RBB Digest by Oliver Wyman Group

Financial Services

SEPTEMBER 2011

RETAIL BANKING

NORTH AMERICA DIGEST

IN THIS ISSUE 1

SMALL BUSINESS BANKING: INSIGHTS FROM OLIVER WYMAN RESEARCH  PETER CARROLL

RELATIONSHIP MANAGEMENT FOR MASS-AFFLUENT CUSTOMERS  PATRIK RINGSTROEM

RETAIL BANKING IN A POST-DURBIN WORLD: WHAT THE FINAL RULE MEANS FOR DEBIT CARD ISSUERS  TONY HAYES

DUAL TRACKING: A HUGE CHALLENGE FOR MORTGAGE SERVICERS  AHMET HACIKURA

TABLE OF CONTENTS 1.

SMALL BUSINESS BANKING

Insights from Oliver Wyman Research AUTHOR: PETER CARROLL, PARTNER From a survey of 4,700 small business owners, including many who switched banks within the past 18 months, this article derives real insight into the heterogeneity of small businesses and their owners, shows what banking products and services they use, and how these patterns have changed over time. It also reveals how rarely owners change banks and how they choose a new bank when they do change. It explores where banking profit is concentrated within small business relationships, and suggests an alternative strategy for banksâ&#x20AC;&#x2122; small business units to gain share where the profit is concentrated.

RELATIONSHIP MANAGEMENT FOR MASS-AFFLUENT CUSTOMERS

Personalized Service Creates Value AUTHOR: PATRIK RINGSTROEM, MANAGER Mass-affluent customers are increasingly important as a source of profit for banks, partly because fee and debit card regulation is eroding the value generated by less-affluent customer segments. This article discusses how personalized, cost-effective relationship management with this segment can increase loyalty and allow for unparalleled customer access for cross-sales.

RETAIL BANKING IN A POST-DURBIN WORLD

What the Final Rule Means for Debit Card Issuers AUTHOR: TONY HAYES, PARTNER On June 29, after almost a year of speculation, debate and lobbying, the Federal Reserve released the final rule to implement Regulation II, more commonly known as the Durbin Amendment (as mandated by last yearâ&#x20AC;&#x2122;s Dodd-Frank Act). This article provides our perspective on what this new regulation means for banks as debit card issuers.

DUAL TRACKING A Huge Challenge for Mortgage Servicers AUTHOR: AHMET HACIKURA, MANAGER Among the many challenges that home loan servicers face today, dual tracking is one of the most intricate, divisive and poorly understood. Under pressure to act, servicers may opt for a stop-gap effort to update their practices. This article argues that the risks and complexity involved necessitate a thorough strategy and operational plan.

1. SMALL BUSINESS BANKING INSIGHTS FROM OLIVER WYMAN RESEARCH By Peter Carroll

Small businesses, and their owners, are a paradox for banks. On one hand, they are the source of a high percentage of retail bank profits1. Indeed, some banks find that the combined profit from small business relationships and the personal accounts of the owners represents a clear majority of total retail bank profits.

1. The heterogeneity of the small business and its owner 2. Patterns of financial services product usage 3. The locus of small business profit for banks 4. The criticality of location and checking 5. The possibility of a new approach

On the other hand, if you ask retail bankers, and especially retail lenders, what their single greatest concern is when it comes to availability of actionable data, they invariably cite weaknesses in data on small businesses. The data problem makes small businesses hard to understand.

HETEROGENEITY

One valuable source of small business information is the Federal Reserve’s Survey of Small Business Finances, last published in 2003. However, the Fed has indicated that it does not intend to continue its small business survey. When we learned of the Fed’s plans, Oliver Wyman Financial Services decided to take over this invaluable role. In February of 2011, we executed a survey of 4,700 small business owners. Our methodology was very similar to the Fed’s so that we could make comparisons with their 2003 findings. However, we asked numerous additional questions, the answers to which we judged would be of relevant strategic and tactical interest to our financial services clients. In this brief summary of our findings we will focus on five main areas:

Whatever image comes to mind when one hears the term “small business” or “small business owner”, it is likely that the singular image represents only a fraction of the total small business population. Here is a selection of point findings from our survey that sketch the heterogeneous nature of small businesses and their owners2. •• •• •• •• ••

66% of owners are between 45 and 64 years old 76% have bachelors or masters degrees 74% have household incomes of over $75,000 20% own not just one businesses, but two or more 33% have full-time or part-time employment outside the business •• Only one third of SB owners rely entirely on the business for their HH income •• Only 25% of small businesses have “a full-time financial employee”3 •• 68% of owners regard their business bank also as their primary personal bank 2 3

Here we consider profit on a through-the-cycle basis rather than in the current extremely low-rate environment.

Our survey method required respondents to have been in business “at least one year”, which slightly biases some responses, e.g. on longevity. Despite careful wording of the question, we feel this response overstates the presence of a true “full-time financial officer”; separately, “yes” responses biased strongly towards the largest firms.

Exhibit 1: SMALL BUSINESS PRODUCT PENETRATION SHARE OF SMALL BUSINESSES 100%

100%

Other loan

Auto loan/ lease

Operational loan

Equipment loan

Mortgage

Any Loan

Retailer/ Store card

0% Charge card

0% Major Credit card

20%

*Any Card

20%

40%

Internet/ Direct

40%

Money mkt

60%

Savings

60%

Checking

80%

Any Deposit

80%

* Card consists of cards used solely for the business; 44% of SBs are also merchants (accept cards)

These factors, and others that we will cite below, show why it is so hard to get a clear picture of a small business and/or its owner. In a credit underwriting setting, for example, there is no adequate source of information that captures all these dimensions and presents them cleanly and clearly to the underwriter. Meanwhile, recognizing that we excluded businesses that had not yet reached their one-year anniversary, the picture that our survey responses paint is one of established, successful, stable enterprises: •• 66% have annual revenues over $100,000 •• 81% were started by the current owner (another 4% were inherited) •• 84% have been in business for 5 or more years (35% for 20 or more years) •• Only 11% planned to sell or close in the next 3-5 years •• 73% were “very” or “reasonably” profitable last year (2010) •• 75% were said to be in an “established” or “growth” phase •• 55% “have a website” but only 27% of these “have e-commerce capability” Overall, these responses speak to a robust and successful sector that, incidentally, is not clamoring for credit but is cash-flow positive.

