PROJECT REPORT ON

:: RETAIL BANKING STRATEGY ::

:: MANAGEMENT OF BANKS & FINANCIAL SERVICES ::

SUBMITTED BY:

TAPAS ICOT (13)

PRASHANT KANADE (17)
SATISH PALVANKAR (31)
DEEPAK PATIL (37)
PRASHANT RAO (44)
SWETA RAVAL (45)

MASTER’S DEGREE IN FINANCIAL MANAGEMENT – 3rd YEAR

BATCH – 2008-2011

UNDER THE GUIDANCE OF

PROF. S N SAWAIKAR

LALA LAJPATRAI INSTITUTE OF MANAGEMENT

MAHALAXMI, HAJIALI, MUMBAI – 400034.
1
 ACKNOWLEDGEMENT

We would like to acknowledge and extend our heartfelt gratitude to Prof. S N Savikar

for his support, guidelines and encouragement which has made the completion of this

project possible.

We would also like to thank the library staff of Lala Lajpatrai Institute of Management

for the use of their collections without which this project would have been most difficult.

Finally, we would like to thank my classmates & friends for providing their valuable

advice, guidance and support which made me complete this assignment efficiently.

2
 CONTENTS

Sr. No. Particulars Page

1. INTRODUCTION 4

2. EXECUTIVE SUMMARY 5

3. CURRENT SCENARIO 8

4. FUTURE OF RETAIL BANKING 10

5. COMPETITION IN RETAIL BANKING 11

6. FUTURE DEVELOPMENTS IN RETAIL BANKING 12

7. MARKETING MIX – RETAIL BANKING STRATEGIES 14

8. CONCLUSION

9.

10.

11.

12.

: INTRODUCTION :
3
Retail banks have traditionally provided intermediation and payments
services

to individuals and small businesses with all the components of those

services

supplied by the bank. However it is becoming increasingly difficult to

identify

the nature of a retail bank. Firstly because many banks now combine
both

retail and wholesale activities. Secondly because technological

developments

have enabled banks to supply a wide range of retail financial services to

its

customers but not supply all the sub-components of those services.

In this project we begin by examining the nature of traditional retail banking.

In
particular we investigate the provision of intermediation services and how
banks
manage the risks involved in that provision. We also examine the nature of
payments
services provided by retail banks and discuss why banks have traditionally
combined
provision of intermediation and payments services. Finally we investigate
recent
developments in retail banking and discuss the impact of these on the future
organization of retail banks. We focus in particular on how it is now possible to
separate the components of a financial service/product and the trend towards
outsourcing or sub-contracting the supply of components of a financial
service / product.

What is retail banking?

It is becoming more and more difficult to define a retail bank.
Traditionally,

retail banks provided banking services to individuals and small businesses

4
dealing in large volumes of low value transactions. This is in contrast to

wholesale banking which deals with large value transactions, generally in

small

volumes. We deal with wholesale banking in the next chapter of this

guide. In

practice it is difficult to identify purely retail banks that fund themselves

from

retail deposits and lend in the retail loan markets. In the UK, Australia, US
and

many other developed countries the large banks combine retail and
wholesale activities. Technological developments are also changing the
nature of retail

banking. Traditionally a retail bank would need a substantial branch

network to

collect the deposits of the public, facilitate repayment of deposits and

other

account payments and make loans. The widespread use of automated

teller

machines and the growth in telephone banking, postal accounts and more

recently internet banks has allowed new types of retail bank to emerge
that do

not require extensive investment in branches. To make sense of the many

developments in retail banking it is helpful to see retail banking as a set

of

processes rather than institutions.

Meaning
Retail banking is a banking service that is geared primarily toward individual consumers.
Retail

banking is usually made available by commercial banks, as well as smaller community

banks.

