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F R A N C E S X . F R E I
Commerce Bank
The hardest thing about becoming a big bank is not becoming a big bank.
Douglas Pauls, chief financial officer
Introduction
Deborah Jacovelli looked up from her desk as a big pumpkin, a Dalmatian, and a masked crusader ran by her office. It was business as usual at Commerce University, Commerce Banks Cherry Hill, New Jersey training center, but it was also Halloween on a rainy day in 2002 and the employees were getting into it with their usual enthusiasm. As dean of Commerce University, Jacovelli had witnessed the development of many innovative methods for energizing the companys employees. Halloween costumes and people decorating their cubicles, hardly typical bank behavior, were not at all strange at Commerce. Jacovelli noticed that someone had adorned the giant C
character outside her office with a cape.
It took a special kind of person to deliver the high-quality customer service Commerce Bank promised. Happy customers were the banks top priority. An internal system of incentives and cultural training implemented by Jacovelli and her coworkers to reinforce a deep commitment to
WOW! ing customers included awards, commendations, and compensation, as well as intense training and education. We want to exceed customers expectations every time they visit our bank,
insisted Commerce Chairman and CEO Vernon W. Hill II. Commerce referred to its branches as
stores and looked for operational comparisons to retailers such as Starbucks and Home Depot rather than the bank next door. How does Starbucks get you to pay $6 for a cup of coffee? mused Hill. Its the retail experience. Thats what we care about and its paying off. Some critics say our stock price is high for the banking sector, but if you look at other power retailers and compare our multiples, we are undervalued. Since 1990, Commerces stock price had increased twenty-fold (Exhibits 1and 2 present company financials.)
Because Commerce encouraged customers to visit its branches, or stores, it wanted the experience to be positive even when the branch was busy. A handful of competitors were beginning to copy some of Commerces extra service features, such as weekend and evening hours, prompting the bank to be mindful of staying one step ahead. With coffee and newspapers already available to waiting customers, the bank considered adding entertainment to the lobbies of its stores. Retailtainment,
proposed in 2002, was Commerces latest idea for WOW! ing customers. Among the ideas piloted ________________________________________________________________________________________________________________
Professor Frances X. Frei and Research Associate Corey Hajim prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 2002 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of Harvard Business School.
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as part of this atmosphere enhancement concept were free hot dogs, a guitar player and juggler, and an employee on roller blades dressed as a big C character. While not completely off the map for a bank that encouraged its employees to dress up in costume, this latest program concerned Jacovelli. She wondered whether customers really wanted to be entertained when they visited a bank branch. Even with a program limited to Fridays, if execution at different branches varied, would the consistency of great service be put at risk? Had the bank, Jacovelli worried, finally taken the retail experience a step too far?
The Banking Industry
Products
Retail banks offered deposit and loan products, which were widely considered to be commodity products. Deposit products were a way for customers to store their money with the institution in exchange for access to the payment system (through electronic transfers and checks), interest on their money, and contact with the bank service infrastructure (branches, ATMs, call center, and Internet).
Deposit products tended to be more transaction oriented than loan products, although not every deposit product was associated with ongoing transaction. For example, in the case of certificates of deposit, a customer agreed to store money with the bank for a set amount of time at a higher interest rate than a typical, demand deposit account.
Banks typically had a dozen or more types of checking accounts distinguished by a variety of characteristics including minimum balance required to avoid fees, channel access, checks that could be written free of charge, and overdraft protection.1
In 2001, the banking industry loaned almost 90% of its deposit base. In addition, growth in both deposits and loans was about 20% over the period of 1998 to 2001. (See Exhibit 4a for the consolidated balance sheet for the banking industry.) Large institutions that experienced larger than average growth typically accomplished this through mergers and acquisitions.
Two important trends in the industry had evolved. The first was a push to increase the cross-sell of productsthe number of products each customer used. Although the industry did not formally track this number, on average, customers tended to hold 1.5-2.5 products at an institution.
Most companies had cross-sell goals that were significantly higher than this level. The second trend was towards growing revenues from fees customers paid for certain transactions and functionality.
