Conventional wisdom on the future of bank branches has see-sawed so many times in the past decade that you need a score card to keep track. The ATM and telephone boom of the 1980s appeared to herald the end of the branch. In the United States, usage of ATMs has grown to almost 700 million transactions per year, and over 40 percent of households use telephone banking.

Paradoxically, however, the geographic acquisition strategies of Norwest, BancOne, NationsBank, and others seem to be celebrating the importance of physical distribution. According to Payment Systems, Inc., 69 percent of households still visit branches at least once a month. Moreover, small businesses, which account for one-third of retail bank profitability, continue to be heavy branch users.

Then again, today’s multimedia boom appears to be sounding another death-knell for branches. Forty percent of US households own personal computers, and 54 percent of those have modems. These households have access to full online banking through Microsoft Money, Quicken, and other services. Big branch closures at Chemical and PNC, among others, seem to confirm that branches are, in the words of Bill Gates, "going the way of the dinosaurs."

If everyone in America were to step into a bank at the same time, each would enjoy at least a square foot of breathing room

Undoubtedly, branch networks are too big. The numbers speak for themselves: at over 250 million square feet, US bank branches occupy more space than all the nation’s general merchandise department stores put together. If every man, woman, and child in America were to step into a branch at the same time, each would enjoy at least a square foot of breathing room. Several factors will drive the rationalization of branch networks: the high density of most current networks, particularly postmerger; the shrinking role of bricks and mortar in meeting customers’ transaction needs; and the ineffectiveness of traditional branches compared with more focused physical distribution formats.

But the truth is that branches are not dinosaurs destined for extinction. In evolution-ary terms, they are more like the first bird, archaeopteryx. They are going to have to transform themselves to adapt to the changing environment, and many will vanish, but large numbers will survive the current upheavals. Online services, ATMs, direct mail, and phone channels will indeed grow, but physical distribution will remain a crucial aspect of personal and small business financial services delivery.

Dramatic changes in branch banking will manifest themselves not so much in the total number of branches as in what those branches look like and what happens in them day to day. The "plain vanilla" branch will disappear, to be replaced by a variety of new flavors such as supermarket branches, investment centers, and ATMs offering expanded services. Some of these innovations are already in evidence at such banks as Huntington, Citibank, and Wells Fargo. In the new environment, branches have entirely different economics; customers do different things in them; and employees have new roles and responsibilities.

Turning the branch of today into the branch of tomorrow will not be easy. It will take a long time, much experimentation, and great effort. Pioneering banks are demonstrating that the skills to make this transition cannot be taught in the abstract. They must be acquired in the real world through actual experience of changing branches one by one. Indeed, a decade from now, the dominant retail banks will be not those with the largest customer base or the most geographically dense branch network, but those that are skilled at making this transition quickly and economically.

Many channels, many products, many customers

The goal for banks’ senior management is to turn today’s "all things to all people" branch networks into highly differentiated systems for distributing multiple products. The foundation for creating such systems is superior insights into customer behavior. These can come in many forms, but at their most basic they entail understanding customer needs for the delivery of different products, how these needs vary by customer type (including small businesses), current customer behavior (especially as it relates to channel usage), and customer profitability. It is this multifaceted understanding of customers that yields actionable implications for distribution strategy.

As in retailing, there is no such thing as an overall channel preference. The truth is that most people buy through many different channels. A typical consumer uses a host of channels regularly; these might include a mail-order company like L.L. Bean, a discounter such as Wal-Mart, and an upmarket store like Saks Fifth Avenue. Similarly, the majority of a bank’s customers "shop" all its channels, selecting each according to the complexity of the product or service they are seeking (Exhibit 1).

A customer wishing to take out a mortgage, for example, might want a lengthy consultation with an experienced mortgage banker, and thus prefer a face-to-face meeting even if it means waiting a few days for an appointment. When making a simple withdrawal or loan payment, he or she will probably prefer the convenience and speed of an ATM across the street. The same individual might hold a brokerage account with Charles Schwab and use a home computer to get quotes, a telephone service to make trades, and a local branch to set up an individual retirement or custodial account.

