Credit Union Financial Sustainability: A Colloquium at Harvard University ideas grow here PO Box 2998 Madison, WI 53701-2998 Phone (608) 231-8550 PUBLICATION #232 (3/11) www.filene.org ISBN 978-1-936468-11-9 Credit Union Financial Sustainability: A Colloquium at Harvard University Copyright © 2011 by Filene Research Institute. All rights reserved. ISBN 978-1-936468-11-9 Printed in U.S.A. Filene Research Institute Deeply embedded in the credit union tradition is an ongoing search for better ways to understand and serve credit union members. Open inquiry, the free flow of ideas, and debate are essential parts of the true democratic process. The Filene Research Institute is a 501(c)(3) not-for-profit research organization dedicated to scientific and thoughtful analysis about issues affecting the future of consumer finance. Through independent research and innovation programs the Institute examines issues vital to the future of credit unions. Ideas grow through thoughtful and scientific analysis of toppriority consumer, public policy, and credit union competitive issues. Researchers are given considerable latitude in their exploration and studies of these high-priority issues. Progress is the constant replacing of the best there is with something still better! — Edward A. Filene The Institute is governed by an Administrative Board made up of the credit union industry’s top leaders. Research topics and priorities are set by the Research Council, a select group of credit union CEOs, and the Filene Research Fellows, a blue ribbon panel of academic experts. Innovation programs are developed in part by Filene i3, an assembly of credit union executives screened for entrepreneurial competencies. The name of the Institute honors Edward A. Filene, the “father of the U.S. credit union movement.” Filene was an innovative leader who relied on insightful research and analysis when encouraging credit union development. Since its founding in 1989, the Institute has worked with over one hundred academic institutions and published hundreds of research studies. The entire research library is available online at www.filene.org. iii Acknowledgments For their help with, and participation in, this important research colloquium, the Filene Research Institute would like to thank the presenters: • Frances Frei, UPS Foundation Professor of Service Management at Harvard Business School. • John Lass, senior vice president at CUNA Mutual Group. • Dorian Stone, partner at McKinsey & Company and Filene Research Fellow. • Peter Tufano, Sylvan C. Coleman Professor of Financial Management at Harvard Business School and Filene Research Fellow. • We would like to thank Theran Colwell of CUNA Mutual for his fantastic and ongoing efforts in gathering and synthesizing this essential sustainability analysis for credit unions. In addition, the colloquium came together due to the work of wonderful partners. We would like to thank: • Dan Egan, CEO, and the staff of the Massachusetts, New Hampshire, and Rhode Island Credit Union Leagues. • Gene Foley, CEO of Harvard University Employees Credit Union. iv Table of Contents List of Figures vi Executive Summary and Commentary vii About the Colloquium Leaders x Introduction xi Chapter 1 Lumber and Credit Unions 2 Chapter 2 Sustainability of the Credit Union Business Model 5 Chapter 3 Operational Excellence Drives Sustainability 14 Chapter 4 The Basis and Need for Operational Innovation 25 Conclusion and Synthesis 33 Endnotes 44 Chapter 5 v List of Figures 1. Quarterly Personal Savings Rates as a Percentage of Disposable Income 2. Ratio of Household Debt to Disposable Income 3. Gross Spreads Move Lower 4. Increasing Reliance on Fees and Other Income 5. Credit Union System Sustainable Growth History 6. Credit Union System Sustainable Growth Trend (ROE, 1985–2007) 7. Sustainability Factors: Will the Trend Reverse or Continue? 8. ROA and ROE Defined 9. Credit Union Sustainable Growth Analysis 10. Credit Union Summary—June 2010 11. Case Studies Summary (As of June 30, 2010) 12. Labor Reality 13. Commerce Bank Attribute Map 14. Employee Management System 15. Job Design Dilemma 16. Focus on Rate of Improvement 17. Consumers Are Deleveraging, Especially in Credit Cards 18. Consumers Increasingly Rely on Online Channels 19. High Penetration or High Balances, but Not Both 20. Account Opening and First Month Accounts for 72% of Lifetime Cross-Sells vi Executive Summary and Commentary by Ben Rogers, Research Director John Walton, billionaire son of Walmart founder Sam Walton, died in 2005 in a tragic airplane crash. A skilled pilot, Walton crashed while flying an experimental aircraft he had built himself. An investigation found that the aircraft had crashed when a malfunction cut off control of the airplane’s pitch—the up or down angle of the nose of the plane. Controlling pitch, along with roll and yaw, is essential to flying an airplane. Careful command of all three factors is vital whether you’re flying one mile or one thousand, and even a slight malfunction in the control of any of them turns a routine flight into a deadly one. The stakes are lower but the dynamics are the same in sustainable credit union growth. A colloquium called “Credit Union Sustainability: Evidence and Actions,” held in Fall 2010 at Harvard University, addressed the variables that—like pitch, roll, and yaw—must be monitored and maintained in order for credit unions to both stay aloft and gain altitude. Flight dynamics are a useful metaphor for balance sheet dynamics, because small changes corrected in the middle of a long flight are not likely to have large effects. But when those changes come during takeoff or landing (a financial crisis) or when they continue uncorrected (years of declining growth), the results are as sad as they are predictable. Instead of pitch, roll, and yaw, this colloquium considered factors like net interest margins, operating expenses, asset turnover, and leverage. In both cases, the factors must be finely calibrated to assure a successful flight. In both cases, failure to do so will result, eventually, in a crash. What Is the Research About? This report documents the presentations and discussions of the colloquium, which combined insights from academia and business to make a stark assessment of how sustainable the credit union business model appears—how well the system and individual credit unions are managing their pitch and roll. With the exception of some individual credit unions, the trends are sobering. But the problems are understandable and, therefore, manageable. Colloquiums are designed for interaction, not just presentation, and this one didn’t disappoint. Perhaps the most intriguing part of the whole event was the panel discussion at the end, where the day’s presenters took on trenchant questions, like: “What kinds of collaboration should credit unions invest in?,” “How do you change strategy with an unreceptive board of directors?,” and “Should credit unions minimize operating expenses in exactly the same way as other firms?” vii What Are the Credit Union Implications? Peter Tufano, a Harvard Business School professor and Filene Research Fellow, introduced a classic Harvard business case to show that growing profits and growing sales do not always a viable business make. The case study’s Butler Lumber Co. has to determine— just like credit unions—the right mix of profit margin (lowering costs, raising revenues, or both), asset turnover, leverage (using as much capital as possible), and payout (distributing funds to shareholders). If Butler gets it wrong, they will grow their way right into default. The credit union corollary: Credit unions with excess capital can manage with low profits for a long time, but without access to outside capital, the only way to grow sustainably in the long run is to pull one of those four levers. Building on Tufano’s sustainable growth theme, John Lass, senior vice president at CUNA Mutual Group, led a lengthy discussion of exactly what those levers look like at credit unions. John noted he had first learned the sustainable growth model while studying the Butler case during the first year of his MBA program 30 years earlier. He also noted he had applied it in numerous industries as a strategy consultant and has recently found the model works particularly well for the credit union system given the lack of access to secondary capital and the tax exemption. Harvard Business School Professor Frances Frei taught that you can fail even though nobody dislikes you. Credit unions have to be particularly careful about trying to be all things to all members, because a drive for across-the-board excellence is likely to lead to mediocre performance in all areas. It takes strategic courage to instead decide what your credit union will not do well . . . and make sure you don’t do it. If you try to be good at everything, you will run out of money long before you’ve succeeded. Not a recipe for success. Outsized operating expense ratios are the bane of the majority of US credit unions, argues McKinsey & Company partner and Filene Research Fellow Dorian Stone. A straightforward comparison of operating expenses at the smallest US banks and credit unions shows credit unions lagging banks by 20% or more. Moreover, competitors aren’t likely to get less efficient, so it’s time for credit unions to do better. Key elements for credit unions to assess include whether they are utilizing scaled operational models, prioritizing the right performance improvements in order to deliver value to the member, and putting the right accountability in place at each level to ensure high levels of performance. viii The good news, and the key difference between Walton’s crash and credit unions’ plight, is that most credit unions are not yet at the mercy of emergency fixes. Most have time to fix their pitch, moderate their yaw, and steady their roll. ix About the Colloquium Leaders Frances Frei Frances Frei is UPS Foundation Professor of Service Management at Harvard Business School. Her research, course development, and teaching examine how organizations can more effectively design service excellence. Her academic research has been published in top-tier journals such as Management Science and Harvard Business Review. In addition, she has published dozens of case studies across a variety of industries, including financial services, government, retail, software, telecommunications, and hospitality. George Hofheimer George Hofheimer is the chief research officer at the Filene Research Institute, where he oversees a large pipeline of economic, behavioral, and policy research related to the consumer finance industry. He also leads a new Filene initiative focused on applied research and innovation. George has authored numerous papers on consumer finance topics and is a frequent presenter at national and international trade events on topics such as executive development, technology, governance, and strategic planning. John Lass John Lass, senior vice president at CUNA Mutual Group, directs corporate strategic planning and CUNA Mutual’s business development unit with a focus on identifying and pursuing strategic diversification opportunities. John has worked extensively in the credit union system and worldwide as a speaker and strategic advisor. Dorian Stone Dorian Stone is a partner at McKinsey & Company’s San Francisco office. His consulting work focuses on customer experience and growth opportunities in service industries, including financial services. Peter Tufano Peter Tufano is the Sylvan C. Coleman Professor of Financial Management at Harvard Business School and the incoming dean of the Saïd Business School at the University of Oxford. He previously served as Harvard Business School’s senior associate dean for planning and university affairs, as its director of faculty development, and as head of the finance unit. His research and course development focus on mutual funds, corporate financial engineering, and consumer finance. x Introduction The “Credit Union Sustainability: Evidence and Actions” colloquium was intended to serve as a funnel, to take broad principles of finance and strategy and then boil them down into credit union– specific contexts. So, Professor Peter Tufano taught an introductory Harvard Business School case on ROE, while Professor Frances Frei talked about design principles for effective service organizations. Beyond that, John Lass broke down ROE in the credit union context to examine the financial growth levers available to credit union leaders, and Dorian Stone unpacked the state of the financial services industry to identify challenges and opportunities available to credit unions. The final session of the day, a panel among the lecturers, synthesized the discussion and took aim at some of the credit union system’s warts. Consider the credit union system in the context of the following quote from Analysis for Financial Management: “When a company is unable to generate sufficient growth from within, it has three options, ignore the problem, return money to shareholders, or buy growth.”1 For a mature industry or a mature institution, those are the options. Many are choosing the first option and ignoring the problem, hoping that some gradual return to normal earnings is in the future. For credit unions with a strong capital position, ignoring the problem is a straightforward proposition. And it’s possible to ignore the problem all the way into the night, because their capital position will shield many credit unions into irrelevance. Very few credit unions call it quits and return money to their shareholders. Instead, buying growth (or seeking growth) through a merger is a common route. But these are the stark options available to credit unions that cannot grow organically. So, the Harvard colloquium and this report prize sustainability and seek out ways to keep organic growth alive at credit unions. xi CHAPTER 1 Lumber and Credit Unions Professor Peter Tufano of Harvard Business School teaches the classic case study on sustainable growth. But what do credit unions have in common with a small lumber company? No matter what the industry, financial performance and business model sustainability turn on just a few key hinges. “Butler Lumber Company” is a classic Harvard Business School case. For more than 50 years, it has served as an introductory look at enterprise-level financial analysis. And while the specifics of Mark Butler’s business selling finished lumber to contractors are quite different from those of issuing loans to credit union members, the financial principles of ROE and sustainable growth are the same. The case method encourages readers to take the story and decide how to act on the information. This is the classic case study for understanding the financial management of companies. Here’s a short summary of the situation from the four-page case: Despite good profits, the Butler Lumber Company has experienced a shortage of cash and now needs to increase its borrowing, but it is near the limit on its current line of credit. Butler’s net worth is increasing, as are his sales, but his cash is dwindling. Readers are given the company’s operating statements and balance sheet and asked whether they would extend a larger loan to Butler.2 Growth Is Good but Not Always Sustainable Why all these details about a little lumber company? It builds a conceptual point. Normally growth is good, and readers of the case see that Butler’s sales growth is 26% per year, that net income is growing 19% per year, and that his capital is 35% of assets. But uncontrolled growth is not a good thing, and his growth trajectory demands more and more cash. Just putting up big growth numbers is not a reason for celebration; in this case, the more Butler grows, the deeper the hole he digs for himself. Butler’s equity is growing, but his debt is growing at a faster rate. That trend is manageable in the short term if Butler takes on additional debt, but in the long term it’s unsustainable. He has to find a way to keep his overall growth in line with his return on equity (ROE = net income / equity). If he wants to keep constant leverage (net worth ratio) and grow his business, the only rate that works 3 without outside capital is his return on equity (ROE) times 1 minus the payout rate (dividends). Sustainable growth rate (G ) = (R × earnings) / equity R is the firm’s retention rate, or 1 minus the dividend payout ratio. G can also be written in other, more familiar iterations: G = R × ROE G=P×R×A×T In this last equation, P is a firm’s profit margin, A is its asset turnover, and T is its assets-to-equity ratio, or leverage. All of these will be examined in greater depth in Chapter 2, but the long and short of it is that any company, including a credit union, can only grow in a way that keeps its margins, its dividends, its asset turnover, and its leverage in good correspondence. If your actual growth rate is greater than your sustainable growth rate, then the leverage ratio goes up and you need more cash. If your actual growth rate is slower than your sustainable growth rate, you are becoming less leveraged. In one sense, that’s a good problem to have, because it’s easy to solve: Pay out more to members. Basic Financial Levers for Improving ROE ROE is the upper limit of sustainable growth, so an efficient business’s goal should be to improve ROE. Because ROE is composed of two financial measures (leverage and dividends) and two operational measures (profit margin and asset turnover), those are the four areas to target. For credit unions, dividends are tied to interest rates on loans and deposits and thus are distributed to member shareholders in the normal course of business. Leverage, on the other hand, is variable and—within regulatory boundaries—under management’s control. A lower capital ratio means more leverage, and more leverage translates into higher ROE. On the operational side, asset turnover means selling your products faster. Credit unions can increase asset turnover by selling loans more often, either by bringing loan duration down or by selling newly issued loans in order to re-lend more money. And finally, profit margin is one of the most straightforward ways to improve ROE. You can do it by either raising prices or bringing cash expenses down. Credit unions are inefficient compared to similarly sized banks, so reducing expenses is one of the credit union’s best shots at improving ROE dramatically. 4 CHAPTER 2 Sustainability of the Credit Union Business Model With the general principles of financial sustainability in hand, John Lass, senior vice president of CUNA Mutual Group, defines sustainability for credit unions, identifies unsustainable credit union trends, and homes in on the factors credit union leaders can control today. Sustainability in Focus The word sustainability holds a myriad of meanings in modern business. But for the purposes of this examination, its meaning is quite simple, as expressed in these two definitions shared by John Lass: Sustainability is the ability to continue a defined behavior indefinitely. A sustainability system or process must be based on resources that will not be exhausted over a reasonable period, sometimes expressed as the long term. In credit unions, the resource that should not be exhausted is capital, so sustainable growth is business growth that maintains a steady level of capital in reserve. That challenge is pressing, not just among credit unions, but among larger sophisticated enterprises, too. According to researchers at Bain & Company, “The odds of achieving sustained, profitable growth remain challenging: Only about one in 10 companies worldwide managed to grow profits and revenues more than 5.5% over the 10 years ending in 2008, and earn back their cost of capital.”3 So credit unions are in the same milieu with other firms; both are challenged to maintain steady sustainable growth. Healthy growth is imperative, because it generates returns that serve members’ economic interests, it creates space for retaining and promoting talent, and the resources it generates can be further invested to keep up with changing markets and shifting consumer demands. If only 10% of companies have been able to post consistent growth in the 10 years through 2008, consider the macroeconomic headwinds credit unions face today. And consider whether they are sustainable. Figure 1 shows the personal savings rates of American consumers, expressed as a percentage of disposable personal income. From 1950 up until about 1980, consumers tended to save anywhere from 8% to 12% of their disposable personal income. But in 1980, it was as if 6 Figure 1: Quarterly Personal Savings Rates as a Percentage of Disposable Income 14% 12% 10% 8% 6% 4% 2% 0% 1980 1985 1990 Sources: CUNA Mutual Group; Bureau of Economic Analysis. 1995 2000 2005 2010 somebody had flipped a switch: The savings rate started on a nearly straight-line decline. What’s going on here? Some argue that the definition of savings changed with the growing use of 401(k)s, IRAs, and mutual funds. That may be true, but regardless of that trend, the percentage of funds that people put into a safe investment with a limited risk of loss of capital did take a deep nosedive. The decline in savings shows an interesting correlation to a post-1980 rise in the ratio of debt to disposable household income. “Back in 1952, the ratio of household debt to disposable income was less than 40% in the US. At its peak in 2007, it reached 133%, up from 90% a decade before.”4 Could that trend have continued? Would it have been theoretically or practically possible for consumers to keep piling on debt? Is there any structural or mechanical reason why that would have to blow up? The answer is: It’s unsustainable. Figure 2: Ratio of Household Debt to Disposable Income 140% 120% 100% 80% 60% 40% 20% 0% 1980 1985 1990 1995 2000 2005 Sources: CUNA Mutual Group; Board of Governors of the Federal Reserve System; Bureau of Economic Analysis. 2010 Sinking interest rates are one cause of the slack savings and booming loans, but 10-year Treasury rates are close to 0% now, down from 16% in the early 80s, and there’s nowhere lower to go. Add to that unsustainable trend another in the form of a rising debt-to-GDP ratio and increasingly stressed state-level debt loads. The current macro environment is bleak. Unsustainable Credit Union Trends Credit unions confront their own set of challenges in addition to those facing all firms. 7 Basis points The compression in the gross spread has been similar among banks and credit unions. Although the spread widened a bit through the middle of 2010, it’s Figure 3: Gross Spreads Move Lower unclear how much more it will move 420 and how much of the improvement 400 is permanent. But regardless of causes 380 and permanence, the constricted 360 spread makes it 340 much more difficult to earn high ROA. 320 Historically, ROA and gross spread 1992 1994 1996 1998 2000 2002 2004 2006 2008 Q2 have moved 2010 together. They still Sources: CUNA Economics and Statistics; CUNA Mutual Economics. do, but the increasing reliance on fee income has had the benefit of weaning credit unions off pure interest rate earnings, with the downside that fee income is subject to regulation. Overdraft and interchange income represent 70% of credit union fee income. 300 The recession also took a bite out of credit unions’ historically high capital ratios, which moved from more than 11% at the start of the Figure 4: Increasing Reliance on Fees and Other Income 150 Return on average assets (ROA)* 100 Basis points 50 0 ROA less fees and other income* –50 –100 –150 1990 1992 1994 1996 1998 *Q2 2010 annualized Sources: CUNA Economics and Statistics; NCUA; CUNA Mutual Economics. 