertising.1

In payments, larger banks enjoy a scale advantage in providing traditional services such as ACH payments. Due to the high fixed cost of processing ACH transactions, the largest banks have the opportunity to spread their cost over significantly higher volumes. The four largest banks in the country, based on assets, represent just over 63% of total ACH originator volume (See Table).2

Regional banks are typically competing on two fronts. They must offer products on par with their largest competitors while simultaneously providing a level of customer service typically associated with community banks. The advantage most community banks try to leverage is their involvement in the local market and a “high touch” approach to customer relationships and service. Often, the community banks will depict large bank competitors, regionals and the largest banks, as unconcerned and out-of-touch with the needs of the local customer or small business. But regionals can also appeal to customers who resonate with these virtues.345

When competing against community banks, regionals have greater resources to provide products and credit to customers. When competing against the largest banks, regionals are typically not as complex and therefore may pose less risk, a factor of increased importance in today’s regulatory and compliance environment. With the implementation of the Dodd-Frank Act, regional banks must meet many of the most demanding requirements but have more resources than smaller banks to do so. Despite assurances from regulators, many community banks still fear the uncertain impact of legislation’s applicability.

In the best-case scenario, a regional bank would optimize its moderate scale to offer the most valuable products and services to its customers, while winning and retaining customers who prioritize a relationship with a “Main Street” financial institution. Of course, the big question is, with so many possible strategies on the table, how does a regional bank determine which will allow it to flourish?

The Strategic Game Plan

Regional banks have several opportunities to maintain and grow their business, many of which will involve decisions around payments technology. In formulating a broad strategy regional banks should consider the following factors to make the most of their moderate scale:

• Explore emerging technologies that have applicability to banking services and, if possible, develop partnerships with the companies that are responsible for their development.
• Establish a mechanism to examine new product introductions in the market and rapidly determine a response strategy.
• Put a process in place to incubate new products and services. Such a process should force a quick execution and allow for a fast fail.
• Emphasize relationship banking. Maximize the local feel by giving loan officers and staff leeway in servicing their customers. Provide sufficient guidelines and limits, but give staff authority to make decisions regarding customer needs. Speed, consistency, and accuracy should be the hallmarks for providing quality customer service.

Ideally, a regional bank should choose one strategy and stay focused. To get this right from the outset, it should assess the marketplace opportunities and identify business lines with the greatest potential for success. This would include examining its culture, personnel, strengths, service capabilities, and policies. Payments will increasingly play a critical role in some of these opportunities.

Regional Payments Strategy: Challenge and Opportunity

The largest banks have separated themselves from the rest of the banking industry in new product innovation and introduction in the payments space, particularly in processing and customer information management. New services, such as electronic bill payment and presentment, electronic check presentment, cash management information dashboards, transaction origination, mobile banking, and mobile payments have changed how consumers and businesses interact with their bank.

While the basic functions of handling payments (account issuance, payment initiation, clearing, settlement, and exception handling) have not changed, the methods of how they are processed continue to evolve and the largest banks have a distinct advantage in attracting the early-adopters among customers.

The entrance of nonbank entities, such as PayPal, Amazon, and telecommunications providers, into the payments ecosystem challenges the ability of many smaller and community banks maintain a strong role in payments. There’s a formidable threat that the transaction fee-based services will become dominated by the largest banks as well as nonbank competitors.

To help guide regional banks through the payments strategy maze in this complex environment, a thoughtful approach to screening and selecting opportunities is vital. Regional banks should:

• Consider the materiality of payments income and the income earned from the accounts that the features support.
• Focus on customer motivators.
• Evaluate relevant competitive threats.
• Factor in consideration of their payments competencies and existing relationships.

For most banks this evaluation will lead to the conclusion that the payments strategy should focus initially on add-ons to core accounts, particularly checking. Innovation is important, but the profit potential of stand-alone services will likely be less important than retaining or growing the core checking base. Regional banks will win through actions that provide payments-driven revenue growth, profitability improvements, and retention of core customers. However, the divergence of products and pricing structures makes this difficult and risky. Some decisions can be fraught with unintended consequences.

Below are observations on the most pertinent payments opportunities for regional banks and a suggested approach to each.

Redesigning and repricing the checking and related product line. This is one of the most important decisions a bank can make. Unlike in previous periods, there are meaningful differences in banks’ moves. There is a wide range of monthly fee levels (e.g., $5 to $15) and waiver options (e.g., requirements for minimum balances, direct deposit, or a number of debit transactions). There are also differences in online-only accounts and linked-savings vehicles. Some banks offer flat fee accounts versus accounts that charge incremental fees for teller and telephone center agent usage.

These differences will lead to outsized market-share shifts. A regional bank should first consider higher-order objectives, such as an increase in profitability of certain customer segments or the achievement of annual account growth targets, as well as negative outcomes the bank wants to avoid, including attrition of higher-value customers and negative brand perceptions.