Unlike wholesale banking, retail banking focuses strictly on consumer markets. Retail
banking

entities provide a wide range of personal banking services, including offering savings and
5
checking accounts, bill paying services , as well as debit and credit cards. Through retail
banking,

consumers may also obtain mortgages and personal loans. Although retail banking is, for
the

most part, mass-market driven, many retail banking products may also extend to small
and

medium sized businesses. Today much of retail banking is streamlined electronically via

Automated Teller Machines (ATMs), or through virtual retail banking known as online
banking.

Executive Summary

All around the world retail lending has been an established market; however its rise in
emerging

economies like India has been of recent origin. If recent statistics on consumer finance
are any

indication, the last few years have been trend setting. The traditional debt-averse,
middle-class

Indians who lived within their thrifty means, never to venture beyond their means, seem
to have

given way to a new middle-class that is free from all inhibitions regarding conspicuous

consumption. Unlike its predecessors, the middle-class of today has donned a new
attitude; it

attaches no social-stigma in taking loans for spending.

Indian retail banking is up and kicking. During 2004-05 retail contributed 42% of overall
credit

growth. Growing at the CAGR of 35% over last 5 years the retail asset touched Rs1,89,000
crore.

Major product segments of retail credit include housing finance, auto finance, personal
loans,

consumer durable loan and credit cards to name a few. Housing constitutes the biggest
segment of

48% of the entire retail credit; followed by the auto loans segment which constitutes
almost

27.8%. While the balance retail credit is used by consumer durables at 7.2%, educational
6
and

other personal loans take the remaining 16%.

Banks are increasing their dominance in housing finance and capturing the market share
of the

housing finance companies. During 2004-05, the market share of banks stood at 62%,
against the

33% by Housing finance companies; Rs 2-5 lakhs margins constitutes almost a third of the
loan

size. All the players in this market are adopting an aggressive attitude and the housing
loan

availability is playing into the players hands. Despite this phenomenal growth in India, the

housing loan as a percentage of GDP at 4.91% indicates low penetration when compared
to other

countries like Malaysia (17%) and Thailand (9%). But again this coupled with the
population

growth indicates good future prospects.

Following the housing loans, it is the auto loan which is also giving the growth of retail
credit the

necessary boost. In Asia Pacific, India has emerged as the third largest market for cars
and MUVs

i.e. only after Japan and China. Low interest rates, easy finance, up-gradation of rider from
two-

wheeler to 4-wheelers and opening up of second hand car finance are growth drivers of
this

segment.

The consumer durable loan follows the auto loan market in the third position, constituting

approximately 7% of total credit. Metro centres continue to dominate the market with
29% of total

retail credit, closely followed by the rural market at 27% of total retail market. Urban and
Semi

Urban centres contribute around 22% each. The rural market uprising is a recent
phenomenon,

7
which has immense growth potential. While private sector banks have dominance in
metropolitan

areas, nationalized banks have their hold in the urban and semi-urban areas. The rural
areas are

dominated by RRBs.

The last few years have witnessed a high increase in students aspiring for management
and

professional courses, leading to a spurt in educational loans. Banks are now having a
direct tie-up

with the educational institutions to cash in on the opportunity. Public sector banks (PSBs)
are

more focused on the educational loans segment. In the educational loan segment,
disbursement

of domestic banks has surged by 13% to Rs.2249 crore in 2004-05; up from Rs1983
crores in 2003-

04. The number of students availing education loans has increased to 1,40,000 from
1,08,000

during this period.

The other personal loans market is characterized by intense competition and the players
vie with

one another to get business. These loans are driven by urgent and short-term needs and
banks

have to act swiftly to cash in on that need. Metropolitan and urban areas together
constitute two

third of total loans under this category. Private sector banks lead in metropolitan areas,
whereas

in the rural areas the nationalized banks dominate.

In India, all the retail banking segments are expected to witness a tremendous growth
owing to
the low cost of borrowing, changing customer attitudes towards borrowing and optimism

regarding economic growth. Retail lending constitutes just 12.36% of the Indian banking
system.
Given this macroeconomic scenario, the share of retail banking will grow dramatically and
it is

8
expected that about 35% of the incremental growth in net credit will come from retail
banking. In

the next five years i.e. till 2010, retail banking is expected to grow by a CAGR of 25% to
touch the
figure of Rs.5,75,000 crores This requires expansion and diversification of retail banking
product

portfolio, better penetration and faster service mechanism. Hitherto, the growth had
come from
metros and tier I cities. While the loan requirement from larger cities will continue to
grow,

explosive growth in credit is expected to register in tier II cities, semi-urban and rural
areas.