8 2000 2002 2004 2006 2008 Q2 2010 crisis to 9.8% in the middle of 2010. And while that ratio certainly seems strong, it is only the average, with sand-state credit unions and others showing much weaker capital positions. One trend that is not at crisis, yet, is the membership growth rate. At 0.9% in the middle of 2010, it’s still positive, but it’s down from about 3% at the end of the 1990s. Further, it is not a net growth rate. To be truly healthy, the membership growth rate should hover above the US population growth rate, which in 2010 was estimated at 0.97%.5 A lower number means a gradual loss of market share. Similar macroeconomic forces are driving banks and credit unions to consolidate at nearly identical rates. The total number of institutions in both systems is nearly identical, but the difference is stark in terms of size. Out of 8,000 banks, only 228 have less than $20 million (M) in assets. But out of 7,700 credit unions, 4,161 have less than $20M in assets. The trend reverses on the other side, with just 3 credit unions but 110 banks that have more than $10 billion (B) in assets. That size makes a lot of difference in analyzing sustainable growth rates. In 1987, the credit union system as a whole had, on average, 6% capital. This was before HR 1151, when prompt corrective action didn’t exist. Credit unions could actually operate with a very Figure 5: Credit Union System Sustainable Growth History 2.00 1.80 1.60 1.40 1992 system ROA (%) 1.20 2002 system 1997 system 1.00 1987 system 2006 system 0.80 2007 system 0.60 Q2 2010 system 0.40 2008 system 2009 system 0.20 0.00 12.00 11.60 11.20 10.80 10.40 8.5× 10.00 9.60 9.20 8.80 8.40 10× Sources: NCUA 5300 Reports; CUNA Economics and Statistics; CUNA Mutual Analysis. 9 7.60 7.20 14× Capital/Leverage (%) Sustainable growth rate: 8.00 5% 10% 15% 6.80 significant amount of leverage, and that leverage fueled the growth of the system. ROAs were also strong, averaging about 100 basis points. From 1987 to 1992, and on to 1997 and 2002, the strength of ROA built the capital of the system. Earnings carried capital from 6% all the way up to 11%. From 2002 on, ROAs started to weaken. So from 2002 through the first half of 2010, ROA has weakened, and capital has been pulled back by lower earnings and the financial crisis. Your ability to grow is equal to ROA times leverage. So the top line in Figure 5 means that the credit union system as a whole could grow at a rate of 15% per year. The middle line represents a 10% growth rate, and the bottom line is 5%. Despite some small recent improvements, the challenge at the collective and individual levels is to figure out what growth level credit unions need to sustain. The long and short of it is that today, in most cases, it has to come more from ROA, because many credit Figure 6: Credit Union System Sustainable Growth Trend unions have pulled their net (ROE, 1985–2007) worth down to the point where it would be somewhat risky to 20% use that as the principal driver 18% of growth. 16% 14% 12% 10% 8% 6% 4% 2% 0% 1985 1990 1995 2000 Sources: NCUA 5300 Reports; CUNA Economics and Statistics; CUNA Mutual Analysis. 2005 2010 The sustainable growth trend shown in Figure 6 is clearly problematic. The deterioration in the first half of the trend is mainly due to the system building capital, which is not bad. However, the second half of the trend line results from declining ROA, pushed lower by narrower interest rate spreads, loan securitization, increased competition, higher compliance costs, cyclical headwinds, and increased operating expenses. That’s the bad news. The good news is that although the system as a whole may be engaged in an unsustainable trend, individual credit unions don’t have to participate. Figure 7 shows the seven factors that weigh on credit union sustainability and the requisites for each that contribute to, or detract from, ongoing sustainability. 10 Figure 7: Sustainability Factors: Will the Trend Reverse or Continue? Trend reverses Factor Trend continues Spread widening continues Spread Compression reverts to trend System costs rationalized Operating costs Costs increase (regulatory burden, channel proliferation) Release improves ROA Loan loss provision/allowance for loan loss Macroeconomic challenges continue New sources identified Fee income Caps imposed Risk-based capital (RBC) reduces overall burden Regulatory capital requirement More capital required Credit unions sell more loans to secondary market Asset turnover Continue to balance sheet loans (except real estate) No further assessments Special assessments Additional assessments Source: CUNA Mutual Group. Credit Union Levers for Controlling Financial Sustainability John Lass recalls, “Six years ago, when I was first coming into the credit union system, one of the first things Jeff Post [CUNA Mutual CEO] asked me to do was go around the country interviewing CEOs of large credit unions. I asked the CEO of a very large credit union if it was important for that credit union to be able to grow. The CEO’s answer was, ‘If we stop growing, we cannot remain relevant to our members’ needs.’” Not every credit union needs to have the same answer, but it is a prospect that each needs to consider and debate. The DuPont model offers a simple way to unpack the different factors that roll up into ROE and therefore determine financial sustainability (see Figure 8). Figure 8: ROA and ROE Defined Profit margin Net income Revenue Asset turnover × Revenue Assets Leverage × Assets Capital ROA ROE Sustainable growth The fastest a credit union can grow assets without affecting its capital ratio Source: CUNA Mutual Group. 11 The first ratio is profit margin. Profit margin is equal to net income divided by net revenue. For most credit unions, net revenue has three primary components: net interest income (spread income); fee income, which is your noninterest income; and nonoperating income. Now, nonoperating income is usually a very small number. In 2009, some credit unions had big numbers because they pushed the NCUA insurance fund assessment back to 2008. And when the Temporary Corporate Credit Union Stabilization Fund came out, many credit unions spread their payments over seven years. As a result, many booked a large gain that showed up in nonoperating income. For some credit unions, as much as 15% of revenue in 2009 was in the nonoperating income box. But typically, that portion of net revenue is small. Six primary factors that credit unions can control feed into the overall ROE equation: • Interest rate spread. • Fee income. • Loan loss provision. • Operating expense. • Asset turnover. • Leverage factor. Pushing on any of them is akin to controlling an airplane. Instead of having the rudder, flaps, and thrust, credit unions have the six levers to pull. By manipulating those levers properly, individual credit unions stay on a sustainable course. Moving one lever in a positive direction can cause another one to move in the opposite direction. For example, increasing spread income by getting into member business lending is a perfectly reasonable strategy. But what does that do to the loan loss provision? That will have to rise as well. The trick in flying the credit union airplane is understanding and controlling the intricate interrelationships among all six levers. Of the six controllable factors in ROE, operating expense is the one most under management control, and there are some very clear benefits of scale when it comes to operating expense (see Figure 10). The smallest credit unions run operating expenses of 85.6% of revenue. Credit unions between $250M and $1B in assets run 75%, $1B–$10B credit unions average 65%, and the operating expenses for the largest three credit unions are 55% of revenue. The differential between the smaller institutions and the larger institutions is consistent and it’s huge: 30 percentage points of operating expense 12 Figure 9: Credit Union Sustainable Growth Analysis ROE ROA Profit margin Net income/ Net revenue Net income Net revenue Net interest income Plus Influencers Net margin to average earning assets Yield on average loan Yield on average investment Cost of funds to average interest-bearing liabilities Average earning assets to average interest-bearing liabilities Net revenue/ Average assets Times Divided by Estimated breakdown Interchange and fees NSF and Courtesy Pay Other fees and operating income Asset turnover Total expenses Nonoperating income Plus Leverage factor First mortgages sold YTD/Total first mortgage real estate sold but serviced to Total real estate loan to share Net revenue Minus Fee and other operating income Average assets to average equity Times Loan loss provision Breakdown Gain on investments Gain on assets Other Plus Influencers Delinquency Net charge-offs/ Average loans Allowance for loan losses/Total loans Loan loss provision/ Average loans Operating expense Influencers Operating expense/ Average assets Operating expense/ Net revenue Members/Branch Source: CUNA Mutual Group. relative to revenue. These are impressive numbers in terms of ongoing sustainable growth. The differential raises several questions: What are the redundant costs in the system? What is the sustainability threshold? Figure 10: Credit Union Summary—June 2010 Credit union asset size <$250M Number of credit unions ROE Operating expense (% of net revenue) 6,905 0.70% 85.6% $250M–$1B 528 3.88% 75.3% $1B–$10B 164 5.65% 65.4% 3 11.36% 55.4% 7,600 4.10% 72.9% >$10B All credit unions Sources: NCUA 5300 Reports; CUNA Mutual Analysis. 13 CHAPTER 3 Operational Excellence Drives Sustainability Looking outside the financial services sector, Professor Frances Frei of Harvard Business School uses short case studies to show how service excellence demands having the stomach to be bad at some things, avoiding gratuitous service, designing better systems for employees, and teaching customers to behave differently. There are four traits that sustainably excellent service organizations have in common—four design principles. They can also be seen as four obstacles that get in the way of well-intentioned management. What follows is a description of each, along with illustrative examples. Each principle is incredibly important, and together they are essential. Four Traits for Sustainably Excellent Organizations Have the Stomach to Be Bad By far, the number-one obstacle to service excellence across industries, and this includes credit unions, is that firms don’t have the stomach to be bad at anything. The number-one obstacle to service excellence is actually an emotional obstacle. A culture that can’t bear being bad at something can’t have sustained excellence. The best illustrative example for this is Commerce Bank. Commerce Bank became the fastest growing bank in the United States on deposits by bucking conventional wisdom about how to grow a retail bank. Historically, the rules of the road were straightforward: Offer the most attractive rates and you’ll attract customers. And if that’s too onerous, just buy another bank, and you’ll look bigger. But Commerce didn’t make acquisitions, nor did they offer attractive rates. In fact, they offered the worst rates in every local market. It was a promise that they made to their customers: “No one will pay you less for your money than we will.” Yet, they became the fastest growing bank in terms of deposits. They did it by differentiating on two very specific attributes of service. First, Commerce had the best hours in every local market. They kept their branches open late at night—sometimes until 11 p.m.