PRODUCT USAGE Our survey shows that virtually every small business has a checking account and that this was the first product obtained with the bank that the owner regards as the business’s “primary bank”. Around a third of small businesses also have a savings account but the incidence of savings, money market, and time deposit (CD) usage by small businesses is generally lower than by consumers at large. 72% of small businesses use either a credit card or a charge card (or both) that is “exclusively used for the business”. Moreover, 44% are merchants who accept credit cards as a form of payment from their customers — a growing category. The interesting and surprising survey response on “other credit” is that only 38% of small businesses have any kind of loan other than a business credit card. Furthermore, the most likely form of such small business borrowing is not a “small business loan” but a first mortgage or an auto loan. Only about 1-in-5 businesses have what the industry thinks of as “small business loans”. Comparing the Fed’s 2003 responses with ours (which were based on the 2010 year), we see that small businesses’ use of checking and savings products has

risen. So too has their use of credit and charge cards, as well as debit. However, their use of credit has declined. One could argue that this reflects the severe economic conditions in 2010, as well as “banks’ unwillingness to lend”, so often cited recently in the press. Our survey responses do not decide the issue one way or the other but we see a case that can be made that the reason for the low credit usage is not supply constraints, but the fact that successful small businesses are actually not heavy credit users — they are equity-rich and cash-flow positive.

BANKING PROFITS Our survey design included questions that would enable us to model the profitability and value of each respondent’s banking relationship. Any such model requires numerous assumptions, among them the appropriate transfer price for crediting revenue to DDA and Savings balances, plus the assumed spreads (over cost of funds) and expected loss rates on different forms of credit. Recognizing the current anomalous market conditions, we elected to make what we thought were reasonable “through-the-cycle” assumptions and reached the following conclusions: •• Small business banking is indeed very profitable •• Profit is concentrated in deposit products — even in a post-Durbin world

•• Credit and charge cards also contribute strongly •• So too does merchant acquisition for the 44% of businesses that accept cards •• Other small business credit, however, does not contribute much to economic profit Our analysis allowed us to compute the profitability of each respondent and to explore patterns of profit, for example by industry type or size of business — two traditional yardsticks used in small business segmentation and marketing. We sorted respondents into three categories: highly profitable, modestly profitable, and unprofitable. We found that the smallest segment, businesses with <$100,000 of revenue per year, were deficient in highly profitable business relationships. However, with that exception, we found more generally that size and industry were very unreliable yardsticks for locating profitable relationships: there are super-profitable relationships to be found in all industry sectors and all revenue size segments (above $100,000). Additionally, we found that profitability is highly skewed. For example, 93% of all small business DDA balances are in the 36% of accounts with an average balance greater than $10,000. This begins to suggest a new marketing approach that relies less on segmentation by industry and size bracket and more on data-driven targeting of high-value accounts and relationships. Of course, to do

Exhibit 2: DISTRIBUTION OF BUSINESS PROFITABILITY BY INDUSTRY % OF SMALL BUSINESSES 100% 80% 60%

Wholesale trade

Utilities

Transportation

Retail

Real estate

Professional services

Over services

Mining

Manufacturing

Mgmt of companies

Finance+ insurnce

Information

Other Industries

Health care

Not Profitable

Education

0% Construction

Modestly Profitable

Arts+ entertainment

20%

Agriculture

Highly Profitable

Hotels+ restaurants Waste Management

40%

this, the industry may need to re-address its long-running frustrations with commercial data availability.

LOCATION, LOCATION, CHECKING In a twist on the ancient aphorism, the critical factor in attracting and retaining small businesses and their bank accounts is location —— plus the provision of basic reliable checking services. Various survey responses highlight this central fact: •• 97% of businesses have a DDA and for 88% of them it was their first product •• 75% of respondents say they have only ever had one or two DDA accounts •• The reported switching rate is 11-12% every 18 months, an implied lifetime of 12-14 years •• 87% visit their branch between daily and monthly, only 13% less often •• 88% have a branch that is within 1-14 minutes travel time from their business •• Business owners report focusing far, far more energy and effort on questions like “My customers and their satisfaction” [66% “a great deal”] than on “My primary banking relationship” [4% “a great deal”] •• Rather, 95% agree, or strongly agree, with the statement: “Once I have my banking relationship in place, I basically just want it to work right every time and not have to think about it again” All of this argues for a continuing focus on branch network strategy: where to put branches, in terms of markets and

locations within those markets. While this information is reassuring with respect to customer retention, it presents a conundrum with respect to new account acquisition. Once they have their DDA account and their “primary banking relationship” in place, small businesses are not very “open to buy”. All of the above suggests that traditional bank small business marketing techniques, focusing on products (especially credit products), product features and pricing, and using relatively mass-media communication vehicles like radio, TV and newspapers, will inevitably be low-impact.