However, there are some areas of concern like rising NPA in consumer loans
particularly,

the delinquency rates in credit cards, and frauds in home loans. Housing prices
have

grown rapidly. Deflation of asset value is a possibility in certain areas. Aggressive

credit

growth in retail has increased the requirement for measuring and managing this risk.

These require extremely skilled workforce and highly evolved credit delivery and

monitoring processes. The other concern is of suicidal pricing by the aggressive

banks.

This is bringing the margins under pressure. Though rational pricing is critical, the

competitive market shall continue to see the pricing pressure. There is also a need
for a

database and management information system to identify the right type of

borrowers.

Keeping pace with explosive changes will pose challenge to regulatory authorities. This
will not limit only to increase of risk weight of consumer loan by 25 basis points which the
regulator announced in mid-term policy review 2004-05. Revision of credit cards issue
regulations, and recent draft guidelines on outsourcing are the steps in the right direction.
Lack of consensus on definition of retail and transparency in declaration by the players as
well the coverage of retail by the central banker in its reports; all of this needs a thorough
re-look.

9
 : CURRENT SCENARIO :

• Indian retail banking has been showing phenomenal growth.

• In 2004-05, 42% of credit growth came from retail.

• Over the last 5 years CAGR has been over 35% .

• Retail credit level crossed Rs.189K Crores in 2004-05.

• Market has transformed into a ‘buyer’s market’ from a ‘seller’s market’ .

• Comprises of multiple products, channels of distribution and multiple

customer groups .

Economy vs. Retail Banking

• Retail assets are just 22% of the total banking assets of India

Contribution of retail loans to GDP:

India 6% China 15 %,

Thailand 24% Taiwan 52%

Indian population below 35 yrs of Age – 70 %

Reach of Formal Banking Channels – 20-25% of Indian population.

Market Share : Retail Loan – 2005

Home – 49% Consumer Durables – 7% Auto – 28% Other Personal

Loans – 16%

Drivers Of Retail Growth

CHANGING CONSUMER DEMOGRAPHICS :

• Growing disposable incomes

• Youngest population in the world
• Increasing literacy levels
• Higher adaptability to technology
• Growing consumerism
• Fiscal incentives for home loans
• Changing mindsets-willingness to borrow/lend
10
 • Desire to improve lifestyles
• Banks vying for higher market share

INDUSTRY’S RESPONSE TO THE CHANGE :

• “Any where”, “Any time” Banking.

• Improved processes/Bundled product offerings
• Faster service/Reduced TAT’s
• Customer specific products/offerings on a regular basis
• ‘Bank’ customer has replaced ‘Branch’ customer
• Focus on understanding customer needs/ preferences
• Segmentation/Differentiation of customers
• Customer driven strategies
• Building relationships.
• The accelerated retail growth has been on a historically low base.
• Penetration continues to be significantly low compared to global bench
marks.
• Share of retail credit expected to grow from 22% to 36%.
• Retail credit expected to grow to Rs.575,000 crores by 2010 at an annual growth rate of
25% ..

: FUTURE OF RETAIL BANKING :

• Dramatic changes expected in the credit portfolio of Banks in the next 5

years.

• Housing will continue to be the biggest growth segment, followed by

Auto loans

• Banks need to expand and diversify by focusing on non urban segment

as well

as varied income and demographic groups .

• Rural areas offer tremendous potential too which needs to be exploited.

STRATEGIC PREREQUISITES

• Performance oriented leadership.

• Sophisticated marketing and sales

• Efficient distribution channels

11
 • Process efficiency and ease of scalability

• Superior credit policy, procedures and skills

CHALLENGES

 Sustaining Customer loyalty

 NPA reduction & Fraud prevention

 Avoiding Debt Trap for customers

 Bringing rural masses into mainstream banking .