— and all day Saturday and Sunday. Customers loved this. The customers of the competition loved it, too. They asked their banks to do the same thing, and these competitors very reasonably said they couldn’t afford it. Right? It would cost too much money. So the question is, 15 if the competition couldn’t afford it, why could Commerce afford it? And the answer is, because they paid the worst rates in every local market. Commerce Bank is best in class at one thing precisely because it is worst in class at another. If you learn nothing else from this discussion, you should at least understand that you cannot be great at everything. You should also realize that if you have an inability to make tradeoffs, you’re taking it out on your employees. At some point, it becomes unfair to ask employees to support that. It’s a classic price/quality tradeoff. Second, Commerce had the best customer interactions by far. Sometimes their competition would indicate that Commerce was 20 points better on a 100-point scale. These were really distinguished interactions. Commerce had better customer interactions because they hired a different type of employee than the competition did. They selected on attitude. They didn’t select on attitude because they were more enlightened. They selected on attitude because they could. That is, they didn’t need much aptitude. And that is the dirty little secret of service organizations. Figure 12: Labor Reality $ $$ Aptitude High $ Low Low High Attitude Any organization can deliver great service with employees who have great attitude and great aptitude. Here’s the problem: Everybody wants those employees, and as a result, they end up costing about twice as much as anyone on the diagonal (see Figure 12). Commerce Bank, given the market it was serving, could simply not afford the upper right-hand quadrant. Instead, they ended up with very simple, happy employees with very little aptitude. But they had the simplest product set in all of banking, so no aptitude was required. The competition had 40 different checking accounts. Commerce had 4. The competition had all kinds of loans and fancy products. At Commerce, they said they offered loans, but quite honestly, as a customer, you could never get a loan. Source: Frances Frei. All of Commerce’s customers got essentially the same product. That meant that these low-aptitude employees could thrive. Commerce could deliver excellence with these employees, and good luck trying to beat them on attitude. If Citibank took Commerce’s employees, they would have pleasant incompetence. So this only works if you have a simple system. Commerce was best in class at customer interactions precisely because they were worst in class at cross-sell. 16 Figure 13: Commerce Bank Attribute Map Most important to target market Convenience Customer interactions ... Product range Least important to target market Price 1 Source: Frances Frei. They’re best in class at the two dimensions of convenience and customer interactions (Figure 13). The engine for that is that they’re worst in class in the two dimensions of product range and price. You want to be best in class in things that are most important to customers and worst in class at things that are least important. It’s that diagonal that’s important. Do you want to be great? Super. Just make sure you have the stomach to be bad, and be really smart about which things to be bad 2 3 4 5 at. Sometimes saying you have a culture of Relative performance of firm excellence really means that you can’t make tradeoffs. No problem. But just understand that in the real world you’re competing against companies that are making those tradeoffs. Don’t do the corporate version of Whac-A-Mole. Don’t run after one thing you’re bad at, and another thing, and another, with everything snapping back to mediocre along the way. That’s a good way to end up with exhausted employees and still not be good at everything. Consider the MacBook Air. Apple scanned the horizon and decided they wanted the MacBook Air to be best in class at laptop lightness. That meant it had to be worst in class at memory. At a moment in time, these two things traded off against each other. Apple had a AN ALTERNATE VIEW OF COMMERCE BANK’S SUCCESS There’s more to the Commerce story than not always good at managing the ROI of meets the eye, says McKinsey partner and the incremental decisions they were mak- Filene Research Fellow Dorian Stone. One ing in the spirit of the “Commerce Way.” of the things Commerce did exceptionally well was high-service, convenient delivery. One of the things they didn’t do so well was manage noninterest expense (NIE). And with success, the bank’s NIE started to skyrocket. So their growth came, and they kept doing the things they were good at, in the spirit of driving growth. But they were 17 The bank’s NIE took off and growth was tremendous, easily outpacing revenue. But that didn’t show up in the headlines, because everybody loved Commerce. And the bank didn’t have to face the consequences, because for quite a while their stock continued to go up—until things fell apart. choice: Being best in class at weight meant being worst in class at memory. If you don’t want to make tradeoffs, you can be average at everything. Just put a Dell sticker on it. Importantly, the engineers at Apple were not tormented by the MacBook Air having the worst memory. The reason they weren’t tormented is that physics applies to physical products. The message for credit unions is that physics applies to financial services as well. Yet, we seduce ourselves into thinking that’s not true. In the presence of charisma, it often looks like we can overcome physics. The challenge is that customers do not simply state their preferences. Given a list of variables and asked to rank them in importance on a scale of one to five, most customers will give everything a five. Instead, consumers reveal preferences. Conjoint analysis is the way to get there. Ask members a series of questions: Do you prefer this to this? Consumers have to be coaxed into revealing their preferences. The good news? You can influence what your customers care about. Consider tap water. Everyone was perfectly fine with tap water until bottled water came along. Bottled water companies were able to convince us to care about water, so there’s hope for credit union marketers. Avoid Gratuitous Service The second principle is avoiding gratuitous service. The longer you have customers, the more steady the drumbeat to give them stuff for free. That’s called gratuitous service. Unfortunately, you can’t sustain service excellence if you have too much gratuitous service, so you need to design reliable funding mechanisms into the service offering. There are three ways to do that. If you have at least one designed in, you have a chance at sustained excellence. If you don’t, you’ll likely get episodic excellence, because you won’t be able to pay for the additional service. The first method is clear from the example of Commerce Bank. The Commerce customer paid more for convenience every day, whether they used it or not. By receiving half a percentage point less on deposits, they paid for the extended hours. If you’re going to ask the customer to pay more, however, make it as palatable as possible. Charging for a teller is not palatable. Half a percentage point less on deposits is more palatable. Even if the member is economically better off being charged for the teller, it just doesn’t feel right. The second method is best illustrated with an example: Progressive Insurance. The auto insurance industry is interesting for a number of reasons, primarily because it loses on insurance by design. It pays out 18 more than its customers pay in. The reason the industry stays afloat is that its customers pay in advance. It’s also the most price-sensitive industry in the United States. If Progressive charges $100 and State Farm charges $95, customers flock to State Farm. This is a true commoditized service industry. Against that backdrop is Progressive, which spends more on service than anyone else by far. The customer won’t pay extra for that service, and yet the service directly contributes to why the company is more profitable. If you’re a Progressive customer and you get into an accident, you call the police and you call Progressive. Progressive shows up at the scene of the accident long before the police do. They come in a sporty, white van. They’re really kind. They dust you off. They ask if you’re OK. They assess the damage right on the site. They even write a check right there and give it to you. Customers love this service. But those vans are very expensive. The wireless technology to support remote claim settlement is very expensive. Claims adjusters, unfortunately, can no longer work just 9 to 5, because customers get into accidents at all times of day and night. Managing three shifts of workers is very expensive. How does Progressive make it work? By showing up at the scene of the accident, they reduce a really big cost: fraud. In this industry, $15 out of every $100 of premiums goes to fraud and legal fees. Progressive didn’t come up with this idea to enhance customer service: This is fraud reduction in a pretty dress. That’s the second method. Start with operational savings and creatively figure out how to dress it up. There is not an organization that has attempted to do that and been unsuccessful. Sequencing matters. If you start with a service and try to reverse-engineer how to pay for it, it’s a needle in a haystack. Instead, start with your biggest, most persistent bucket of cost, preferably one that has plagued the industry. Put a cross-functional team on it. It’s not even going to take them more than three hours. Fraud-busters framed as the immediate response van. That’s the second funding mechanism. The third funding mechanism is becoming increasingly popular: Shift employee labor to customer labor. But be cautious. This is a way to fund service, not necessarily a way to fund excellence. The requisite quality standard for turning customer labor into an excellent experience is not easy, but it is straightforward: Design a self-service that is so good that customers prefer it to a readily available full-service alternative. Think airline kiosk check-in, not supermarket checkout. That seat map in the airline kiosk that lets you pick your seat is lovely. It allows you to work out all your own private idiosyncrasies and then just 19 point and click; it’s a beautiful thing. No full-service person can help as much as that seat map can help. The supermarket checkout is completely the opposite. Designing a system that pushes customers toward self-service because full-service is grim can’t lead to excellence. At the supermarket self-checkout, you do exactly what an employee would do. Asking the customer to do the exact same task as an employee cannot lead to excellence. You have to fundamentally redesign the task so that unskilled, heterogeneous customers can do it. Design Systems So Typical Employee Can Be Excellent The third principle—and this is one that bedevils credit unions— is that great organizations design their systems so that a typical employee can reliably produce excellence. Most organizations design their systems so that their best employees can achieve excellence, but what you need to do is design your systems for employees that you are likely to attract and retain—not for the employees you wish you had, but for the employees you actually do have. Well-intentioned managers try to set their best employees up for success. But sustained excellence comes from aiming at the middle of the pack, not at the top. You shouldn’t optimize for your best employees because you can never have enough of them. Instead, optimize for typical employees. If your employees can’t achieve excellence, you haven’t designed the job correctly. In other words, if your service is not dependent on the person delivering it, you’ve designed a system that reliably produces excellence. That system decomposes into four parts: (1) who you hire, which has to be aligned with (2) the training you provide, (3) the job that you ask employees to do, and (4) the performance Figure 14: Employee Management System Hire for attitude Train for service Permits Limited product set Creates Better customer interactions Design a system where typical employees have a reasonable chance of success Source: Frances Frei. 20 management system you put in place. Employees are reasonably able to excel when your job design matches these four characteristics. Incentives rarely solve problems, but they can certainly create dysfunction. Job design solves lots of problems. For instance, Commerce Bank knew within 15 