A NEW APPROACH? Our survey results reinforce the attractiveness of the small business sector. However, they point towards a new logic for strategy and tactics. Instead of the conventional approach, a new set of tactics can be used to identify high-value prospects and use unconventional sales and marketing methods to bring those high-value customers on board and then retain them. The new approach would rely on two essential elements that need to be designed and proven for it to work: 1. High-value prospect modeling 2. Design of an effective “switching offer” First, using the existing pool of high, medium, and negative value small business customers, and selected third-party data (e.g. from Dun & Bradstreet, Experian or Lexis Nexis Risk Solutions), create a reliable predictor of relationship value. Clearly it

Exhibit 3: LEAD PRODUCT AND CHECKING ACCOUNT SWITCHING BEHAVIOR FIRST PRODUCT AT THE PRIMARY BANK SBs with multiple products

PERCENT OF SMALL BUSINESSES THAT SWITCHED DDA ACCOUNTS IN THE PREVIOUS 18 MONTHS

Savings account 4%

15% 12.4% 10%

Loan 4%

Credit card 4%

Checking account 88%

11.5%

10.7%

0% Less than $100 K $100 K-$2 MM More than $2 MM SMALL BUSINESS REVENUES

Exhibit 4: WHETHER AN INCENTIVE WOULD PERSUADE A SMALL BUSINESS TO SWITCH BANKS 100%

Poor

Good

Poor

Best

Worst

Good

Best

80% 60%

Definitely

is essential that this prediction be “directionally correct” in its ranking of prospects by potential value; and, it must also be able to make this prediction or ranking using only data that are available on businesses that are not yet customers of the bank. Second, given that 80% of respondents told us that they had “never changed their primary bank as the result of a bank’s sales initiative”, a tangible reflection of their low “openness-to-buy” at any given moment in time, it is essential to devise an effective “switching offer”. What is a switching offer? It is basically a make-over on the old “free toaster” idea. In the old days, banks would offer a free electric toaster to those who opened a new checking account. The problem was, this economic incentive was undifferentiated — anyone could take advantage of it. And arguably, it appealed more to consumers whose future behavior would define them as low value or even negative value relationships. The new style of switching offer, however, will only be made to high-value prospects. And the NPV of a high-value small business relationship can be $10,000 or significantly more; there is, therefore, ample economic headroom to offer something more than a $15 toaster. Some part of the switching offer will need to deal with “soft” but powerful disincentives to switch banks, like

A travel award (e.g. 2 free bund-trip airline tickets)

A Droid or iPhone

A free remote deposit capture gizmo

One-year subscription to Dun & Bradstreet services to check customers’ credit ratings

Definitely not

Waived bank fees for one year

0% A pre-paid gift card to Kinko/FedEx Staples or office Max

Probably not

A flat-screen monitor for your workplace computer

20%

A QuickBooks software upgrade

Probably

A copy of intuit’s QuickBooks software

40%

the need for a merchant to change POS systems and terminals, or the need for an online banking user to reestablish all online bill payment arrangements. The other key part will be the toaster make-over: in our research we asked whether a sales initiative that included certain offers might “persuade you to switch”. Across a range of possibilities whose true economic costs to the bank were in the $100-400 range, responses were highly asymmetric: people simply value things differently and sometimes surprisingly. The winning ideas included: •• Two free round-trip air tickets •• A Droid or iPhone •• A flat-screen monitor for your office computer Whether these are really the best things to offer remains to be seen, or rather tested. The underlying principle is this: find something that works; find something that gets the attention of a non-open-to-buy, high-value business owner and that will trigger the switch. Naturally, it has to be something that costs much less than the expected value of the new account. Finally, these switching offers need to be made to the prospect without the use of undifferentiated massmedia. Not only are these media ineffective, they let your competitors know what your strategy is.

2. RELATIONSHIP MANAGEMENT FOR MASS-AFFLUENT CUSTOMERS PERSONALIZED SERVICE CREATES VALUE By Patrik Ringstroem

CONTEXT Mass-affluent customers1 constitute ~25% of the population and are increasingly important as a source of profit for banks, partly because fee and debit card regulation is eroding the value generated by less-affluent customer segments. Within the massaffluent customer base, long-term loyalty and deep relationships across multiple product holdings are crucial, because the cost to acquire mass-affluent customers tends to be higher than for other customers and the cost-to-acquire/lifetime-value trade-off is under pressure due to lower interest rates and increased competition for this valuable segment.

introduced individually assigned concierges to their highest status (and most valuable) members.

WHAT IT IS

Personalized relationship management with this segment can increase loyalty and allow for unparalleled customer access for cross-sales, but can be expensive from an operational standpoint. Delivering this personalized service in a cost-effective manner for the right customer base can, therefore, generate significant value for retail banks.

A low-cost personalized relationship is typically phone based (although an initial face-to-face meeting is helpful to build a relationship foundation), and consists of an outbound and an inbound component. At the core of the outbound component lie data-driven triggers: For example, if a customer deposits an unusually large sum of money, the relationship manager will be notified and will call the customer to understand the reasons behind the transfer, and if there are bank products or offers the customer may want to take advantage of. Other triggers include large withdrawals, unfinished online applications, negative customer service interactions, and so on. Where there are no triggers within approximately six months, the relationship manager follows up with a general “catch-up” call to ensure a continuous relationship.

A number of firms in the financial services space are moving towards business models that can deliver these low-cost personal relationships. Banks are increasingly providing personalized coverage for mass-affluent customers, and within the brokerage industry personal relationship coverage is becoming standard even at traditionally online-centric firms. Examples from other industries include hotel loyalty programs that have

Another component of a personalized service approach ensures that customers can easily contact their relationship manager for any product related questions, or when they need help with a non-standard customer service request. The relationship manager does not replace regular customer service; the focus should be on high value interactions, not solving general service issues.

Although the definition of Mass Affluent varies across institutions, in this article it refers to customers with $100 K-$1 MM of investable assets.

WHY IT WORKS Our work helping clients develop these relationship programs shows that they generate value to the institution in two ways: by increasing customer loyalty and by deepening the overall customer relationship/depth of wallet. In test-and-control experiments we typically see attrition rates drop by half for customers covered by relationship managers. Poor (standard) customer service is often a cause of attrition and relationship managers provide a “last line of defense” against such attrition. Correctly incentivized personal bankers (in this case, that is, those whose compensation is tied to a retention metric) will work hard to rectify poor service experiences that put their clients at risk of leaving. This increased loyalty also stems from basic human psychology and can be explained in a game theory construct. An interaction with a faceless customer service representative is in effect a “one-turn game”, where there is little incentive for either party to help each other in a vested manner. A formalized relationship, however, comprising a customer and his or her personal banker sets up an “iterated game”, or set of interactions, where the optimal strategy for each party is to be loyal and helpful to the other, as a repayment in kind is expected by both in the future. The second way that a relationship approach can increase value is through deepened customer relationships and broader product holdings – that is, through a higher share-of-wallet. Direct mail or coldcalls to existing customers to inform them of new product offers have notoriously low response rates. The same offer provided by a personal banker, who is informed by customer analytics that the customer may be open to buy an additional product, has a higher likelihood of success. The personal banker also provides a natural contact-person for customers to call when they are, for example, comparing offers across providers for a mortgage, ensuring that the bank is in the running to win the loan. Combined with the additional information a bank holds on its existing customers, allowing it to better assess risk, these personal touch-points can be highly valuable for cross-sale.