STRATEGIES FOR FUTURE SSSS

 Reaching to masses : Need to customize

 Customer segmentation/differentiation

 Data mining/CRM based campaigns

 Products per customer/loyalty

 Promoting low risk retail lending products

 Offer an array of products and financial advisory.

 Cost effective expansion.

 Renewed emphasis on superior execution by front-line employees .

 Grow through Alliances.

Hospitality Education

Retailers Automobiles

Consumer Durables Housing / Construction

“ The bank that best addresses and anticipates customers needs,

delivers consistently
12
higher quality service and connects to the customer via their channel
of choice wins.”

Competition in retail banking:

The retail banking sector in many countries has experienced increased

competition in recent years as a result of new entrants into the industry. In
the UK, these new entrants have come from a variety of sources:

1. Savings and mortgage institutions: 10 the 1986 Building Societies

Act in the UK
permitted building societies to offer current accounts and make
unsecured loans
to persons, to a limited extent. The Act also allowed larger building
societies to
convert into banks of the larger Societies have since taken up this
option.

2. Insurance companies: a number of insurance companies in the UK

have
established banking subsidiaries. These include Legal and General,
Prudential and Standard Life.

3. Retailing organizations: in the UK a number of supermarkets now offer

selected
banking products alongside groceries.

The majority of new entrants under categories 2 and 3 have so far chosen
to offer only a subset of retail banking products, namely credit cards,
savings accounts, personal loans and mortgages. The main retail banking
product missing from this list is the current (or cheque) account. In
addition, many of the new entrants from the insurance industry have
chosen to offer retail banking services/products through new delivery
channels. In most cases the establishment of these new banks has only
come about as a consequence of the ability to offer banking services
through non-traditional channels. Retail banks have traditionally operated
through branch networks. These are costly to establish and to maintain.
The introducton of automated teller machines (ATMs) was the first
development that allowed delivery of certain elements of retail banking
services outside the branch. ATMs were first located inside or on the
outside wall of the branch. They are now located in shopping malls,
workplaces, universities, petrol stations etc. Telephone banking was the
next innovation in delivery channels and many of the recent entrants into
the banking industry are based completely on telephone transactions. The
pioneer in the UK was First Direct, a subsidiary of Hong Kong and Shanghai
Banking Corporation (HSBC). The most recent innovation in delivery
channels is the internet. Many retail banks in the UK have introduced
online banking allowing customers access to account information, to make
13
 payments and to transfer money between accounts. As more households
gain access to the internet and gain confidence in using it to conduct
banking transactions, then new banks are likely to emerge basing their
delivery of banking services solely on the internet. Developments in
interactive digital television also offer a new means of delivering retail
banking services.

All these developments do not imply an early demise for branch networks.
First, many customers will resist using the new technology. Second,
branches allow banks to cross-sell other financial products to customers
who go into the branch to undertake a banking transaction. In addition, a
danger with telephone or internet based banking is that it is likely to
encourage customers to trade more on price so becoming more fickle. This
has implications for banks’ ability to manage liquidity risk.

Activity
What are the implications of the growth in internet banking for a bank’s ability
to manage liquidity risk?

Future developments in retail banking:

Competition in retail banking from non-banks has led banks to diversify

into other financial services. Most retail banks now provide a wide variety
of financial products/services in addition to the traditional services of
intermediation and payments. These include:

• Long-term savings products such as life assurance policies and

pension plans • General insurance. •Portfolio Management • Stock
Broking
• Foreign exchange services.

Activity
Identify the main products/services provided by a retail bank in your country.

