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The Future of Retail Banking

Morningstar's Dan Werner and Jim Sinegal see a move toward digital and direct channels.

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Banks are moving toward more digital and mobile-based platforms to better address the needs of millennials, while re-evaluating the importance of their branch footprint. The best-positioned bank to benefit from these changes, in our view, is  PNC Financial Services Group (PNC), because of its aggressive digital bank strategy, which envisions two thirds of its branches being transformed into more digital and millennial-friendly branches by 2018.

We see two firms under our coverage-- Discover Financial Services (DFS) and  Charles Schwab (SCHW)--as the primary beneficiaries of changing consumer preferences. These two companies are leaders in online banking, with almost no legacy cost burden associated with extensive branch networks. Online firms have historically paid higher rates to gather deposits, but this disadvantage is fading along with the need to visit physical locations to obtain cash and deposit checks. If that weren't enough, these firms are clearly providing a superior customer experience without the benefit of face-to-face interaction. We expect virtual banks to use these advantages to gain profitable deposit and loan market share in the years to come.

One of the difficulties banks have in retail delivery is meeting the expectations of millennials (born after 1981) in order to create positive customer experiences that encourage long-term loyalty. In the new digital/mobile marketplace, the number of touch points between consumers and businesses has increased over the past five years, especially with the advent of social media. If we break down bank customer contacts in terms of channels--earned (such as PR and reviews), owned (physical locations, packaging, and so on), and paid (advertising)--the number of touch points has dramatically increased for most of these channels. Most of these additional touch points are directly related to mobile, digital, or social networks or content.

What Makes an Omnichannel Delivery Platform?
For banks to deliver a true omnichannel experience, they need to deliver on high customer expectations across five dimensions.

First, a bank needs to provide instant information availability. Generally, an omnichannel bank would accomplish this with mobile applications or easy-to-use websites. As an example, the mobile application, website, or ATM would provide real-time account balance information. Customers are fully apprised of their financial situation at their bank at that moment.

Second, the information received by the customer is the same across all channels. Customers should receive the same information regarding their accounts whether they are visiting a branch, using a mobile application, phoning the call center, or using an ATM.

Third, the customer receives personalized service across all channels. While it is obvious how a bank customer could receive personalized service by walking into a branch and speaking with a customer service representative, the ability of the bank to provide text alerts when balances fall below a predetermined threshold as set by the customer through a mobile application is another element of personalization of service.

Fourth, the customer has direct control over the process. Although consumers cannot yet directly receive cash through a computer or mobile device, an omnichannel bank gives them the ability to make payments or transfer funds between accounts, thereby putting control of the transactions in the hands of the account holder. As part of direct control, customers are able to conduct their banking business on their own timetable rather than just the timetable of the physical location.

Lastly, the customer receives information for decision support. In the case of banks, customer account information and balances can be provided to assess sufficiency of funds for transfers or bill paying. Furthermore, account holders can locate the nearest branch or schedule an appointment at the nearest physical location.

Ultimately, the goal of omnichannel delivery is to (1) increase customer acquisition, (2) improve customer retention, (3) develop deeper relationships where the customer will purchase more than one product, and (4) lower the costs of delivering products and services to the customer.

Unfortunately for banks, we think traditional retail banks' ability to deepen their moats by building omnichannel delivery platforms is limited at best. In our opinion, having an omnichannel business model is becoming a necessity for retail banks and is becoming a less effective way of distinguishing themselves from competitors. We're also unconvinced that omnichannel delivery platforms will help large banks deepen their scale-driven cost advantages over small banks. As we observed at the 2014 BAI Retail Delivery conference and exposition, there are several contractors for smaller banks that allow the latter to acquire the ability to become omnichannel with online banking and mobile application design and implementation. Indeed, the ability of banks to provide those tools for customers to conduct banking business at their convenience is pervasive throughout the industry.

Banks' Future Customers: The Growth of Millennials
According to Pew Research, millennials will outnumber the aging baby boomers by 22 million by 2030, and this new generation of customers presents a unique challenge for banks. First, millennials tend to be more of a self-service demographic, given their familiarity with and access to technology to connect with each other as well as with businesses. Second, polls clearly show that they want help with financial matters in a high-touch, high-service manner, which implies 24/7 access to helpful information about their finances. However, according to customer surveys, about 71% of millennials would rather go to the dentist than listen to what banks are saying.

Millennials Are Newest and Largest Segment of Future Bank Customers

Millennial behavior is markedly different from other generations of bank consumers. First, compared with preceding generations, millennials are generally less loyal to their bank. In a March study conducted by FICO, a leading provider of credit scoring, decision management, and fraud detection, millennials were 5 times more likely to close all accounts with their primary bank and 3 times more likely to open a new account with another bank. Thus, it appears that with the new generation of bank customers, the cost of switching banks has eased, damping any ability of banks to build their moats. Second, millennials who like their bank are also likely (56% of those surveyed) to recommend their bank to others. Third, millennials are more connected and mobile than previous generations. They are nearly 2 times more likely to use a smartphone, checking it more than 43 times per day. In addition, millennials are nearly 10 times more likely to prefer mobile applications than baby boomers.