HOW TO SET UP A COSTEFFECTIVE PROGRAM A relationship strategy is clearly only valuable when the retention and share-of-wallet benefits, outlined above, exceed the costs of providing the coverage. Correctly structured, the cost is $200-$300 per household per year, generating returns of 5 times this amount, or more, driven by the decreased attrition rates and increased product holdings outlined above. It is important to note that this value is not equally distributed across households – we typically see no increase in value across 90%+ of the customers covered in any given year; almost all the value comes from the ~5% of customers that did not leave but would have without a relationship manager, and the few customers that take up very profitable products that they would not have done without a relationship manager. Successful programs share four key requirements:

1. THE COVERAGE SHOULD BE TRULY LOW-COST The services provided by effective mass-affluent personal bankers are very different than those of investment advisors or private bankers serving the high net-worth segment, and so is compensation. The role of a massaffluent personal banker is to ensure customers are satisfied, that their needs are met. The bankers are not product experts, but instead refer their customers to the appropriate channel for any specialized product advice. Reasonable compensation cost, plus relatively high “account loading”, allow for low-cost client coverage, which is crucial to achieving attractive economics. Effectively structured programs can cover 500 or more households per banker, who are also paid less than 1/3 of what a wirehouse broker or a private banker typically earns.

2. PAY SHOULD BE LINKED TO PERFORMANCE, SUPPORTED BY EFFECTIVE COACHING AND MANAGEMENT Correct incentive structures are crucial to achieving the desired benefits. Linking a sufficiently large portion of compensation to the desired outcomes ensures that the bankers will work to achieve the positive feedback loop of trust and loyalty that is the source of the program benefits.

Best-practice firms link compensation to performance across retention, deepened customer relationships, and client satisfaction. They also build robust performance management processes closely tied to these metrics that share best practices of top performers, invest in coaching and training across performance tiers, and require measurable improvements from the bottom performing bankers.

3. THE PROGRAM SHOULD TARGET THE RIGHT CUSTOMER SEGMENT Even low-cost personal coverage is generally too expensive for mass-market customers, and certainly for most customers who do not have a relationship that extends beyond a basic checking-account. It is important to only consider measurable benefits when assessing which customers to cover in a personalized manner. There is often a temptation to extend coverage beyond where it is measurably profitable based on an argument of reaping intangible “brand benefits”. However, these benefits are hard to translate into bottom-line earnings.

CONCLUSION Low-cost personal banking relationships can significantly improve loyalty and relationship depth for the valuable mass-affluent segment. A correctly set up program can generate value that exceeds the cost of the program by a factor of five, but this requires an implementation plan that: •• Hires the right relationship managers at the right compensation levels •• Ties compensation to performance •• Targets the right segment •• Is continually optimized Oliver Wyman has significant experience helping clients implement successful relationship management programs, while avoiding the pitfalls that can easily undermine the economics.

4. TEST & LEARN SHOULD BE APPLIED TO OPTIMIZE VALUE Maximizing the value generated from the program requires ongoing refinement and improvement as regulations, competitor practices, and underlying product economics naturally requires adjustments to the “optimal” set-up. Part of this ongoing refinement is having a rigorous approach to constructing and maintaining hold-out samples, in order to compare the benefits of coverage, and continually testing variations in the program setup to improve the value generated to the firm.

3. RETAIL BANKING IN A POST-DURBIN WORLD WHAT THE FINAL RULE MEANS FOR DEBIT CARD ISSUERS By Tony Hayes

On June 29, after almost a year of speculation, debate and lobbying, the Federal Reserve released the final rule to implement Regulation II, more commonly known as the Durbin Amendment (as mandated by last year’s DoddFrank Act)1. This article provides our perspective on what this new regulation means for banks as debit card issuers.

THE REGULATION There are two important new rules within the Durbin Amendment:

1. REDUCTION IN DEBIT CARD INTERCHANGE Financial institutions with at least $10 BN in worldwide assets will have the interchange rate that they can receive on their debit card transactions capped. The regulation limits the maximum revenue per debit card transaction to $0.21 + 0.05%; issuers that qualify may receive an additional $0.01 per transaction to help recover some of their costs related to fraud prevention. There is also an “anti-circumvention” provision: the rule directs banks’ regulators to look at all monies paid from a network to an issuer (including incentives and signing bonuses) to ensure that banks are not receiving more, de facto, than the allowable rate. The new rates will go into effect on October 1, 2011.

2. DEBIT NETWORK PARTICIPATION Any debit card issued by any size financial institution must participate in at least two unaffiliated payment networks. In most cases, this means that every debit card will be in one signature debit network and one PIN debit network that is not affiliated with the signature brand (e.g. not Interlink with Visa, or Maestro with MasterCard). The majority of banks already comply with this requirement; every issuer must comply by April 1, 2012.

WHAT DOES REG II MEAN FOR BANKS? At an industry level, Regulation II will wipe out $10 BN per year of retail banking revenue. On top of other recent regulatory developments in the retail banking and retail payments market (the CARD Act, Reg E, the order of check processing), a major source of noninterest fee income has been eliminated. Moreover, since compliance will not reduce banks’ operating expenses, the revenue reduction is essentially also a one-for-one reduction in operating profit. Faced with this significant, exogenous shock to the system, retail banks need to develop response plans in four categories:

See http://www.gpo.gov/fdsys/pkg/FR-2011-07-20/pdf/2011-16861.pdf for the final regulation.