Banks have increasingly used sophisticated marketing techniques to help

target these other financial products at certain types of customer. In
particular, banks have segmented personal customers according to
wealth, income and a host of other social and demographic factors.
In the future, banks may have to consider diversifying into non-financial
business. Banks have developed certain core competencies or
comparative advantages from their traditional business that could be
applied elsewhere. These competencies/advantages include:
• information advantages (banks have access to financial information on
customers) • risk analysis expertise
• expertise in the monitoring and enforcement of
contracts • delivery capacity.
14
Activity
What kinds of non-financial business are the competencies/advantages
of banks ideally suited to?
Banks have traditionally been fully vertically integrated firms, that is they
supply all of the components of a product or service within the
organization. However developments in new technology are changing the
nature of the financial firm. You need to read Buckle and Thompson
(1998), section 3.4. The important points to
understand are:
1.It is now possible to separate (or deconstruct) a financial product or
service into its
component parts which can then be supplied separately.
An example of this is a mortgage loan. This can be separated into the
following component processes:
a. origination - the mortgage is brokered to a customer
b. administration - paperwork processed
c. risk analysis - assessment of the credit worthiness of the borrower d.
funding - finance raised and asset held on the balance sheet and capital
allocated to the risk.
2.A firm may have a comparative advantage in certain parts of the whole
process but not every part. For example, a bank with a branch network
may have a comparative advantage in origination of mortgage loans but
may not be the most efficient in terms of funding the loan, perhaps
because of a capital constraint. 11 It is becoming increasingly common in
the US for banks to securities their mortgage loans and issue the
subsequent securities into the capital market.12 When an asset is
securitized it is effectively packaged into a security and sold to investors
Securitization allows a bank to turn an illiquid asset (like a mortgage loan -
which, we saw in Chapter 2 of this guide is a non-traded loan) into a liquid
security which the bank can sell.

3.A new entrant to banking can sub-contract (outsource) some part of

the process involved in delivering a financial product. This allows them
to obtain the economies of scale for that process without having to
invest. This makes it easier for new firms to enter into banking. New
entrants can therefore offer a wide range of financial products/services
to customers but not be involved in every component of the delivery of
the product/service.
4.The organisation of a retail bank will probably become more like the
organisation of firms in other industries where the degree of vertical
integration is lower. For example a car manufacturer like Toyota
supplies finished Toyota cars to its customers but many of the
components of Toyota cars are supplied by other firms.

15
 “ MARKETING MIX – RETAIL BANKING STRATEGIES “

Modeling can help optimize marketing mix resource allocation to maximize customer equity.

Financial institutions have traditionally based their marketing budgets on a percentage of last
year’s

revenues or budget, which often results in suboptimal results and wasteful spending. Better
results can be

achieved by using econometric and optimization modeling to determine an optimal marketing

budget that

allocates spending across appropriate media to increase customer equity and shareholder
value. One bank

found that a 100% increase in direct mail spending would yield a 7% gain in customer equity
through

better customer retention.

How should marketing dollars be allocated? The question is one that financial services and
other industries

have been wrestling with for more than 100 years. Many organizations in 2005 find
themselves in the same

situation as Sir William Hesketh Lever, the soap-maker and eventual founder of Unilever, who
in the late

1800s commented: “Half the money I spend on advertising is wasted, and the trouble is I don’t
know which

half.”

Traditionally, marketing budgets are based on a percentage of last year’s revenues or budget.
Such

budgets are easy to create, but this is an approach that falls short. It fails, for example, to
address how

much should be invested in customer acquisition or retention, which customer segments and
products

16
should be targeted, and even the type of marketing media to be used. Because it does not
challenge

marketing investments to be productive, it can lead to suboptimal results and wasteful

spending.

To enhance marketing productivity, many financial services organizations are turning to

econometric

analysis and optimization modeling. The former examines the relationships over time between
marketing

mix variables that are controlled and performance measures, such as sale or market share,
that represent

the outcomes of marketing plans.

Optimization modeling is the ideal allocation of resources to maximize objectives. The bank
that tracks its

marketing spend across media and customer acquisition/retention can gauge the
effectiveness of its

spending and determine an optimal amount of money to be allocated to various marketing

activities. The

key is to find the point where the expense of marketing in a channel creates the highest
shareholder value.