From 1998 to 2001, fee revenue, also known as non-interest income, had increased at 27%, a much higher rate than interest revenue, or interest income, which grew at 11% (Exhibit 4).
Service
Banks typically used demographics such as age, income, and geographic location to help segment customers. More recently, many banks had been calculating individual customer profitability, used in part to help determine how to differentiate service amongst customers. Customer satisfaction with the banking industry had historically been quite low, with satisfaction being significantly higher for the smaller credit unions (Exhibit 5).
1 Overdraft protection allowed customers to write a check over their current account balance, whereby the bank then made a short-term loan to cover the difference.
2
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A retail bank could lose up to a third of its customer base each year to attrition. Even the best performers lost 15%. By far the largest attrition occurred in the first year of a banking relationship. A study of the banking industry found that 34% of customers that leave a bank indicated that they did so out of dissatisfaction with steep fees and fee surprises, poor service, and errors. Thirty-four percent left as a result of a geographic move, primarily because they were outside the reach of current bank branch locations. Fifteen percent of customers left because of availability of more convenience elsewhere such as longer hours.2
Distribution
Customers selected their bank for a variety of reasons. The decision was often heavily influenced by proximity of a local branch. In response, banks created enormous branch networks, with the number of branches increasing even as the number of banks decreases (see Exhibit 3b). Many branches changed hands as banks merged, either becoming part of the merged entity, or sold off to another bank after a merger due to redundancy.
Banks also created large ATM networks. Customers could access their banks ATM for free and other banks ATMs for a fee or sometimes for two feesone by the owner of the ATM and one by the customers bank for processing the out-of-network transaction. Originally ATMs had been considered cost centers, but due to the ability to generate fee income, ATMs were increasingly viewed as profit centers.
In addition, virtually every bank had a call center open 24 hours a day, 7 days a week, as well as a voice response unit (VRU) whereby customers could execute an increasing number of transactions via the telephone without having to talk to a live agent. By 2002, Internet banking was commonplace, providing customers the ability to view balances, move money between accounts, and pay bills electronically, which often incurred a $5 monthly fee.
As a result of the lower marginal cost associated with the electronic channels, most banks actively encouraged customers to move their transactions from full-service channels to self-service channels.
Banks strongly advertised the availability and convenience of the electronic channels, offered monetary incentives for using the channels, and occasionally monetary penalties for using the more expensive channels (e.g., charging $3 to visit the teller).
Employees
Front-line employees in retail banks were often selected for their ability to perform repeated tasks, interact with customers, and their willingness to accept relatively low wages. Training primarily consisted of learning about bank-specific policies and procedures as well as the various features amongst the dozens of deposit and loan products available at any point in time. The latter became especially important after mergers, when customers from one institution where often forced into new products with unfamiliar attributes. Compliance with processes and understanding of specific product attributes was paramount in the industry. Key measures of performance were volume of calls handled and number of transactions processed.
2 David Dove and Chuck Robinson, Mind the Back Door While you Greet New Customers, American Banker, August 22, 2002.
3
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The Commerce Story
When Hill founded Commerce Bank in 1973, he was determined to be different. The world, he reasoned, did not need another me-too bank. I had no capital, no brand name, and I had to search for a way to differentiate from the other players. With $1.5 million he started a community bank in southern New Jersey and since had grown it, without acquisitions, into Pennsylvania, Delaware, and New York.
Hill created a retail franchise with branches typically open from 7:30AM-8:00PM during the week and modified hours on Saturday and Sunday. If the branch was in a busy location, its drive-through window might be open as late as midnight. Or, more precisely, ten minutes after midnight, as stated in the companys 10-minute rule, which asserted that branches should open 10 minutes early and stay open 10 minutes late.
When customers came into branches to open a checking account, they were treated with outgoing, friendly service. After the customer selected from the four different checking accounts (Exhibit 6), Commerce routinely gave a free gift for opening the account.