seconds if they were hiring the right person for a frontline job. How? They looked to see whether the applicant smiled in a resting state. Most people smile when provoked, but Commerce tested for more than that. They hired people for whom smiling was not a conscious decision. They aligned their job design, their selection, and their training. And they were very thoughtful about how they did it. Another example, because Commerce is almost artificially simple, comes from a large international bank trying desperately to improve their branch experiences. They put in incentives. They put in training programs. They tried everything, and they couldn’t get there. So a senior executive went to work on the front line. Here’s what she reported after her first day: “From the time the doors opened, customers were yelling at me. Now, we knew it was bad, so this was unfortunate, but confirming.” But then she sheepishly admitted, “By the end of the day, I was yelling back.” This executive was working with a system reliably designed to produce customer antagonism. Behind the scenes was a common culprit: Marketing was making promises that operations couldn’t deliver on. And the disconnect was experienced at the front line. In just the past few years in financial services, operational complexity has increased. It’s had to. But has the level of employee sophistication changed over the same period of time? Probably not. You can’t get excellence with that gap (see Figure 15). That Figure 15: Job Design Dilemma gap reliably produces unpleasant experiences on the front line. Operational complexity Level Gap experienced by front line Employee sophistication Time You can dramatically enhance employee sophistication. But it’s easy to underestimate how big a deal that is. You can’t solve this with a weekend retreat. The other choice is to reduce operational complexity to match employee sophistication. The challenge is to do it in a way that doesn’t simultaneously reduce revenue. It is the obligation of executives, not frontline staff, to close the gap. Teach Customers to Behave Differently In order to deliver excellence, sometimes you have to get customers to behave differently than Source: Frances Frei. 21 they want to. When your customers are blocking your path to excellence, you have to get them to behave differently in order to be able to thrive. Here’s the problem. It’s pretty easy to get customers to behave differently and have them dislike you for it. But great organizations can get customers to behave differently while simultaneously boosting satisfaction. That’s the trick. The classic example here is Starbucks. Starbucks was experiencing severe product proliferation. It got so severe that it threatened the graciousness with which their baristas could deliver their service. So they came up with a really good idea. They decided to offload the ordering process to the customers, so the baristas wouldn’t have to remember all of those drinks. But if customers used any language they wanted, in any sequence they wanted, it would introduce chaos into Starbucks’ operating environment. So they came up with a mechanism that got customers to use their language and their sequence and, just as importantly, to like them for it. They did two important things to accomplish this. First, they published a 22-page book. Part of it reads, “If you’re nervous about ordering, don’t be. There’s no right way to order at Starbucks. Just tell us what you want, and we’ll get it to you. But if we call your drink back in a way that’s different from what you told us, we’re not correcting you, we’re just translating your order into barista speak.” They’re telling you how the cool kids would have ordered it, is what they’re doing, but they’re doing it in a really important way. They yell it back so everyone else in line can hear. Doing that has a normative effect, and customers aspire to get it right. If they order it wrong, they apologize. In quick review, remember the four principles: • In order to be great, you’ve got to be bad. • You’ve got to pay for the service you give. • Set your average employee up for success. • Don’t be afraid of confronting ingrained customer behavior. Excellent Organizations Ruthlessly Expose Problems Beyond the four principles that characterize excellent service organizations, here is a final illustration about strategy. Steinway & Sons, in its heyday, essentially owned the entire piano market. They owned the top of the market. They owned the bottom of the market. This wasn’t surprising, because every single Steinway piano was a work of art. It was handcrafted, lovingly assembled with 22 aged wood. To Steinway’s craftsmen, each assembly of a piano was really just a magical experience. And then along came Yamaha, which had just finished conquering the not-so-related field of lawnmowers. They looked around the world and saw an uncontested market. The problem was, nobody at Yamaha had any idea how to make a piano. But they had excess capacity, and they had a really good idea. They bought a Steinway piano, and they very carefully disassembled it. They kept track of all their disassembled pieces, and with their automated processes they built something like it. Because at Yamaha, there are no craftsmen; they just manage automated processes. They replicated every one of the disassembled Steinway pieces, and then they reassembled their replica pieces into something that seemed exactly like a piano—until you played it. By every objective measure, this piano sounded like crap. But in the piano market, the quality of the piano only has to be slightly greater than the skill of the person playing it. Yamaha was able to get away with lower quality, which was less expensive, and they got the entire bottom of the market. The next year, Yamaha got a little bit better at their automated processes. They still made lousy pianos, but they were good enough to get the next layer of the market. The next year, they got a little bit better again, and at this point, Steinway got scared. They did what a lot of companies do when they get scared: They hired a consultant. Their consultant came in and did a beautiful analysis. The conclusion: Yamaha’s incursion was good news for Steinway. Why? Because pianos are a segmented market. And Yamaha’s low quality emphasized Steinway’s high quality. What a relief. But Yamaha kept getting better year after year, and when Steinway finally decided to take them seriously, it was, quite tragically, too late. Steinway filed for Chapter 11 the day after the first Yamaha piano was played in Carnegie Hall. And since then, they have been rescued on the verge of bankruptcy repeatedly. The brand is now a shadow of its former self. In Figure 16, it’s unimportant which specific organizations you give as examples. The generalizable lesson comes down to: Which would you rather be, Company A or Company B? Steinway or Yamaha pianos? GM or Toyota cars? Triumph or Honda motorcycles? If someone else is improving at a faster rate than you, they will become better than you. It is simply a question of when. Company A often waits too long to take action. Company A loves to benchmark how much better they are than everyone else. If 23 Figure 16: Focus on Rate of Improvement At any point in time, benchmarks of absolute difference can be very misleading for Company A Company A Quality Source: Frances Frei. Company A would just focus on rates of improvement instead of the absolute difference, they would get terrified sooner and have a chance to act. So how do you improve at a faster rate? Surprisingly, there is in fact something demonstrably different about companies that improve faster than everybody Company B else. They relentlessly seek to expose problems. A typical organization does not strive to surface problems. For example, utter the phrase, “Don’t bring Time me a problem unless you bring me a solution.” That’s a magnificent way to make sure that you only surface a subset of all the improvement opportunities. It’s a magnificent way to make sure that someone else has a rate of improvement that’s better than yours. In excellent organizations, problem surfacing can be a solo sport. Solving problems, that’s a team effort. People in lagging organizations don’t make waves, because nobody wants to be a squeaky wheel. In conclusion, you have to get the service design principles right and change your attitude toward problems. Relentlessly seeking out problems coincides with extraordinary rates of improvement. 24 CHAPTER 4 The Basis and Need for Operational Innovation Dorian Stone, partner at McKinsey & Company, examines credit unions against competitors, finding strengths in loyalty and trust but weakness in operational expenses. Collaboration will be helpful, eventually, but better efficiencies need to start today. Improving operational efficiencies and changing the focus of your credit union is like remodeling an airliner in midflight. You can’t take it out of commission or you’ll lose your business, but you have to make overhauls and adjust your course or the plane will eventually drop out of the sky. The efficiency ratios of the credit union system are unsustainable, and there are a lot of moving pieces to manipulate in order to fix that problem. But fixing the problem is not optional; either you do it or you will eventually be out of business. Credit unions enjoyed a single-pronged challenge over the last few years as the banking industry was getting rocked. Deposits were flowing in, and even though loan growth was stagnant, there was a feeling of success, of gains in market share. But now a two-pronged challenge is emerging. In addition, a more efficient and competitive banking industry is emerging. They are already stripped through and reinvesting in performance culture. And they are upping the ante on some functional elements as well. In response, your credit unions are now the plane in the sky that needs to be rebuilt but, at the same time, needs to keep moving. As leaders of your institutions, you have to look for win–win ways to reduce costs while winning over customers in such a way that they actually increase their value to you as an institution. Consumer Sentiment and Credit Unions Consumers are starting to feel a little bit like they did before the recession. For example, think about the revolving debt segment (see Figure 17). Intention to use loans sank across the board through early 2010, but it sank most dramatically for credit cards. You don’t need any more warnings about the importance of the Internet. The way consumers get information about financial products has already shifted. And the way consumers open accounts is 26 Figure 17: Consumers Are Deleveraging, Especially in Credit Cards Deleveraging activities will continue across most loan products, but the focus will continue to be on credit cards What are you likely to do with your loans over the next six months? Percent of respondents* Product Q1 2009 Q2 2009 8 Mortgage 11 Home equity loan 6 10 Personal loan 6 36 +2 5 4 +3 7 3 –1 9 Credit card balance 3 +14 20 +4 7 +3 14 Auto loan 3 +12 20 Q3 2009 +3 6 4 +30 +23 27 Open/Increase Q1 2010 4 +4 8 5 +2 7 6 +2 8 4 +3 7 6 +20 26 Close/Decrease 3 +3 6 4 +1 5 5 +1 6 3 +4 7 6 +20 26 Delta *Balance indicated no change intended. Source: McKinsey Consumer Financial Health Survey, January 2010 (survey of 3,000 consumers across 13 segments). shifting quickly. Anywhere from a fifth to a third of financial products are being acquired online. Even more interesting is that the majority of credit card solicitations arrive in the mail, but they are drawing their largest set of responses online. Figure 18: Consumers Increasingly Rely on Online Channels Information gathering Account servicing Product purchasing Preferred source of financial information Use of online banking Acquired last financial product online TV and radio 9% 25% Internet 66% Print 2000 Q2 2010 Source: McKinsey 2010. 