For example, one bank found that increasing marketing dollars spent on direct mail by 100%
increased

“customer equity” by 7%, or $5.3 million. This was accomplished by extending the average
customer

lifetime — customers who stay longer with the bank can yield more long-term value even if
the annual

contribution they generate is unchanged.

CUSTOMER LIFETIME VALUE

Underlying the marketing productivity boost is the concept of “customer lifetime value,” which
is the net

present value of a customer’s current and future contributions to profit. The sum of all
customers’ lifetime

17
values is customer equity. There are four sources of customer equity:

• The attraction of new customers, which are a source of revenue growth;

• Improvements in the retention of customers, which makes customers stay longer;
• The cross-selling of current customers to other business lines;
• The up-selling of current customers to a higher consumption within a business line.

Long used in the catalog industry, customer lifetime value is becoming increasingly prevalent
in the

financial services industry as executives recognize that marketing success is not just the
number of

customers but the value of those customers over the course of their “lifetime” with the bank.
Savvy

management aims to increase customer equity as a means of enhancing the long-term value
of the

financial institution.

Marketing instruments have a differential impact on the four components of customer equity.
These

impacts are classified into two areas:

• Marketing communications, whether broad such as national TV, or very focused such
as direct marketing;
• Other controllable factors, including branches per capita or service employees per
branch;

In addition, external economic factors such as the consumer price index, stock market index
and housing

starts, for example.

Econometric methods, which are used to develop market response models, indicate how
marketing media

such as TV, radio, print ads, direct mail, etc. impact the various performance metrics,
specifically

acquisition rate, retention rate and revenues. For example, if television advertising doubled,
there would be

a simultaneous impact on several metrics in the short run — the effects of which can be
simulated. The

long-term implications of these short-term movements indicate how sound the strategy is in
the long run.

18
Development of these models requires a bank’s IT department to gather prescribed data that

econometricians or statisticians can use to create the response models. The response models
are the basis

of optimization or simulation software developed for use by the bank’s marketing department.

How “should” marketing dollars be allocated? An optimization routine can find the “best”
combination of

media expenses to give the institution the highest customer equity value. By taking the major
elements of

the marketing mix and performing a customer equity optimization, the optimal allocation can
be calculated,

both for the short- and long-run in concert with the bank’s strategic goals. A plan to build
market share will

favor a different marketing mix compared to an objective of maximizing individual customer

worth.

Short-term goals may focus on media that increase acquisition, but these new clients may
stay only a few

months, decreasing long-term metrics such as customer equity. Most likely, the optimizations
and

refocused marketing spend will have a beneficial effect on short- and long-term objectives.

The critical question for customer equity maximization value is: how does the short-term
revenue from new

customers translate into long-term revenue? For financial institutions, the answer depends on
two

important metrics: the customer retention rate, which is never 100%, and therefore gradually
decreases

the size of the existing customer base, and the discount factor, which ranges from around 6%
to 12%

annually. The retention value of the institution’s customers diminishes over time as the effects
of attrition

and discount factors are compounded.

19
ESTIMATING CUSTOMER EQUITY

Financial institutions are in the relationship business and thus have comprehensive customer
data that can

be used to optimize marketing mix resource allocation to maximize customer equity. This data
includes the

marketing spending by channel, new and lost customers, revenues segmented by

products/services, by

branches, designated marketing areas, and customer segments gathered on a weekly basis.

Econometric modeling uses changes in marketing activities such as direct mail, TV, Web
activities, etc., so

that the effects of those specific spending changes on acquisition, retention and revenues can
be

statistically isolated. The revenue from acquisition and retention in the long term creates both
top-line

performance (revenue) and bottom-line performance (customer equity).

Banks can estimate customer equity for 10 or more years out. After 10 years there is severe
discounting of

the cash flows. For example, at 12%, a $100.00 cash flow in the 11th year is worth only
$28.75 in today’s

value. The patterns of acquiring and losing customers and generating revenues, along with the
gross

margins on the various financial products, yield both the short-term and the long-term
estimated

contributions to profits. Then, by properly discounting these gross profits back to the present,
the

institution can get an estimate of customer equity. Naturally, these are estimates or
projections that are

subject to revision as, for example, economic and competitive conditions change. Even so, the
projections

are strategically useful as they provide a trajectory of future business performance based on
current and

projected marketing investments that management can evaluate and improve upon.