1. Remedies for the Debit P&L 2. Strategy for selecting a Debit Network 3. Repositioning the DDA 4. Exploring other payment mechanisms

1. REMEDIES FOR THE DEBIT P&L Based upon the Fed’s analysis, the average interchange revenue received on a debit card transaction is $0.44. As of October 1, this rate will drop to no more than $0.24 (based upon an average ticket size of $40) for all $10 BN+ issuers, representing a ~45% revenue decline in debit transaction revenue. On a fully-loaded basis, the average bank’s cost per debit transaction is $0.272. In other words, with the new regulated rate, banks will lose money on the average debit transaction. Clearly, something needs to change. The primary first-order strategies include: •• Reduce debit card expenses In our experience, best-in-class issuers have significantly lower cost structures than their peers. In the past, the priority was on top-line growth; now the focus also needs to include a strong emphasis on operating efficiency. Some of the most promising areas are likely to include rewards program optimization, third-party expenses (card production, transaction processing, and network fees), and fraud losses (including fraud recovery rates).

•• Explore new revenue sources Cost cutting and mix shifting alone will be insufficient to solve banks’ P&L shortfall. Any issuer attempting to mitigate Durbin’s impact on its earnings must also explore new revenue sources. Within the confines of the debit card business, this is likely to mean either per-card or per-transaction fees, either on all cardholders or on certain segments. Relative to its current price point, the introduction of any new charge risks a strong customer backlash. However, relative to other payment options, some alternative price structures and price points may represent a fair value exchange. Would consumers opt to pay, say, $3 per month for the privilege of having a debit card? For customer segments without access to credit cards, this could represent an attractive proposition. The customer retains his or her ability to shop online, avoids the need to carry a check book, and avoids the need to carry excess cash (or perhaps pay high ATM surcharges). An emerging revenue source is the monetization of debit cards and their associated spend. Specifically, large issuers can mine their debit card bases, utilizing techniques honed in the credit card market, to target relevant merchant advertising to specific customer segments, either offline or online. By influencing customers’ buying decisions, debit card issuers can extract rents from merchants or Web data specialists.

•• Shift the mix from signature debit to PIN debit The ratio of signature debit to PIN debit transactions at most issuers is approximately 65/35. Yet, issuers’ costs associated with supporting signature debit are more than twice that of PIN debit. Pre-regulation, signature debit’s higher interchange revenue was more than enough to offset this higher expense. But the Durbin Amendment does not distinguish between authentication methods: there is one rate cap for all debit transactions. Because of this, issuers will benefit from encouraging their cardholders to use their PIN instead of signing (and also by supporting greater merchant PIN acceptance, such as for online payments). 2

2. STRATEGY FOR SELECTING A DEBIT NETWORK The final rule mandates that all debit cards participate in two unaffiliated debit networks. As a result, only a select number of banks (those that participate in Visa/Interlink or MasterCard/Maestro exclusively) will need to adjust their affiliation with payment networks. At first glance, network participation appears to be a straightforward business decision. Upon further inspection, however, we believe that important strategic and financial issues need to be considered when a bank evaluates its debit network affiliations.

Based on the industry comment letter to the Fed sent jointly by the ABA, The Clearing House, CBA, CUNA, Financial Services Roundtable, ICBA, MBCA, NAFCU and National Bankers Association, dated February 22, 2011.

•• Effective interchange rate Many issuers breathed a sigh of relief when the final rules were released. Rather than the $0.07-0.12 or $0.12 rate originally proposed by the Fed, the final rule caps the maximum interchange rate that a Covered Issuer can receive at $0.21+0.05% – a significant increase (although still materially lower than today). While that is the maximum, the actual rate that an issuer will receive will be determined by its debit networks (one for signature and one or more for PIN). Some networks may deliver revenue close to the cap; other networks may offer merchants a lower price point in order to secure transaction volume (as merchants now have greater transaction routing ability). Furthermore, since the cap is the maximum per transaction (rather than an average), any purchases that are priced below the cap (such as for small value payments) will pull down the effective average. In other words, banks should not assume that every network will deliver revenue equal to the Fed-mandated cap. Regulation II will stoke intense competition among networks and issuer revenue may be a casualty. •• Network configuration A related issue is the question of whether an issuer should participate in one or more PIN networks. The simplest choice for many issuers would appear to be to sign with an additional network to ensure compliance. But the introduction of more routing choices may promote negative dynamics among the competing networks, undermining issuers’ interests. Issuers also need to consider how their PIN network(s) will compete with their signature network, and vice versa. Our work with issuers suggests that the key is to negotiate a contract that adequately protects the bank’s interests along multiple dimensions.

3. REPOSITIONING THE DDA As noted above, the Durbin Amendment will remove ~$10 BN in annual income from the banking system.

What’s less well understood is that for some customer segments, revenue from debit card interchange represented more than 1/3 of the bank customer’s total revenue contribution. At the new lower run-rate, many bank customers will move from profitable to unprofitable. The fundamental value exchange between the bank and its customers will need to evolve. Banks will change their value propositions so that some customers pay more directly (in higher service fees) and others will pay more indirectly (with higher balance requirements or inducements to consolidate balances in order to continue to qualify for “free” checking). A number of banks are already actively moving in this direction, with redesigned product suites under development. The biggest challenge will be for banks that built their consumer franchises around heavily-marketed “totally free” checking accounts. When 70% or more of your customers are in free accounts, it simply is not viable to move from free to priced overnight. In fact, for these banks, the best approach may be to inflict even greater short-term pain by lowering the price of charged accounts, and thus lowering the threshold for migrating customers away from free services.

4. EXPLORING OTHER PAYMENT MECHANISMS Finally, banks need to re-think the full portfolio of payment products that they provide to their customers, and how these are positioned and priced. The Durbin Amendment cuts the revenue associated with debit card transactions. There are no similar interchange revenue limitations on credit cards, charge cards or general purpose reloadable prepaid cards. Different customer segments have different payment needs, and non-debit card-based payment solutions may offer a better solution for some customer groups. By identifying the right target markets and by offering payment products that align with their payment needs, banks can further mitigate the revenue shortfall created by Durbin.