Customer segments based on channel preferences can be only partly correlated with demographic indicators. As a result, identifying and sizing these segments entails either tracking and synthesizing the details of existing customer channel usage or conducting market research. Many banks do capture channel usage data for routine transactions, but this information is often difficult to access and manipulate. Once they have been clearly understood, customer channel preferences should be checked against customer profitability to ensure that the cost of serving a customer in the channels of his/her choice does not exceed that customer’s profitability. If it does, the bank probably needs to reprice channel usage or aggressively migrate customers to cheaper channels.

Making the move

In fact, helping customers find their way naturally to the most economic delivery format is a critical aspect of making the transition to next-generation banking. Customers should be actively directed toward electronic channels, especially full-service telephones and ATMs. Concerted efforts should be launched to educate customers about the uses and benefits of these channels and to reward them for changing their behavior. Aggressive banks have found that most consumers, once educated, prefer convenience and speed for most interactions.

In particular, overcoming consumer resistance to making deposits at ATMs or via direct deposit is essential if banks are to serve the transaction needs of the mass of customers electronically. One North American bank managed to increase ATM usage for deposits to over 90 percent in a pilot region by recognizing that customers who want human interaction do not necessarily need the human to conduct the transaction. By placing a greeter at the door to direct customers to an ATM, and initially show them how to make a deposit, this bank was able to meet its customers’ needs for human interaction much more efficiently.

Banks have successfully experimented with carrots to encourage customer migration to electronic channels

Other banks have successfully experimented with carrots to encourage customer migration to electronic channels. Citibank abolished fees for its PC-based banking service, while Bank of America held a "double your deposit" sweepstakes for ATM deposits. Still others have offered free checking with direct deposit.

This customer migration can significantly reduce the capacity requirements of the branch network. The remaining traditional branches, as well as new physical distribution formats, can then be tailored to the kind of products or services offered or the type of customers served.

Now numbering over 1,800 in the United States, supermarket branches illustrate the power of tailored formats. Supermarkets typically handle about 15,000 to 30,000 customers per week and are visited about eight times a month by the average household. Bank branches located in supermarkets usually offer more convenient access for transactions than traditional branches, and can be far more productive sales outlets for relatively simple products such as checking accounts or auto loans. Moreover, at about a sixth of the size of a traditional branch and with just five to six officers as compared with 10 to 12 total staff (officers and tellers) in a standard branch, they have operating costs that run about 25 percent lower (Exhibit 2). Some banks are also beginning to experiment with formats focused on small business and affluent customers, such as business and investment centers.

Unbundling economics

The leaders of the banks that have begun this transformation have spurred their management teams to action with a simple approach: unbundling product manufacturing and delivery economics, and assigning P&Ls to the management of each. By isolating the costs of delivery through different channels and charging appropriate prices to product managers for channel usage, leading banks have been able to clarify the true cost and value of channels—creating the bank equivalent measure of "retailer gross margin." These CEOs have encouraged distribution channel managers to minimize their cost base and maximize their value-added by-product, and encouraged product managers to seek delivery through the most cost-effective channels. With this new economic transparency, the executive team is much more likely to feel a sense of urgency and take radical steps to redesign physical delivery.

These economics can be further unbundled to expose the profitability of sales and service operations. After a fair market rent has been allocated for premises expenses, many of these operations lose money for the typical branch. They are often simply not productive enough to carry their own weight.

Department stores faced a similar situation in the 1980s. Many realized—some after being prompted by financiers—that they were sitting on valuable downtown real estate, yet customers were increasingly shopping in the suburbs. To turn themselves around, they sold a lot of it and found equally productive but less expensive locations in the suburbs. Banks will have to begin doing much the same—migrating not to new sites necessarily, but to less-expensive formats.

