INNOVATORS' INSIGHTS ISSUE

Currently, commercial banks are fighting a two-front war. On the one hand, they are making the move up into the rarified air of investment banks. At the same time, they are losing chunks of business at the low end as disruptors attack them. In both battles, the commercial banks’ weapon of choice is the bundling of disparate services. We’re quite optimistic about their chances for success in the up-market melee but pessimistic about their likelihood of victory in the down-market battle.

Historically, commercial banks such as Citigroup have taken deposits and made loans to companies and consumers. They’ve built business models that allow them to process a large volume of transactions, each of which has a relatively slim profit margin.

In the pursuit of growth, commercial banks have increasingly eyed the lucrative, higher-margin offerings of investment banks such as Goldman Sachs, which work with companies on such complex transactions as M&As and IPOs.

To date, commercial banks have clearly established a solid beachhead in the investment banks’ turf. The share of equity underwriting (which banks do to help companies sell stock shares) commanded by America’s three largest commercial banks — Citigroup, J.P. Morgan Chase, and Bank of America — grew from 12% in 2000 to 18% in 2003.

Commercial banks have achieved this growth by bundling these services with loans. They have even used the loans as loss leaders to get stock underwriting and M&A work from their business customers. Commercial banks’ business models allow them to lose money on loans to companies without killing their overall profit margins as long as they can recoup revenue (and then some) with underwriting deals.

Clearly, this spells trouble for investment banks. Many investment bank customers have already asked the investment banks to offer them lines of credit and other sorts of loans. However, that’s an unattractive proposition to the investment banks and creates what we call an asymmetry of motivation. The investment bank turf looks attractive to commercial banks given the commercial banks’ cost structure. The commercial banks’ turf looks unattractive to investment banks given the investment banks’ cost structure. This asymmetry of motivation is what makes it difficult for companies to respond to attacks from down-market players.

Commercial banks seemed poised to make further inroads into investment banks’ territory, and the investment banks will eventually have no choice but to respond. Who will win this battle is unclear. Regardless, these developments will make the investment banking industry structurally less attractive.

Still, all is not rosy for the commercial banks. They face their own disruptive threat from specialist lenders. Powered by credit scoring, specialist lenders have attacked commercial banks at the low end of their traditional businesses. Credit scoring, which is based on a statistical methodology that examines quantitative measures of a consumer’s credit history, such as bill paying or the number of credit accounts per consumer, was first used in the mid-1950s by department stores and oil companies issuing charge cards to consumers.

As credit scoring has lessened the risk of lending, specialist lenders such as auto loan and mortgage loan providers have been able to pick off some of the commercial banks’ most profitable customers.

In defense, commercial banks have bundled together a broad variety of different services, in the process evolving into one-stop shops for all their consumers’ banking needs. Today, at the local branch of nearly any commercial bank, you can get everything from a checking account to retirement planning to life insurance. The idea driving this strategy is that once a commercial bank has a customer in the door, it can cross-sell other services to him. The banks believe that customers will pay for these services because it is more convenient to get everything from one provider.

Historically, this kind of bundling would have made sense. The relationship with a customer would have given a commercial bank the in-depth knowledge it needed to assess the risk and return of offering additional services. However, commercial banks’ bundling strategies have failed to block the rise of specialists for two reasons.

First, providing a checking account doesn’t impart any unique information to a bank that a competitor wouldn’t have; there is nothing inherent in a bundle that included a credit card or an individual retirement account that allows banks to offer a better product than a specialist. And the margins on these services are not high enough to make up for losing money on another service in the bundle. Second, by focusing only on a particular type of lending (as opposed, for example, to also taking deposits, like a commercial bank), specialists can be profitable with a different business model than the incumbent commercial banks, which had historically dominated these lending markets.

Evidence of specialist lenders’ success is compelling: In 1990, commercial banks dominated the credit card industry, holding more than 80% of outstanding credit card loans. In the fourth quarter of 2003, specialist lenders controlled nearly 50% of outstanding loans.

As credit scoring grows ever more sophisticated, specialist lenders will continue to gain market share. Although many regulatory hurdles exist (for instance, around lending to subprime candidates), specialist lenders will be highly motivated to make inroads into other tiers of the market, such as small-business loans, and will likely do whatever is necessary to clear those hurdles.

As such, we don’t expect that bundling will allow commercial banks to stave off the carving up of the industry. In fact, the need to develop a skilled sales force that is knowledgeable in products as different as life insurance, savings accounts, and mortgages may be more of a liability than an advantage. The expenses tied to training and retaining such skilled workers will force the banks to charge rates and fees higher than those that consumers can get from specialist firms.

So, for commercial banks, bundling is a good news/ bad news story. The good news is at the high end, since investment banks are unwilling or unable to fight back against loss-leading loans bundled with higher-margin services. The bad news is at the low end, where we don’t expect that the commercial banks’ bundling efforts will adequately defend their consumer lending business from specialist lenders, which look well positioned to continue chipping away at the commercial banks’ lending base. 

Further reading:

“How Can We Beat Our Most Powerful Competitors?” and “Getting the Scope of the Business Right,” Chapters 2 and 5 of The Innovator’s Solution: Creating and Sustaining Successful Growth, by Clayton M. Christensen and Michael E. Raynor. Harvard Business School Press, 2003.

“Banks Give Wall Street a Run for Its Money,” by Jathon Sapsford. The Wall Street Journal, 5 January 2004.