Deposit growth had averaged over 30% per year since 1996. In 2001 alone Commerce deposits grew by almost 40% (Exhibit 2) while its households grew by 20%. By comparison, cumulative deposit growth in the United States was 5% in 2001 (Exhibit 4). Hill reflected on the Commerce approach:
Other banks decided to push consumers out of the branch because it is the high-cost delivery channel. They wanted to push them online. We totally reject that. You cant name me one retailer in this country that has pushed people where they dont want to go and succeeded. But the banks decided to push to electronic delivery, and they have totally failed.
Our model is, we are going to give you the best of every channel knowing you are going to use all of them. The result is not only do we have the highest deposit-rate growth in this country by a long factor, but our online usage is 34%, which is higher than Wells Fargo.
I dont have to make a sale to you every day. Once you open your account I am making money on your balances. The big-bank attitude sees a customer as a cost, not a revenue generator. I dont see it that way.
You cannot find me any retailer who has driven store count down and has survived, and yet banks think they can drive customers out of their branches and still keep their business. I find that very hard to understand. We have some branches that get 100,000 customer visits a month; the average branch gets 40,000. As a comparison, an average McDonalds gets 25,000
per month.
Growth
To Commerce, New York City represented an enormous opportunity. Everyone will tell you that New York is the most over-banked market in the country, Hill said. I think it is the most under-banked market in the country. There are $500 billion in deposits in New York. Commerce did not enter its newest market quietly. Commerce spent $500,000 per branch on promotion, five times its usual spend, which included direct mailings, ads on subway and phone kiosks, and with the 4
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help of street vendors, 10,000 hot dogs given away wrapped in Commerce napkins.3 Success was immediate. Commerce broke even in half the time it usually did, even with four times higher costs than any other region.
Hill maintained that the business should continue to grow organically. No one has built a power retailer in this country through mergers and acquisitions, he emphasized. You can only build a delivery model like this from scratch. Mergers and acquisitions are cost-cutting devices at their heart, and the merger of cultures and the dilution of brand is a formula for failure. Every big bank merger in this country has failed. In Hills view, its easier to build a bank than to fix one.
It had taken 18 years for Commerce to grow to $1 billion in deposits, but it now surpassed this amount in individual quarters. Commerce expected to ultimately reach $100 billion in deposits and total 1,000 locations, from Washington, D.C. to Boston. Commerces success was not limited to deposit growth. The banks net income doubled from 1998-2001, compared with 20% for the industry as a whole. Doug Pauls, Commerces chief financial officer, recalled the projections he saw when he came on board: I am an accountant by trade and therefore a little conservative by nature, so when I looked at the projections in 1994 after I arrived here I thought they were pretty aggressive. But I wish I had that original plan, because we have completely blown that away.
Debits and Credits
Deposits
We believe the value of a bank is not its loan base, Hill explained, but rather the deposit base, what we call core deposits. Those are deposits that come to you for non-rate reasons. We are generally the lowest ratepayers in every market. Commerces deposit rates were often half a percent lower than those of competitors.
Commerces focus on its consumer business was unusual for the banking industry. Commerce generated more than half its deposits from its consumer business, compared with most banks whose consumer business was closer to a third of overall business. Hill observed:
Banks had given up on growing altogether because they thought you had to pay the highest deposit rate to get growth. The big players decided in the late 80s, early 90s that it was too much trouble gathering and growing deposits on the consumer side. On the one hand, they began to fund themselves in the wholesale market; on the other hand, they began to cut costs in the retail network.
Pauls added: When people ask Vernon if he is concerned about competition, he says not really, because they are fighting an air war while we are winning the ground war at the store level. We cant lose sight of that. Deposit growth at the store level is the basis of everything we do.
A branch network with longer hours inevitably has higher costs, which readily showed up in the expense ratio of a bank.4 A low expense ratio is a minus, not a plus, Hill emphasized. The guys with a low expense ratio are every day disinvesting in their business. Hill had committed to investing in providing service in his branches after asking customers what they wanted. We asked 3 Chuck Salter, Lessons from the Best Bank in America, Fast Company, May 2002, p. 91.
4 Expense ratio is the percentage of income spent on operating expenses; it is a common measure of a banks cost structure.