The Durbin Amendment resets the economic contribution of banks’ debit card businesses. But debit will continue to grow – as consumers, merchants, networks and issuers maintain their support and preference for this critical payment method. Debit card issuers that adapt will be well-positioned for this new environment.

4. DUAL TRACKING A HUGE CHALLENGE FOR MORTGAGE SERVICERS By Ahmet Hacikura

“Dual tracking” is a mortgage industry practice which allows delinquent borrowers to apply for workout options in parallel with an ongoing foreclosure process. The practice has been criticized for causing unnecessary borrower confusion and, in rare cases, unintended foreclosures. Advocates of dual tracking point to the less than perfect success rate of most workout attempts and the significant costs that would be borne by lenders and investors if the practice were to be stopped and foreclosures were to be delayed. Large servicers have been required to review and change their dual tracking practices in response to a recent consent order from their primary regulator or in response to instructions from the Federal Housing Finance Agency (FHFA) for loans that they service for Fannie Mae and Freddie Mac. Remaining servicers may choose to do the same to align with emerging industry standard practices, and to reduce borrower confusion, while continuing to protect the interests of investors on the loans they service. Facing intense regulatory pressure and with many other things to occupy them, servicers may initially feel that a quick stop-gap effort to update dual tracking practices is the smart option. But the risks and complexity involved necessitate a detailed, fact-based strategy and operational planning effort to ensure compliance and to balance benefits and costs. We set out a suitable strategy and operational plan below.

DEFINING DUAL TRACKING AND UNDERSTANDING CHALLENGES Home loan servicers generally start working with delinquent borrowers within 45 days of their last paid installment to determine whether willing and able candidates can be offered short term solutions (e.g. forbearance1, repayment plan), or permanent modification of loan terms to enable them to retain ownership of their homes. For borrowers unwilling or unable to maintain home ownership, disposition options (short sale, deed-in-lieu of foreclosure2) are offered as more graceful and often less costly alternatives to foreclosure. For borrowers who are actively pursuing these workout options, the start of the foreclosure process is usually delayed until ongoing efforts are concluded3. Even after the foreclosure process is started, servicers will continue to attempt to contact borrowers and encourage them to pursue workout options, either because the borrower did not respond prior to the start of foreclosure, or because circumstances have changed 1 2 3

Temporary reduction or suspension of payments, to be followed by a temporary repayment plan with increased monthly payments to catch up on past-due balance. A deed in lieu of foreclosure is a disposition option in which a mortgagor (i.e. borrower) voluntarily deeds collateral property in exchange for a release from all obligations under the mortgage. Definition of active workout varies by investor (e.g. receipt of application package vs. approved and signed offers), and not all workout options may qualify as reasons to delay start of foreclosure for all investors.

since the last consideration4. The foreclosure process can take anywhere from a few months to more than a year, depending on geography (the state where the property is located), the investor on the loan, and the borrower’s specific situation. There are typically pre-foreclosure sale review processes in place to ensure that foreclosure sales are not conducted during active workout efforts. Borrowers who choose to pursue a workout option while simultaneously engaged in a foreclosure process will find themselves in a situation commonly referred to as “dual tracking.” They will concurrently receive foreclosure-related communications from attorneys and workout-related communications from servicers. Because workout attempts often do not result in a resolution of default (either because borrowers do not qualify, or because they fail to perform), dual tracking ensures that costly foreclosure processes are not needlessly delayed and extended. However, there are concerns that borrowers can become confused during the dual tracking process, and that any errors (which tend to be very rare) in pre-foreclosure sale reviews could lead to unintended foreclosures while borrowers are actively engaged in a workout. The OCC, in its role as regulator of most large and some smaller servicers, has expressed a strong desire to change dual tracking: •• John Walsh, acting head of the OCC: “We agree that this dual track is unnecessarily confusing for distressed homeowners, and the OCC is directing national bank servicers to suspend foreclosure proceedings for successfully performing modifications where they have the legal ability and are not already doing so. It is important to remember, however, that GSEs and private investors dictate the terms for non-HAMP modifications, so this option may not always be available to servicers.5” •• Recent OCC supervisory guidance: “Borrowers are often confused when a servicer is working with them to modify their mortgage but continues with legal proceedings related to foreclosure. To reduce this

confusion, management should suspend6 foreclosure proceedings for successfully performing trial period modifications7 where they have the legal ability to do so under servicing contracts.8” Advocates of dual tracking point to the foreclosure delay costs that would be borne by servicers, investors, as well as taxpayers in the case of Fannie Mae and Freddie Mac, if the practice were to be stopped. By some estimates these costs could be approximately $1,000 per month for each defaulted loan, excluding any impact on the value of the property. There can also be additional spill-over costs such as deterioration of neighborhood conditions and drop in local property values. FHFA, in its role as the regulator of Fannie Mae and Freddie Mac, directs servicers’ workout and foreclosure activities on loans serviced for these two government sponsored enterprises. FHFA’s views and recent guidance on dual tracking aim to strike a balance between the costs highlighted above and the benefits to borrowers: •• Edward J. DeMarco, Acting Director, FHFA: “At times, simultaneous actions are necessary because of the long timeframes of the foreclosure process and because borrowers are not always responsive to foreclosure alternative offers.” […] “Delay is costing taxpayers money and creates undesirable incentives for homeowners to stop paying their contracted mortgage obligations.9” •• Recent FHFA guidance: “Under the new requirements, servicers must engage in a single track for considering foreclosure alternatives up to the 120th day of delinquency.” […] “Even after the foreclosure process has begun, servicers must continue to work with homeowners on foreclosure alternatives to ensure borrowers have additional opportunity to avoid foreclosure beyond the initial four-month period. Monetary incentives will encourage servicers to continue to reach out to borrowers during this time frame. If an alternative resolution is not possible, foreclosure must proceed to mitigate harm for investors, taxpayers and communities.10” 6

The calls to end dual tracking often do not take into consideration this crucial benefit to borrowers. If borrowers do not respond to early workout attempts by servicers or they experience a change in their financial profile that would enable them to qualify for an option they did not qualify for in the past, dual tracking enables them to have another chance prior to foreclosure sale to retain their home. Even the Home Affordable Modification Program (HAMP) designed by the US Department of the Treasury allows dual tracking until borrowers are successfully performing in a trial modification, if the servicer made reasonable efforts, but was unable to get the borrower in HAMP prior to starting the foreclosure process. Statement of John Walsh, Acting Comptroller of the Currency, before the Committee on Banking, Housing, and Urban Affairs, US Senate, December 1, 2010.