27 8% Checking 48% Non-Checking 21% 27% Do consumers think of credit unions as an industry easy to do business with online? Do they see remote channels and multichannel functions? Combine that challenge with the uptick in smartphone usage and it becomes even more pronounced. Smartphones are expected to constitute 58% of US handset shipments in 2013. They offer an opportunity to resolve traditional consumer pain points, but only for financial institutions with the scale or the willingness to keep up. When it comes to customer satisfaction, every year the largest banks underperform the regional banks. The regional banks underperform the small banks. The small banks underperform credit unions, right? You don’t even have to look at the scores, because that’s always the basic trend: credit unions at the top. The problem is that despite the fact that people may not have a lot of goodwill toward their financial institutions, they’re not likely to leave them. So you may be gaining deposits, but it’s a lot harder to become the primary financial institution. People still love the devil they know. People say, “Even though I don’t trust the system, I trust my bank.” When comparing the different reasons that people are loyal to an institution, trust and service are always important, and credit unions consistently score well there. But consumers actually tend to rank credit unions as underperforming on overall value. And in the downturn, across industries people are making decisions based on the value portion. Consumers are looking for an institution that is proactive and valueoriented and that understands the balance between functional and feel-good. When I walk into a credit union, I think about people who are really friendly. If I need something, they’ll react. That’s good. And I trust them to do the right thing. But frankly, the front line may not always be the sharpest. They’re not always the most aggressive. I don’t get the sense that they’re always really banging away. And that may be fine, but in this economic cycle, that starts to raise some questions as to what type of growth you can win. Challenge: Cost-Efficient and Attractive Even the smallest banks outperform similarly sized credit unions in operational efficiency. A steady gap persists, with banks between $500M and $17B running noninterest expenses on average around 50% of net interest and noninterest income. Credit unions of the same size run noninterest expenses 10–20 percentage points higher. 28 In a competitive market, that’s a fatal difference. What can credit unions do about it? First, there’s a structural issue: You’re only as big as you are for operational efficiency. But there’s a DNA issue as well, which is also very real when you consider credit unions’ performance culture. Most credit unions have historically pounded on service, and in many cases that has been a crutch to justify higher expenses. Efficiency ratios for larger credit unions should be below 55%, or even below 50%. Union Bank operates at about 42%. The more efficient elements of Washington Mutual, before it went under, were operating at about 38%. As a thought exercise, try to rebuild a credit union and hit 42%. It’s a fascinating exercise. We did this in 2007. We rebuilt banks, universal banks, with different mixes of business. The early hypothesis was that not every bank can get below 50%, because some are deeper in mortgages, and some are doing more on the retail side; some have credit cards and some don’t. That hypothesis was wrong. Everyone could get below 50%. That’s a strategic consideration for every credit union: Banks out there are going to keep pushing to get below 50%. The winning formula is below 50%. There you can actually hold your own and take market share from the weaker banks in the mid-50s. North of the 60s is dangerous territory. Better Execution, Not New Strategy Up until about 24 months ago, the largest banks were telling us, “We don’t want to tinker with strategy anymore. That’s just not where the juice is.” Instead they wanted to know how to get a distributed group of networks—branches, service teams, etc.—to perform better. In breaking the issue apart, you find that the execution quality of the branch network is at least half of the value at stake for any given bank regardless of whether the bank’s historical performance is good or bad. This is very encouraging, particularly for the credit union system. In the near term, maintaining the growth that credit unions have seen will come by increasing the total customer value per customer. You, like any financial institution, probably have a large percentage of customers who are unprofitable. So turn inside the network instead of trying to solve the harder strategic issues. That might be the best place to focus. But there’s always a choice. Most banks focus on one strategy or another (see Figure 19). It’s either lots of products or high balances 29 Figure 19: High Penetration or High Balances, but Not Both Few products per household but high balances per product Customer relationship value (CRV) per product (dollars)* 250 No bank is in sweet spot of high penetration and high revenue generated per product 175 High product penetration but low balances per product 100 3.0 4.5 6.0 Customer relationship index (CRI; number)** on fewer products. There doesn’t seem to be anyone that can sustain a high total number of products and high balances in those products. The Wells Fargos of the world (the lower left quadrant in Figure 19) have a product-oriented culture. The target is eight or more products per household and the focus is on execution within product silos. They don’t have to coordinate. Every separate business unit is accountable for cross-selling their product line, and it’s ruthless. *Average annual revenue generated per product across all products per demand-deposit-account household. **Average number of total products per demand-deposit-account household. The banks in the upper left are different. These are like Source: McKinsey Branch Benchmark. Citibank, where they shield the customer from frenetic crossselling because they want higher-value, more sophisticated customers. They reinforce deeper, higher-balance relationships, and they’re not afraid to introduce new products more slowly, more deliberately. And when they get those customers, they get two, three, or Figure 20: Account Opening and First Month Accounts for four times the balance of what 72% of Lifetime Cross-Sells the retail side of Wells Fargo would be getting. Products per new personal demand-deposit-account household by time since first account opened* Percent of lifetime value—average across all participant banks and branches 100 Range across banks 72 73 75 30 days 60 days 180 days 61%–87% 61%–88% 62%–88% Lifetime** *Includes all new personal demand-deposit-account households originated within the branch network; for purposes of this metric, direct deposit, online banking, bill pay, and overdraft were not counted as product accounts; includes savings, money market, CD, mortgage, home equity loans, home equity lines, investments, and credit cards. **Average product accounts per personal demand-deposit-account household as of December 2008 for all banks that reported. Source: McKinsey Branch Benchmark. 30 Regardless of how many products are opened, however, the initial account opening and the first month are critical for overall cross-sells (see Figure 20). In contrast, consumers on average add virtually no accounts between 60 and 180 days from initial account opening. And beyond the first year, there’s only a gradual addition of accounts. Branch execution means several things. First, it’s everything from scheduling the right people for the volume of customers—predictive staffing. It’s frontline training. It’s making sure that administrative tasks get done during service troughs instead of trying to stay open extra hours. It’s putting saved money back into sales incentive and staffing in the branch. It’s getting the right forms into customers’ hands before they get to the teller. Another great example is the now-defunct Washington Mutual. They were trying to cross-sell personal financial services, their equivalent account opening for a brokerage account. The problem was that the original forms were made for a financial advisor, but they couldn’t pay top salaries for frontline employees who could make sense of such complex material. They realized that it didn’t work to have lower capacity individuals trying to explain these complex forms that were designed for mass affluent customers. So they dumbed down their forms. They literally put pictures on them. The question “How much do you want to save?” was accompanied by a picture of a dollar sign and a blank space for the number. They piloted this approach in a number of areas very successfully. It was like a cartoon, and they did that so their lower-cost frontline employees could actually understand it. A secondary positive result was that the customer was put at ease, because everything was simple. They marketed it as bringing simplicity to customers’ lives. They said, “Trust us. We’ll take care of all the complexity. And people that are trying to make it hard for you, they’re taking advantage of you.” They certainly didn’t talk about it as a crutch for frontline employees. They weren’t seen as the unsophisticated bank. Instead they were bringing value to the customer. Effective branch management is not always fun, though. In credit unions, like everywhere else, there are different people staffed into different roles. What’s different about credit unions is that you try to move them into other roles to keep them. Maybe they’ve been with KEY BRANCH SUCCESS QUESTIONS How do you simplify member-facing How do you minimize the time members materials? have to interact with tellers without sacrific- How do you design the member’s process at key moments like account opening or cross-sell? 31 ing satisfaction? you for a long time. Maybe they’re very friendly. Credit unions are like the Southwest hug culture, not the Virgin America clubbing culture. This friendliness pervades credit unions’ management decisions. There’s nothing wrong with being nice . . . until there is. And strong branch execution relies on having a performance culture at the front line. Performance culture at the front line relies on knowing what good looks like and holding people to it. And you can’t do that credibly if you allow employees to miss the bar and still stay. It’s nice, but it means your good employees will start to look around and get frustrated by the culture. MORNING HUDDLES TO DRIVE BRANCH EXCELLENCE Morning huddles are best when they actu- good performers and seek input from ally review daily performance instead of them. They indirectly target low performers simply waving pom-poms. They recognize by spotlighting success stories. 32 CHAPTER 5 Conclusion and Synthesis The final panel discussion asked the speakers to consider the structure and mission of credit unions in relation to operating expenses and profitability. Also explored: the role of boards, marketplace opportunities, and what member value should look like. The Sustainability Colloquium drew 75 CEOs and senior credit union leaders, all of whom participated throughout the day. But at the end, a panel discussion exploring the suitability of the DuPont model and its place for credit unions brought the lessons of the day into focus. What follows is a summary of the in-depth conversation. The credit union structure is a cooperative structure with members as shareholders and shareholders as customers that derive benefits from a firm’s expenditures. What does that mean about operating expenses? Given that structure, should credit unions simply minimize them as any other firm would? John Lass: You have to have a cost structure in your organization that’s going to be consistent with your value proposition. I think that came through loud and clear in several of the presentations, particularly in Frances’s presentation. Whether you’re a cooperative entity purely, or a mutual entity, or a for-profit entity, you still have to make the numbers work. I remember when I first got involved in the credit union system six years ago, I interviewed a CEO. This person said their credit union’s ROA had gone over 100 basis points, but not to worry, they would figure out how to get it back down again. This person saw me twitch a little bit and said, “In theory, if your capital’s adequate, your ROA should be zero, because if it’s not zero, you’re not giving enough value back to the members.” Now I understand that kind of philosophy, but in the current environment, I don’t think that that works anymore. You have to have a reasonable ROA, because many of our institutions have pulled the capital down to the point where, in order to support growth, you’ve got to have earnings. And so I think it’s just a question of coming up with an operating cost structure that works within the value proposition. But I think you have to be prepared to try and drive some profit in the organization. 