While digital and mobile delivery options will grow in importance over the coming years, the branch still has value, in our view. According to a recent Gallup poll, nearly 80% of the populace used a branch in the past six months. However, banks are clearly moving toward branches in smaller spaces with fewer but highly trained personnel to service and engage the customer. During the exposition, we spoke with exhibitors specializing in bank branches and ATM kiosks. Based on our conversations, it is clear that bank branches are becoming smaller, with an average size of 2,500 square feet. Interestingly, if a bank is reconfiguring existing space, the drive-through window is sometimes sublet to another business (for example, a dry cleaner). Bank branch traffic has fallen off at banks of all sizes, with the superregional banks experiencing the largest decline over the past two years.

Virtual Banks Offer Low Costs and Superior Service
We see opportunities for investors in the stocks of firms that are managing the intersection of digital banking and customer service, keeping costs low while providing a superior experience for customers. In our view, pure-play virtual banks are poised to succeed at the expense of traditional institutions in this area. Renting, equipping, and staffing branches can account for half of total operating costs at large retail banks, providing a clear path to cost leadership for virtual banks. Though all banks are investing in online and mobile offerings, we think there are major differences between pure virtual banks and the online and mobile offerings of traditional banks.

In our view, virtual banking is an idea whose time has finally come. Though online banks have been around since the 1990s--Security First Network Bank opened in 1995--it took more than a decade to perfect the business model. A number of reasons for previous failures were cited by conference presenters, including regulatory issues, poor customer service, ineffective risk management, and limited product offerings. Academic studies have pointed to low levels of noninterest income and low core deposits as other reasons for direct banks' initial lack of success. However, we think other changes over the past 15 years have made a pure direct banking model more viable. The Check 21 Act, which took effect in late 2004, allows a check image to be treated as an original check, opening the door for remote deposit capture and further reducing the need for branch and ATM visits. At the same time, the use of cash has declined, making convenient locations for withdrawal less important and reducing the burden of fee reimbursements that can plague online-only banks.

We think these changes are now allowing virtual banks to achieve the cost savings that eluded them for the first few years of their existence. We estimate that online customer acquisition costs, for example, are less than half of the costs to acquire the same customer through a branch. Studies by Coreprofit/Andera and Forrester have estimated costs of similar magnitude. Transaction costs are also much lower online--between $0.10 and $0.20 versus $0.60 at an ATM and up to $4.00 at a branch.

Customer preferences have also contributed to the viability of the virtual bank. As recently as 2008, customers favored branches over ATM and Internet channels. Opinions changed quickly, though, and by 2009 online banking had become the most popular channel, according to annual surveys by the American Bankers Association. By 2013, mobile banking had begun to rival the ATM channel, with 39% of customers favoring the Internet for most activity.

Furthermore, research by J.D. Power has found that millennials and affluent customers are the least satisfied of all banking customers. These are also the customers most likely to seek out direct banks, as the offer the innovative technology and higher interest rates these customers desire. While younger customers are often perceived as the typical users of digital banking, Digital Insight has found that nearly half of baby boomers and senior citizens use online and/or mobile banking channels, and seniors can actually be more consistent users of online bill payment offerings than younger generations. According to the J.D. Power study, "Midsize banks are falling behind in meeting the needs of the fastest-growing demographic groups, millennials and minorities, especially in online, mobile, and problem resolution. If midsize banks don't change their focus to adjust to demographic shifts, they are extremely vulnerable and risk losing market share to competitors and becoming irrelevant."

The J.D. Power data also shows that the most common reason customers switch banks is poor customer service, which accounts for more than one fourth of all account moves. Although it seems that face-to-face interactions and personal relationships with branch bankers would improve customer service, direct banks may actually have an advantage in this area. Discover, for instance, maintains call centers in the United States and heavily advertised this practice in its "Peggy" commercials.

Discover's superior service is not only a marketing ploy. The company has maintained a number-one ranking in customer loyalty for 18 years in a row in the Brand Keys Customer Loyalty Engagement Index, and it joined American Express (AXP) in 2014 atop the J.D. Power Credit Card Satisfaction Survey, which measures interaction, credit card terms, billing, and payment, rewards, benefits and services, and problem resolution.

Data from the Consumer Financial Protection Bureau supports the assertion that customers actually experience better service from online banks. Virtual banks, including Discover, Ally Bank (ALLY), and Charles Schwab Bank, have experienced far fewer complaints relative to consumer assets than peers with large branch networks since the CFPB began collecting data.

Online banks have historically needed to pay higher rates to attract deposits than more convenient branched banks. However, online banks are now taking in plenty of deposits despite having few, if any, physical locations. More important, the funding cost gap between online and branched banks has fallen from 1.36% to only 69 basis points over the past five years. We expect this gap to narrow further as consumers continue to shift preferences to online offerings.

Online Banks Are Increasing Deposits

At the same time, virtual banks are gaining market share in lending. Discover has gained an average of 40 basis points per year in credit card market share over the past five years, 7 basis points per year in student loans, and 23 basis points per year in personal loans. We expect the company's low-cost direct business model to result in further market share gains over our forecast period.

In summary, we think the combination of a low-cost position due to a lack of physical branches, shifting customer preferences, and superior customer service is strengthening the competitive advantages of the bank subsidiaries of Discover Financial Services and Charles Schwab, supporting these firms' positive moat trends.

Dan Werner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.