For many home loans in default, the foreclosure process can be put on hold and resumed at a later date. Servicers’ ability to do this depends on local foreclosure rules and regulations. 7 Many modification programs require a three month trial period during which borrowers have an opportunity to demonstrate their ability to make the temporarily reduced payments before the mortgage terms are permanently modified. 8 OCC 2011-29 Foreclosure Management: Supervisory Guidance to CEOs of All National Banks, Department and Division Heads, and All Examining Personnel, June 30, 2011. 9 Statement of Edward J. DeMarco, Acting Director, Federal Housing Finance Agency, before the Committee on the Judiciary, US House of Representatives, “Foreclosed Justice: Causes and Effects of the Foreclosure Crisis,” December 2, 2010. 10 Frequently Asked Questions, Servicing Alignment Initiative announced by FHFA on April 28, 2011.

IDENTIFYING CONSTRAINTS Compliance with externally imposed11 minimum standards is one of the biggest concerns in policy determination, so a review of these is the first critical step in narrowing down the range of options available to servicers. When servicing loans that are held on the servicer’s parent company’s balance sheet, there is often more flexibility than there is with loans serviced for other investors. In determining the options available for portfolios serviced for others, servicers need to identify what they are able to do under the terms of their servicing contracts. In addition to regulatory, legal and contractual constraints, any operational constraints on what the servicer can do in the targeted timeframe should be identified. These may include scarcity of resources and competing priorities driven by other externally imposed standards.

ASSESSING ECONOMIC IMPACT Suspensions and restarts in foreclosure processes result in extended foreclosure timelines and corresponding increases in costs borne by servicers and investors. For example, the economic impact of suspending dual tracking during trial modifications would depend on the following key factors: •• Benefits of suspending dual tracking if trial modifications are successful, such as the avoidance of foreclosure-related costs that would have been incurred during trials in dual tracking (e.g. foreclosure attorney fees, property inspection and maintenance costs) •• Costs of suspending dual tracking if trials fail, such as tax and insurance advances12 made and foreclosures costs incurred during the extended foreclosure timeline Historical cost data can be used to quantify these impacts and historical trial success rates for modification programs can be analyzed to create probability-weighted expectations and scenarios of net economic impact.

11 Each loan may be subject to a range of externally imposed standards including federal, state and local laws, regulatory requirements and directives, Fannie Mae and Freddie Mac Servicing Guides and directives, FHA directives, and “Making Homes Affordable” directives from the US Department of the Treasury. 12 During any period in which the borrower does not make payments, servicers typically advance their own funds to pay property taxes and insurance premiums, and, if the loan is owned by outside investors, recover these costs from investors at a later date.

DETERMINING DUAL TRACKING STRATEGY Once constraints are identified, and an economic impact assessment framework is built, servicers can evaluate options and set a strategy that achieves the right balance between benefits and risks. Often, less easily quantifiable benefits (e.g. reduced dual tracking-related borrower confusion and complaints) and challenges (e.g. operational complexity) also need to be considered in determining strategy In the case of a trial modification, as described above, a key strategic decision that needs to be made is whether to suspend the foreclosure process as soon as a trial modification offer is sent to the borrower, or to wait for the borrower to make the first trial payment. Several factors can be considered in making this decision: •• Investors or guarantors may specifically require one option or the other •• By reviewing the percentage of borrowers who receive a trial modification offer, but never make the first payment (typically a low percentage), the foreclosure timeline and cost impact of the two options can be compared •• Because borrowers are typically offered one or two months to make their first trial payment after receiving a trial modification offer, they could be confused by foreclosure notices if the foreclosure process is not suspended until they make their first payment. Until and unless they miss that first payment, they have not done anything to indicate that the workout will not succeed •• Tracking timely and complete trial payments can be operationally more complex13 and prone to error than tracking the sending of trial letters, thus making the latter a simpler and less risky trigger for the suspension of foreclosure processes The servicer should arrive at a strategy that clearly defines the start, end and suspension of dual tracking; the following is a good example of a high level strategy outline:

13 Tracking timely and complete trial payments is more complex because the payment processing team needs to become part of the dual tracking framework, and also because employees often have flexibility to accept late payments within certain limits and borrowers may make multiple small payments instead of one full trial payment on time.

•• Do not start foreclosure until reasonable efforts have been made to offer borrowers alternatives to foreclosure, and until any active workouts are completed •• Do continue to work with borrowers during the foreclosure process to find a viable alternative to foreclosure •• Do not complete a foreclosure sale until any active workouts are completed •• Suspend foreclosure processes if borrowers are successfully performing in a trial modification and promptly resume foreclosure if they fail out of the trial, or fail to sign and return documents to make the modification permanent after a successful trial The strategy should be reviewed and approved by the appropriate governing bodies to ensure that operational, compliance, legal and reputational risks are satisfactorily addressed.

BUILDING THE OPERATIONAL FRAMEWORK The majority of challenges that home loan servicers face today concern the revision or remediation of existing processes, rather than the building of new processes from scratch. Therefore, an important part of building the operational framework involves understanding the current state in order to identify changes that need to be made, and address root causes of any problems that could continue to exist under the new strategy.