34 George Hof heimer: We do have one foot in the for-profit world and one foot in the not-for-profit world. But considering the economic environment that we’re in, I think the discussion has changed so much that we have to consider operating expenses as: If we’re not efficient, we’re taking money out of our members’ pockets. So I think kind of flipping the discussion around such that everyone asks, “What is our main purpose?” It’s to provide the best possible service to members. And part of that equation, I think, has to be centered around the cost structure of the credit union. Peter Tufano: I will just ask, “What is the means, and what is an end?” Cost reduction and operating efficiencies are a means to an end. The end is member satisfaction, member service, and all the kinds of things that the cooperative movement is designed to deliver. I think it’s a pretty important means to that end but not the only means to the end. Similarly, we talked about sustainable growth, which isn’t about the sustainable part but the growth part. And you could ask the same question: Why should credit unions want to grow, and how does that relate to their mission or just to the pure economics of it? So I think as long as you maintain this organizational structure and the tax implications of this organizational structure, you’re going to have to face this at two levels: one, at your organization’s level; and two, in Washington, where other questions are brought to bear. There’s so much opportunity to the meltdown that’s happened in financial services for credit unions to move into spaces that competitors had been operating in. And yet, coming off of the assessment, there’s also a sense of: Hunker down; now’s not the time to stretch. Could you talk about the opportunity for us to grow market share? George Hof heimer: We still have 7,600 credit unions in the United States. We know that the consolidation and concentration process is going to continue. I personally believe that there’s opportunity for a fair amount of efficiency gain to be had as that consolidation process takes place, which could be a means of achieving growth through the merger process but also creating a platform for the expanded entity to drive better organic growth. My guess is that within three to five years, you will see significant consolidation taking place. There’s organic growth, which is really what we focused on, but there’s also acquisitive growth, and I think that has to really be on the radar screen right now. John Lass: It’s all about smart growth, too. Right? The point of this morning wasn’t to beat you into submission and tell you, “You can’t 35 grow. Just hunker down.” Not even close. But if you want to do that, you’ve got to do it really, really smart. So you have to worry about operational efficiencies. You have to worry about whether there is a new business model. You have to worry about where the money’s going to come from as opposed to doing it on a hope and a dream. So I don’t see what we said this morning as trying to throw cold water on innovation or on growth or anything. It simply says there’s a discipline that goes with it, and that can’t be avoided either by you or by Citibank and Bank of America. This new market is a combination of market forces and regulatory forces. We haven’t seen yet unleashed the full complement of regulation that’s going to happen when the new Bureau of Consumer Financial Protection comes into place. We better be really smart about that stuff. Historically, credit unions have taken the high road. I think there’s opportunities there, but, again, you can’t lose money when you do it. Dorian Stone: Three years ago, the banks were gearing up, as everybody remembers. Branches were growing at 9% a year, but population growth’s only 2% a year. So what’s going on? It was riding on the back of our real estate boom that was reaching the apex of the bubble by 2008. These last three years actually have been quite an inflection point. And I think you’re at a crossroads. I unfortunately think that the credit union movement as a whole has not done what it should have done. I am not as close to it as you all are, but if I look at the numbers in terms of the efficiency ratios, if I look at the celebration of the growth in deposits as if it were something that anyone could take credit for. My bigger concern is that the job of aggressively growing in 2011 is going to be tougher than it has been in the last few years. I think you absolutely should do it, but I think you’re going to have to do it in a way that also drives your efficiency ratios down. If you’re a credit union that hopes to be of scale or thinks you are of scale right now, if you are not trying to find ways to get your efficiency ratio down to the low 50s, if you’re not fighting toward that number while at the same time making these other improvements, you’re not working hard enough. And that’s me, and you can throw a brick, but I would put hard numbers there. We’re going to see huge shifts in where our money’s going. We’re going to see spreads fluctuating. And I think that’s going to continue to hide the true efficiency of what you need to be driving down. But part of what we’ve also seen is that when spreads and everything else 36 are moving, it actually hides the true cost of running your credit union. I’ve heard very little talk about driving down unit costs, let alone considering that in parallel with the percentage of operating costs. That would be a really healthy conversation that would allow you to grow in that smart way. At a credit union, the governing structure is not just economic return to our members, and changing strategy with a credit union board of directors is very different from changing strategy with a shareholderowned company. So what should the conversation be like when we go back to the boards with this kind of information and say, “We need to make our legacy members angry; we need to drive down costs and give less service”? How does that fly among directors who are often focused on different issues and not pure economic issues? George Hof heimer: You probably want to use different language. I think you flip it on its head, and you talk about operational efficiency not as a way to better serve our members, but that every dollar that we do not spend efficiently is a dollar that we take out of the members’ pockets. That’s how you frame the discussion. Dorian Stone: Have you truly coalesced around a vision of what the credit union’s going to look like in three and five years and how that’s going to translate into specific metrics? Forget segments; forget any of that. I want to be bigger, smaller, I want to do it by how much, and I want to move at this pace to get there, and I want to keep my customers happy at some level of happiness. Can each of your board of directors say, “We have built a set of what good looks like that I know when I get there”? If you don’t, then I think these conversations become very problematic, and they become regular. We could invest all that money to go penetrate the left-handed, disabled, under-five-foot-two category. We could do that. And for the credit union movement and for whatever, we’re going to feel great. We’re going to talk about what we’re doing to get into the community . . . but if we assign operating budget versus PR dollars to justify that, we’d better be damn sure that that gets us to our vision of what this means to be a scaled business. Without that sort of very clear definition of success, you start to do the things that are actually in all the right spirit and all the right mission, but without any common foundation for discussion, it has a hard edge. If you’re not getting that discussion from your board of directors, then I would put that on the table to the board of directors. And if 37 they’re still not, and they seem just comfortable with what’s going on, and you’re not comfortable with what you see, then I think you need to have a hard talk about if you’ve got the right board of directors. Can a nonprofit navigate the same environment as well as a forprofit organization? Peter Tufano: I run a small nonprofit. It’s not a credit union, but it’s a small nonprofit here in Boston. And we are actually going through this exact process with our board. We don’t see any reason why we can’t be just as nimble as any for-profit. If you think that part of the solution is creativity—thinking new things, doing new things—there’s no reason, especially if you can align your staff around mission, you can’t make a hard right when the situation demands. I see your ability to do this in a small organization that’s missiondriven as probably a lot easier than in a larger organization that’s not mission-driven, where you’ve got a lot of employees that you have to drag along. You know, that’s idealistic. All I’m telling you is, I’ve seen it in nonprofits. Nonprofits can be just as bad if not worse than for-profits. When I first started this, I thought that nonprofits were this idyllic world, and for-profits were tough, even though I teach at the Harvard Business School. I found that the variation in both of them is extraordinarily large. You can be nimble in either organization. You can shoot me if you’d like, but you can’t hide behind your nonprofit status. There are times when it might sound like you can. You say, “Oh, we don’t have the capital. Oh, we can’t hire the same people, because they’re going for these outsized salaries.” I just don’t buy that. Dorian Stone: I spent the last two days in a transformation workshop where I and my client go for two days, and we talk about performance culture. And in that room were a couple of the top executives of a top-three bank, a chancellor of a major public education system, two top executives of a major environmental company, and I could go down the list. Every one personified the Dilbert cartoon pertaining to them—every single one. We’re all human beings; we all have the same problems. And if it’s not because we’re nonprofit, it’s because of something else, or it’s that we’re bigger, or we’re bureaucratic. So I totally agree with Peter. I don’t think it’s a question of being nonprofit, for-profit, or credit union versus bank, or highly incented or not. I think it’s much more of, Are we going to do it or not? Do we have the wherewithal to make the tough decisions? 