The impact of a restructured network will be to enhance customer convenience and access while reducing expense

The overall impact of a fully restructured network will be to enhance customer convenience and access to banking products and services, while reducing the aggregate delivery expense. The balance between cost reduction and revenue increases is likely to vary by bank and micromarket, but we would expect many banks could improve their overall annual pretax profitability by 30 to 50 percent over time (Exhibit 3).

One, two, three, testing ...

No bank will get this complex transformation right first time—furthermore, it is difficult to know precisely what will work

Given the nuances of customer preferences from market to market and segment to segment, and the varying skill base of industry employees, no bank will get this complex transformation right the first time. Furthermore, given the network effects, particularly of consumer transaction behavior, it is difficult to know precisely what will work. This makes testing vital. Banks may want to try out individual formats first to understand their economics, but at some point they should select a contained micromarket for pilot design and deployment of the new reconfigured network. A pilot team usually includes line managers and shares responsibility for such critical activities as customer migration and retention, communications, human resource management, network mapping, and measurement.

In advance of any tests, leading-edge banks carefully plan the parameters that should be tracked. They launch their pilot only when they are ready to capture the required information. Results should be closely monitored and used to refine the overall network design and transition approach. This type of experimentation has long been used by retailers for testing and debugging new concepts. Acting on lessons learned from the pilot, banks should then roll out the new configuration across the entire network.

If banks are to derive full benefit from the new portfolio of tailored channels, the pilots must also address a host of related changes to ensure they are fully integrated.

1. The other marketing "Ps"

Rationalizing and differentiating channels addresses only one element of the classic marketing mix: place. The others must be tackled too. To encourage customer migration, pricing must promote rational economic behavior and reflect underlying costs. Bundled pricing options offer a way to target attractive customer segments.

Products must have clear value propositions that are tied to customer needs and fit distribution channel roles. Current product lines often need rationalizing to reduce complexity. And customer promotion must be consistent and reinforcing across channels to prevent any confusion.

Basic checking and savings products illustrate how the other marketing "Ps" come into play. An aggressive program to migrate customers to electronic channels for all their transactions might, for example, suggest the need for a bundled product that combines checking and savings accounts, direct deposits, and bill payment services. This bundle would be essentially free, with no fees or minimum balances as long as all transactions were conducted through electronic channels; otherwise, fees would be charged. A bank rolling out such a product might want to streamline its branch-based checking and savings offerings at the same time, and should certainly avoid promoting them intensively.

2. Core systems and processes

Many other business elements require substantial change if banks are to pull off a new distribution strategy. Chief among them are:

Information systems. Managing end-to-end customer relationships across products has often been a challenge for banks. In the new environment, information systems must be enhanced to track customer relationships across channels too. Capturing and synthesizing cross-channel customer information will be critical to refining the network configuration appropriately and targeting sales activity.

Incentives should be explicitly tied to employee and channel roles within the overall distribution network. The compensation of the manager of a traditional branch might, for example, be linked to customer retention and product sales, with particular emphasis on complex products, while that of a supermarket branch manager might be tied to customer acquisition and simple product sales.

Staffing also presents a challenge, as fewer employees will be needed and many will have to be moved to new physical formats and electronic channels. To minimize demoralizing layoffs, banks must carefully manage natural attrition, which can run at 30 to 50 percent among tellers in the United States. At the same time, they must retain their highest performers by closely tracking careers and offering growth opportunities. To reduce rivalry among channels and ensure that new channels are fully staffed, banks should develop career paths that encourage rotation between channels.

Redesigning physical delivery will affect roles and responsibilities across all functions of an organization, including sales, service, and operations. The branch manager’s role will probably undergo the most dramatic transformation. During the transition to the new delivery system, the branch manager must communicate the changes to both customers and staff, motivate what may well be a shrinking front line, and continue to meet sales and service goals. After the transition, this role will depend on the nature of the delivery system. A traditional branch manager, for instance, may ultimately manage a group of smaller sales and service outlets in a local market.