5
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people, Why do you open a new account? Hill recalled. Three percent of people said they wanted the highest rate; 62% said they picked a bank for service, convenience, and those kinds of things. Well, the competition is competing on the 3%; we decided to compete on the 62%.
Commerce looked for ways to save money, but not by counting savings on the income statement; instead it gave back to customers. Hill described this strategy:
Every time Wal-Mart beats a supplier down to get a better deal they dont take that extra and add it to the bottom line; they improve the value proposition to the customer. This year we saved millions in expenses by switching ATM contracts, which we invested back to our customers. We could have taken that right to the bottom line, but what we decided to do is eliminate our fees to our ATM and check cards for the entire company. We dont charge for our cards, we dont charge for transactions, and in New York City if you use someone elses machine and they charge you a dollar and a half, we give you that dollar and a half back.5
That is what a power retailer does. You use your competitive advantage to get stronger, not to make more money.
Loans
Loans made by Commerce were assigned to the branches that serviced the customers. The branches also received credit for the deposits. This was not the case across the industry. Falese described the more typical structure:
At Fleet if the health-care lending group produces deposits they keep the credit in their group, and yet the branch has to service the account. The Fleet branch manager hates the health-care manager because the branch has to service the account and gets no credit. At Commerce the branch managers love the health-care bankers because the branch gets the account credit. That little adjustment entirely changes the dynamics.
Commerces loan-to-deposit ratio was significantly below the industry average, and loans were considered carefully. We dont make enough money in terms of the spread to justify taking credit risk, Falese explained. The customers ability to repay is the most important thing. Some of our best loans are the ones we did not make. Added Pauls: The way we look at credit and credit quality is a lot tougher [than our competition]. Deals that would get approved elsewhere might not get approved here. Commerce focused most of its lending on commercial real estate projects, home mortgages, and consumer loans.6
Loan customers were encouraged to open deposit accounts with Commerce. For Falese, it was policy. He explained:
Most other banks are driven by loans. My attitude is no deposit, no loan. We decentralize the delivery of the loan so that at some point you have to come in to the branch and sign the papers. The loan officer is also the branch manager. And that is when we encourage you to let us manage your deposits as well. My job is to make sure we make sound loans that get repaid and at the same time that we generate core deposits.
5 Reimbursement of ATM charges up to $5 per month.
6 Jay Palmer, Service Master, Barrons, January 28, 2002.
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Not Customers, Fans
Were not here to satisfy customers, were here to blow them away, remarked John Manning, one of Commerces most well-known employee trainers. If you talk to our customers, they dont like us, they love us. Hill corroborated: People buy our products because they trust our brand.
Added Pauls:
Ill go out to lunch around here and be in line at a Wendys and someone in front of me will see my Commerce pin and start talking about how great Commerce Bank is. They love the fact that people know them when they walk in, that they are treated well; they are so happy with us they cant believe it. For one of our advertisements we used real customers, and the people who were directing the commercials marveled at how much these customers wanted to tell our story and how they felt about the institution.
Commerce branches were built to be inviting, with floor to ceiling windows and ample parking.
(See Exhibit 7.) Commerce branches were replicated with remarkable consistency. We know every screw in the model, Hill said. Most branches were built from scratch for about $1 million. With few exceptions, they had the same white-brick exterior capped with a black metal roof, the same black-and-white marble, the same no-frills checking and savings accounts, and the same lollipops and dog biscuits. It makes life easier for customers, says chief marketing officer John Cunningham. They know what the deal is wherever they visit one of our banks.7
For Commerce, deciding where to put a branch was just as important as what the building looked like. Hill sought a corner that was busy, but not too busy, with a good residential and commercial mix. Ultimately, Hill, who was also part owner of 45 Burger Kings in the Philadelphia suburbs, made the call himself, a decision that he insisted has more to do with gut feel than with demographic research. Usually, though, its in the competitions backyard. If a competitor closed, the staff at the nearby Commerce branch was awarded $5,000.8 Commerces branches broke even within a year to 18 months. The average bank took three years.