20
For the optimization, the economic factors are typically held at their most recent levels,
though it is possible

to test the effects of different scenarios such as a gradual improvement in the economic
environment.

The first step is to consider marketing spending at its current level and allocation, and to
derive the

implications of this policy for customer-equity development. The second step is to compare
this trajectory

with the marketing investment strategy that is suggested by the optimization. The
optimization will indicate

that the financial institution should allocate its resources in proportion to their effectiveness.
As a result of

allocating scarce marketing dollars more productively, the financial institution should enjoy an
increase in

customer equity.

Recommendations may increase spending for certain marketing activities and cut others. For
example,

cable TV spending may increase at the expense of print advertising or vice versa. These
changes reflect

different positions on the market response curve, which is subject to diminishing returns to
scale. For

example, the higher the lift in response at the current level of spending, the more marketing
investment is

justified, and vice versa.

The shape of the entire market response curve is generated using the techniques of
econometrics, and

results in estimates of response elasticities for each marketing medium. For example, a print
advertising

elasticity of 0.2 implies that, for every 10% increase of print spending, revenue increases by
2%.

21
In cases where the recommended spending for a specific marketing activity is far outside the
current

spending range, it is prudent to engage in a marketing experiment to verify that the response
level is in line

with that anticipated by the optimization model. For example, a bank uses e-mail as a direct
marketing

channel. The analysis indicates gross under-spending in this channel and recommends a 500%
increase.

Since a 500% increase has not been previously tested, this would constitute a risk. So, a 100%
increase is

implemented at first and simulated through the model.

After the completion of the marketing period, actual results are compared with the predicted
results.

Assuming the actual results are close to the predicted, the model is recalibrated, appending
the last

period’s data. The institution now has more confidence in the model’s recommendation for e-
mail spending.

OPTIMIZING BUDGET ALLOCATIONS

As a result of the econometric and optimization modeling, banks can see how different
customer segments

and product categories will generate revenues and gross margins. This is a very useful tool
strategically,

because the financial institution can analyze the consequences of top-line growth verses
bottom-line

growth. For example, the bank may find that, by spending more aggressively, it can expand its
customer

base with customers whose acquisition costs are nearly the same as their marginal revenue.
In that case,

there will be top-line growth, but not necessarily customer equity growth.

A realistic market response model obeys the laws of diminishing returns to scale. If a financial
institution’s

22
direct mail is currently yielding a 3% response rate and if the direct mail budget is doubled,
the institution

should expect a lower response rate on the additional budget allocation. These results will, of
course, vary

with the quality of execution within each medium, which relies upon the creative component
in marketing

communications.

Such qualitative changes may be accounted for in an econometric model. However, the
easiest way to

assess that is by running simple marketing experiments rather than sophisticated

econometrics. Insofar as

a financial institution is more successful in increasing lift due to higher execution quality, it
follows that the

institution should spend more on that medium. The optimization generally assumes that the
quality of the

financial institution’s marketing execution remains the same, and thus its marketing spending
is subject to

the laws of diminishing returns. Different scenarios can be used to test the sensitivity of
customer equity to

changes in the quality of marketing execution.

If a financial institution reallocates its marketing spending based on insights from an

optimization exercise,

the impact will be beneficial for both short-term and long-term profitability. Pursuing a
strategy of top-line

growth — expanding total customers and total revenues — can be consistent with customer
equity

maximization, although not always. The result depends on the customer equity drivers and
especially the

drivers of customer retention.

No longer should executives be in a quandary about marketing budgets. The use of

econometric and

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optimization modeling can guide financial institutions to determine their optimal marketing
budget and then

optimally allocate that budget for heightened customer equity and shareholder value.

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