The next level of decisions range from selecting fees for certain items to choosing an emphasis on repricing accounts versus conceiving new accounts to appeal to different segments. Given the preeminence of checking, getting this right is critical.

Recouping overdraft-related revenues lost to Regulation E and subsequent regulatory actions. There are emerging variations in how banks are redesigning overdraft and related services:

• Options for reduced or waived overdraft fees, such as no fee for accounts overdrawn by less than $5 or $10, no fee for overdraft transactions less than $5, and reduced fees for smaller value overdrafts.
• Caps on the number of overdrafts per day, ranging from three to six.
• Introduction of a grace period for overdrafts.
• New unsecured loan products designed to provide short-term liquidity to customers with poorer credit or low deposit balances.
• The use of payments data to make better overdraft and other lending decisions.
• Other services that provide even more of the guardrails that consumers value (and for which they are willing to pay).

Recapturing interchange revenues lost to the Durbin Amendment. The final path to replacing the revenue and profitability of debit is unclear, but early movers have demonstrated some ways to repair their debit card P&L:

• Eliminate debit rewards programs.
• Migrate affluent customers from debit to credit.
• Introduce prepaid card accounts for low-balance customers.
• Introduce monthly debit card fees for low-balance customers.
• Migrate to EMV (chip & PIN), which offers more protection against fraud, because fraud losses and related expenses are only partially reimbursed under the Federal Reserve’s final Durbin Amendment rules.
• Renegotiate payment network relationships and processing fees.
• Consider other restrictions on debit card transactions (e.g., no large dollar transactions, no card-not-present transactions).

Encouraging more customers to conduct transactions via channels that reduce costs and improve retention. Developing an effective channel strategy to reduce the bank’s overall costs will be an important long-term strategic initiative. The cost, retention, cross-sell, and profitability benefits associated with various channels (e.g., online banking, mobile banking, and online bill pay) have been fairly well documented, although selling these channels to customers may prove more difficult in an environment where banks are charging customers for their use.

For many banks, mobile will represent the single largest available payments opportunity. However, banks in several developed markets, such as the U.S., Canada, and U.K., lag the rest of the world in terms of basic mobile banking functionality and currently have little or no mobile payments capability. A more careful consideration of customer demand, behavior, and economics is warranted here. Without a better understanding of these factors, the natural tendency to optimize branch and other channel-related costs may yield counterproductive results.

Innovating new sources of helpful, value-added services. Such opportunities can be grouped into three categories:

• Ongoing assistance, training, and help on financial management, which includes consumer education programs, budgeting and savings tools, credit monitoring, identify theft, and credit rebuilding.
• Tools for better money management that are straightforward to use with instructions that are clear (e.g. specifies when money moves and becomes an available balance); other beneficial communications, such as highly transparent fees and policies, and better alerts (email and text); and features that offer convenience, such as remote deposit capture and mobile payments.
• New payment solutions that address customers’ need for fast, easy and simple money movement (such as person-to-person payments); an underbanked product offering; alternative payments for online purchases; and merchant-funded offers and rewards.

Effective execution and marketing. There are wide disparities in payments penetration, activation, and usage among banks that have similar customer bases. Compelling and targeted marketing and information are critical to both customer trust when pricing models change and the adoption of new services and products.

Increased levels of activation for online banking, mobile banking, and online bill pay lead to improved customer retention and profitability. The same is true for the value of direct deposit services. Debit cards have a direct revenue impact, but there are also indirect benefits from the higher deposit levels associated with greater customer engagement in payments. Together, these payment mechanisms represent some of the most effective and efficient sales and marketing investments that a bank can make.

Similarly, competency in customer communications makes a significant difference in whether customers understand and accept pricing changes. There are many do’s and don’ts, such as demonstrating an understanding of the customer’s total payments relationship, treating customer segments differentially, and using language in print and in conversation that is appropriate and relevant to the customer.

It is possible to improve customer loyalty, profitability, and market share through payment-related decisions that are well conceived and executed. There will undoubtedly be continued customer churn across the industry as pricing models change. Capturing an increased share of this churn will separate the winners from losers.

Whatever strategy a regional bank makes in payments, it will need to carefully and deliberately consider its strengths and its markets. To optimize the virtues of a happy medium in size, a regional must accurately determine which payments functionalities will align it with larger banks in terms of capabilities, then deliver those functionalities with the high-touch and trust more commonly associated with smaller institutions.

There are many highly successful regional banks throughout the country. But, in the face of a continuously changing financial industry landscape, they need to be vigilant about the impacts the changing environment will have on its business. Opportunities and challenges will continue to be available to banks at all levels. The banks that recognize change and make appropriate adjustments to their business strategy will thrive over the long run. •