Core operational processes must be tailored to new channels. A minibranch format might have limited space for supplies and equipment and thus need redesigned product support processes, such as online credit applications. In addition, the deployment of new channels creates an opportunity to centralize and streamline back-office processes.

3. Organization

To ensure that integration occurs across channels, banks must review their existing organizational structure and management processes. At a minimum, branch and nonphysical distribution should form independent business units which sell their services to product and/or customer segment managers. Under such a structure, a distribution business head can focus exclusively on redesigning and optimizing delivery, while a customer segment manager concentrates on maximizing the value of the entire customer relationship.

Further structural integration across channels will vary by bank, depending on whether existing management processes can ensure integration or whether new processes are needed. Some banks have strong traditions of managing horizontally through cross-business taskforces or teams and can, therefore, confidently use existing or new processes to ensure coordination across channels. Other banks have habitually operated their business units more like independent silos, and may need to design a fresh organizational structure to support integration.

Pay as you go

First movers may be able to assume market ownership of a distinctive value proposition leveraging a new delivery system

Banks that move first within their markets to reconfigure their branch networks are likely to capture several advantages. Most important, they may be able to assume market ownership of a distinctive value proposition leveraging a new delivery system. In the late 1980s, Wells Fargo was able to build a strong reputation for convenience by aggressively marketing its "7/24 banking" (7 days a week, 24 hours a day) service, and maintained its reputation for convenience banking long after its competitors had followed suit.

Redesigning a bank’s physical delivery system may attract profitable customers and lose those who are unlikely ever to be

Similarly, a bank redesigning its physical delivery system may be able to boast the benefit of greater convenience. Properly managed, such a value proposition may result in the acquisition of customers who find it attractive and the loss of service-intensive, mass-market customers who cannot be migrated to a more cost-effective delivery system and who are, therefore, unlikely ever to be profitable. First movers may also find that they have greater flexibility in selling or subleasing unwanted real estate or in entering new markets quickly. In particular, those with relatively small, cheap formats that can be quickly built may be able to justify early entry of fast-growing markets. Many consumer finance companies can open a branch for under $25,000, a very different breakeven than a typical bank branch.

Few, if any, banks are able to indulge in the luxury of investing in a new distribution system that offers only a long-term promise of improved earnings. Instead, the pioneers are taking steps to ensure that their distribution change program pays for itself in the near term as well as over the long haul. Their strategy is to launch short-term performance improvement initiatives within existing channels—essentially fixing what they have—while simultaneously designing a new network.

Such an approach can take several forms. Revenue can be enhanced by building the sales skills of frontline branch staff or by making pricing changes, for instance. Cost reduction can be pursued through the redesign of core processes or reduction of management layers in the existing network. With productivity differences across the United States of 20 to 30 percent for large banks, most institutions have room for short-term improvement to fund the transition. For longer-term initiatives involving the creation of the new network, leading banks impose aggressive payback periods that demand the capture of anticipated cost savings from new channels within a year or two. These targets force banks to follow through on difficult branch closures even in the face of resistance.

During the 1980s and early 1990s, the watchwords in branch banking were simple: sales and efficiency. Many retail banks strove to centralize back-office processes, optimize staffing levels, and build a sales culture. Many succeeded in reducing their cost-to-income ratio. But with the benefits of greater efficiency now largely captured, high-performing banks wishing to maintain a long-term competitive advantage through their branch systems must consider more innovative measures.

A handful of leading-edge players have recognized this strategic imperative and are actively reinventing the role of the branch

A handful of leading-edge players have recognized this strategic imperative and are actively reinventing the role of the branch. From their efforts, a new model of the branch system is emerging that combines the radical rationalization of traditional branch capacity, the tailoring of remaining branches to targeted customer needs, and the migration of sales and service activity to nonphysical distribution channels. This new model promises to deliver superior economics and set the standard for retail banking into the twenty-first century.