REVIEWING POLICY, PROCESSES AND PROCEDURES In reviewing relevant existing policies and procedures, key issues to identify are lack of clarity and specificity of instructions. For example, an instruction to suspend foreclosure activity during trial modifications is not likely to result in consistent execution, unless there is added detail regarding when a trial modification is considered to begin and end for the purposes of the policy and procedure (e.g. does the trial end as soon as the borrower misses a trial payment, after a grace period for late payments, or after the borrower is sent a decline letter indicating that a payment was missed and the trial failed?) In reviewing processes, the following are examples of key issues to identify:

•• Manual steps that could allow for employee errors and inconsistencies (e.g. manual monitoring of loan files to identify active trials, manual communication of foreclosure suspension requests to attorneys) •• Information hand-offs between internal departments and vendors (e.g. between underwriting teams, quality control teams, vendor management teams, mailing vendors, foreclosure attorneys) which could allow for miscommunication and errors (e.g. due to use of spreadsheets and e-mails rather than robust workflow tools, weak information reconciliation processes, unclear protocols and service level agreements for resolving questions and problems) •• Third party-owned steps that could, without strong vendor management programs in place, result in delays and errors (e.g. delay between a vendor sending a trial offer letter and informing the servicer that the letter has been sent, unclear service level expectations from attorneys responsible for suspending foreclosure activities, unclear protocols for vendors to get their questions to the servicer resolved) •• Lack of controls and reporting to ensure quality, and to identify and correct errors •• Process dependencies that may limit what can be fixed in the target timeframe

ANALYZING EXECUTION ACCURACY AND CONSISTENCY If process workflow data are available, they should be analyzed to study execution accuracy and consistency. In the absence of workflow data, the actual outcomes of the process can be compared to expected outcomes in order to arrive at similar insights. However, this ad hoc approach usually provides less clarity regarding where the process may have broken down and the possible root causes. For example, if modification tracking databases indicate that a loan is in a trial modification, but the foreclosure database does not show any foreclosure holds for that loan, it is evident that the process of suspending dual tracking failed, but the reason might not be immediately clear. Any loans identified as exceptions can be studied in more detail to understand what went wrong and why. Similarly, unusually low defects or delays in a subset of the loans can provide hints on drivers of delays in the set of loans where defects and delays are more common.

In addition to targeted loan-level reviews of any outliers in the process, it is important to interview employees and observe the general processes to look out for potential problems such as: •• Complaints, questions and suggestions that have not been adequately addressed •• Confusion and errors resulting from interpretation of unclear instructions or lack of training •• Inappropriate use of employee judgment resulting in irregularities •• Shortcuts and workarounds inconsistent with the standard process •• Miscommunication of policies to borrowers, which can further confuse borrowers Findings on problems and root causes should be shared with key stakeholders in order to: •• Agree on findings and discuss potential solutions •• Highlight gaps in findings that should be closed through further research •• Understand whether there are previously unidentified constraints that resulted in the problems identified and will limit the potential range of solutions going forward

DEVELOPING AND IMPLEMENTING A PLAN TO EXECUTE THE STRATEGY AND ADDRESS PROBLEMS The plan to execute the strategy will call for some or all of the following actions: •• Developing, or updating, policies that clearly articulate the dual tracking strategy with enough detail to ensure accurate and consistent interpretation, and address any investor-, geographyand/or program-specific variances •• Designing or modifying processes to address root causes of existing or potential problems – these process changes may include the reduction or elimination of manual steps required, improved and standardized information flow between departments, and the reduction of critical dependencies on third parties (e.g. if vendors consistently send trial offer letters when instructed, then foreclosures could be suspended without the need to wait for a confirmation from the vendor that the letter was sent) •• Updating process flow charts, procedures and job aids for employees

•• Delivering training as needed and monitoring policy and procedure adherence •• Developing or updating internal and external communication materials •• Building appropriate frameworks to control critical quality metrics going forward, which, in default servicing, will include accuracy, consistency, speed, and traceability •• Developing or updating audit and, where relevant, vendor management standards The operational plan and the strategy should be reviewed and approved prior to implementation. Management should ensure that sufficient staff, organizational structure and training will be in place to carry out activities in a satisfactory manner.

MONITORING RESULTS AND ADDRESSING PROBLEMS To confirm the successful execution of the strategy, a quality control and reporting framework will be required to ensure timely delivery of complete and accurate information to management. With a complex problem such as dual tracking in home loan servicing, this will require participation of subject matter experts from a range of departments, and likely necessitate access to information from key sources such as: •• Systems of records that store general loan information •• Workflow management tools used by modification teams to track progress of loans through a modification process •• Tools used by foreclosure teams to track foreclosure process steps and any suspensions and resumptions •• Logs of communications and notifications between internal departments (e.g. logs of codes placed on loan files to indicate that the foreclosure process should be suspended or resumed) •• Tools used to communicate with vendors (e.g. to request trial letters from mail vendors, to instruct foreclosure attorneys to suspend foreclosure activities) There should be processes to remediate any exceptions identified, and to investigate the root causes of these exceptions. Depending on the root causes and scale of exceptions identified, a revisit of the strategy and operational framework may be required.

CONCLUSION AND FUTURE CHALLENGES As new programs are instituted by banking regulators, FHFA, US Department of the Treasury and state or local governments with the goal of helping homeowners avoid foreclosure, servicers will continue to encounter operationally complex problems that need to be addressed in very short time frames, or otherwise face regulatory, financial and legal risks and repercussions. Given the range of potential design and execution flaws detailed in this dual track example, quick solutions are often shortsighted and ultimately ineffective at eliminating risks. Therefore, the only way to avoid a repeat of past mistakes and to ensure future success is to dedicate requisite resources toward a thorough strategy and operational planning effort.

Oliver Wyman is a leading global management consulting firm that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation, and leadership development. For more information on Oliver Wyman Financial Services, please visit www.oliverwyman.com/financial-services.htm. For other inquires please contact the marketing department by email at info-FS@oliverwyman.com or by phone at one of the followingÂ locations: NORTH AMERICA +1 212 541 8100 EMEA +44 20 7333 8333 ASIA PACIFIC +65 6510 9700

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