38 The groups that actually perform in the market, the top three things they say they focus on are accountability, consequences . . . and only later things like managerial leadership. The low-performing ones that say they are really strong at managerial leadership, it’s like, “Thou dost protest too much.” Stop talking about it and do it. John Lass: I want to link the last two questions. When I work with credit unions, I try to lump everything into three buckets: governance, cost structure, and value proposition. I can pretty much get to everything from those three, but it all starts with governance. If you can’t get that piece right, it’s very difficult to get the rest of it to work. What I have loved about the credit union system over the last six years is I have met many tremendous people that are highly dedicated to what they’re doing. They’re mission-driven, passionate; there’s a fervor and a commitment that you don’t find outside the system. However, I also see governance structures that are weak, that are outmoded—where individual agendas and egos drive the day as opposed to a focus on member value. And so I don’t think there’s a disadvantage to being a nonprofit. I think the key thing to remember is that it’s got to be about the member value. Dorian, a year ago you said operating efficiencies or lack thereof will be the doomsday of credit unions. It’s even worse now. We now have more knowledge about assessments; we now have interchange. What are the things that we’re doing that are just stupid? Dorian Stone: I don’t know the specifics well enough, but I think I know the themes. So let me try the thematic level. The first challenge is coming to a recognition that what you do in terms of the products you offer is actually commoditized, a recognition of how the world is actually working around you. The second is the overemphasis on the mission and underemphasis on the tangible success or the performance culture that we need and the tough people decisions that sit behind that. I don’t think there’s any lack of intelligence at credit unions; there’s no lack of capability. I just don’t see any of that. The one thing I do see, though, that is fundamentally different than in other financial institutions and other companies is the unwillingness and the wherewithal to make tough decisions managerially and call the spade a spade. The third theme is too much historical focus on regulatory issues. I’m so glad that I have not heard much about the credit union charter today. That’s a legacy issue that, in the current times and with everything that’s moving, is irrelevant. I’m hearing, “Let’s run the 39 business, we’ve got a real opportunity, let’s make stuff happen.” And that’s great. So what is the single biggest of those three that stands in the way of success? It’s the performance culture issue. I’ll ask again: How many of you right now know someone in your credit union that is lowerperforming or that you would not hire again? Was that person there six months ago? Did you know that then? Why are they still there now? I mean, it’s just a very simple question. You should ask the same question about your board. An exercise that each person could go through is to ask, “What are the key initiatives that I think we need to be successful?” Then write down who are the 5, 6, or 10 people that I’m going to count on in my credit union to get that done. Then ask three more questions: Do they know what they have to do? Are they capable, personally capable, of being able to manage to that end? Do they have the resources to do it? Take a look at that, and then put an “X” next to which ones are performing and which ones aren’t. Then start to ask whether they are not performing because there’s something external to them that’s not working, or is it because I’ve actually got the wrong person? Has he got the wrong talent? If you start to go through that exercise, to see how people are stacking up, you’ll actually find some stuff that’ll force you to really think. George Hof heimer: These are thematic issues. The notion that credit unions overinvest in service, I think the research project that we did with McKinsey last year bears that out with some really impressive data. I see a real lack of differentiation and a willingness to try and differentiate in the marketplace and use different language. It’s like what Frances Frei talked about: that love/hate paradox and being willing to have an offering or a value proposition that a certain portion of the population is going to love and certain portion of the population is going to hate. And as a result a lot of credit unions—and I say this because they’ve told us this—they kind of meet in the middle. And we like to call it white bread. It’s a homogenized experience that is not differentiated in the marketplace. And as a result, it doesn’t capture the imagination of the end consumers. John Lass: Several months ago, I facilitated a planning session and at the end of it, we had a long debate, kind of similar to this one, and at the end of it, a board member stood up, and he said, “Listen, I want to ask you a question. If we had to do it all over again—if we could start from scratch—would we build the US credit union system the 40 way it is today? “For example, would we create 7,600 credit unions? Would we operate off 12 different core operating systems? Would we use 35 different loan origination platforms? If the answer is no, what can we feasibly do to narrow the gap?” What should shareholder value look like at credit unions? In forprofit companies, it’s very clear. It needs to be economic, it needs to be tangible and liquid, you should be able to sell it, and you should be able to buy it. But at a credit union, it’s not tangible. Do you have opinions about what shareholder value needs to look like at credit unions? Peter Tufano: I’ll start by not answering the question, because I don’t think that shareholder value is nearly as well-defined in the real world as you’re pretending it is. For example, I spent some time in Europe, and there are for-profit firms there, and what exactly does shareholder value mean there? It’s a completely different equation. These days, even in large for-profit firms the notion [of share price] as a single-minded, unidimensional metric that you can use for everything is largely gone. It’s not gone completely, because it’s still an important constraint, but it’s not nearly as stark as you might think. Everyone seems to understand, even in business schools, that there’s value delivered to a customer. If not, there’s no long-term franchise value for a firm. And so maybe it’s back to your 0–100 scale [0 as totally not-forprofit and 100 as totally for-profit]. The folks that you think are at 100 are actually backing in a lot. They worry about operational constraints, and metrics, and the value of the membership to the consumer. They’re worried about the long-term value of a customer to them, which is not that far off. They’re worried about cross-sell, because they want a deeper relationship. You’re worried about deeper relationships, too. So I’m not so sure that it’s actually that much different. But is that a difference between the managers and the capital holders? It seems like the capital holders still see it a little more starkly than the management would. Peter Tufano: Yes, but the capital holders don’t make decisions on a day-to-day basis to set strategy or implement it. So, the other kinds of concerns we who are academics and directors worry about are that there are shareholders for sure, there are customers or members for sure, and then there are managers. And sometimes managers’ interests are aligned with neither of the other two. I sit as a director of a couple of public companies. We worry about that a lot, because we have fiduciary duties to our ultimate 41 customers; to make sure that the managers are aligned with the customers is a big deal. John Lass: In many ways, for a credit union, it should be a simpler equation, because the member is the customer is the owner. It’s much more complicated when you get out in the rest of the world. Dorian Stone: I think you should just go out and make as much money as you can. I’m being totally serious. You should do that over time, so you’re not doing things that are unhealthy in the long term for gains today and vice versa. And that’s the advantage you have, is you have less pressure to make those types of decisions. You should use that very much strategically to your advantage over time. But I think your mindset should be: I want to make as much money as I can, and then I’m going to give that money back to my members. There’s this slippery slope that I just detest, which is, I’m not going to [become more operationally efficient] because we’re going to give a little bit back to the members. We don’t even know if the members are willing to pay for that or not. Make as much money as you can, then give the money back to the members. You get that tension built back in, and I think you have a much healthier system. And I think it feeds into some of the other stuff we’ve been talking about. So I don’t make this distinction of credit union or not. The ways you can redistribute that wealth, there are laws and rules around it, but I can think of at least some creative ways to do that in a way that also holds tough on trying to reward profitable customers. I was just curious if the panel had some opinions on specifically what types of collaboration or shared services the industry should focus on and who should really be driving that bus. George Hof heimer: I can answer that with some data that we came up with a few years ago. The top three ideas were around compliance, HR, and training. Those were the three areas that had the highest probability according to actual research done with industry folks and how it should be conducted. It should be conducted through de novo organizations like CUSOs. That’s what the research says. Dorian Stone: I’d come at it the other way. I don’t care what you’re most likely to do. I think we should talk about what you should do. And if you don’t like it, well, I don’t like going to the gym, but I have to do it, right? So I agree, [willingness to collaborate] is one axis of the equation. I think the other axis of the equation is, where’s the real dollar value? 42 If I had to think about where the dollar and impact value is, I’d say training is probably not the right one. But I would think that your IT would start to come up, your bookkeeping would start to come up, your internal help desk to the extent that any of you have scaled institutions. I would think those would just carve out. And in terms of a CUSO, I think that’s a great idea, if you believe as an institution that you can actually do that better than the competition, the competition being other outsourcing firms that have been doing this for decades. But if you think you can do it, great. If not, then maybe it’s a purchasing cooperative with Wipro or somebody like that. But I would start with the blank sheet of paper and say, what do we think the right answer looks like? Now who’s the most competitive to do that? Do we believe that we can actually do it, or do we just want to do it? And there are ways of reinforcing the credit union movement and working together to collaborate around the purchasing cooperative notion rather than the building infrastructure notion. It should be an option on the table. John Lass: Right now, I think there are about 700 CUSOs. Of the 700, I believe that two have revenue north of $100M, and about 12 have revenue north of $10M, so I just want to second what Dorian said. I like the CUSO structure, but only when it makes sense economically. My advice is: Don’t get hung up on trying to keep it inside the system if that means that you’re going to create a subscale operation. 43 Endnotes 1. Robert Higgins, Analysis for Financial Management, ninth ed. (Boston: McGraw-Hill Irwin, 2009), 138. 2. Thomas R. Piper, “Butler Lumber Company,” Harvard Business School Case 9-292-013 (Boston: Harvard Business Publishing, 1991). 3. Chris Zook and James Allen, Profit from the Core: Growth Strategy in an Era of Turbulence (Boston: Bain & Company, 2010). 4. Niall Ferguson, “Wall Street Lays Another Egg,” January 15, 2009, www.niallferguson.com/site/FERG/Templates/ ArticleItem.aspx?pageid=202. 5. Central Intelligence Agency, “The World Factbook—United States,” www.cia.gov/library/publications/the-world-factbook/ geos/us.html. 44 Credit Union Financial Sustainability: A Colloquium at Harvard University ideas grow here PO Box 2998 Madison, WI 53701-2998 Phone (608) 231-8550 PUBLICATION #232 (3/11) www.filene.org ISBN 978-1-936468-11-9