rb i new 103 chapter 2

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Chapter 2: Retail Bank Products/Services – Categories and Functions

We begin this chapter with an open question that is based on an interesting perspective on bank products.*

Open Question #2

DiVanna (2004, page 20)* states that the principal product of a retail bank is “a solution that ful!lls an individual’s need or, more precisely, a set of integrated solutions that support the individual’s lifestyle and !nancial responsibilities.”

What is your opinion about the philosophical point of view expressed by DiVanna?

As we stated in the previous module (course code 102), the core services of a retail bank are a direct response to demands of individual consumers and small and medium-sized businesses (SMEs).

In other words, banks create supply in response to customer demand.

Individual consumers and SMEs use retail banks to:

a) Make payments

As stated in Module 102 and repeated here for emphasis, customers can make payments through a ‘transactional account’. These accounts are called ‘checking accounts’ in the US and ‘current accounts’ in the UK. As opposed to, for example, time deposits, funds in current accounts are available on demand, and hence are also known as ‘demand deposits’. These accounts usually do not earn any interest income since they are intended to facilitate payment services. Banks provide several ways for the customer to conduct payments or money transfers. These include direct deposit (GIRO), standing orders (regular automatic transfer of funds), debit cards (direct cashless payment of merchandise purchases), credit cards, and international transfer of funds (SWIFT).

* Joseph DiVanna: The Future of Retail Banking: Delivering Value to Global Customer, Palgrave Macmillan, (2004).

Course Code 103 - Products

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We present more details on these payment options.

Payments/Transfers – Allows for moving money either between accounts of the same bank (internally) or to accounts in other banks. This service also allows customers to make payments to service providers (utility companies, phone companies) by transferring money from their current/savings account to the entity. This provides the convenience of payment without using cash. In most countries, banks provide these services through online banking for maximum convenience.

By providing these services, the bank reinforces the banking relationship for customers who open accounts. These services induce customers to adopt the bank accounts and ensure use of the same. This in turn leads to customer satisfaction, customer loyalty and retention.

There may be fees for these services that cover the costs of the operation. Banks also may o"er no-fee (waived) payment options to reinforce the relationship. Since the cost of providing these services in the physical world (branches) requires costly branch premises and manpower, most banks are adopting strategies to o"er online services to customers, hence ensuring that customers do not need to come to branches. Customers are increasingly encouraged to arrange these payments online, which saves the bank money and often costs less for customers compared with doing it in the bank branch.

For the customer, payments and transfers o"er convenience and security (especially in the case of large payments). For some operations, and with the advent of online-banking technology, the cost of transferring money may be less than that of writing a cheque or using other payment means, especially as fees are often waived for these transfers. Online service also provides the #exibility for the customer to make these payments and transfers anytime and anywhere in the world.

Currency Exchange – Currency exchange allows customers to exchange currency as an added service to the core account relationship or a convenient and secure means for non-bank customers (tourists and others) to exchange currency on the spot. This may include the ability to open foreign-currency accounts and exchange funds internally (or between accounts). With the global economy becoming more connected, customers of retail banks are increasingly travelling between countries. This has led to increased demand from customers to have access to multiple currencies from their bank.

Since banks exchange currencies, they maintain a ‘spread’ between their buying price and selling price. This spread is income for the bank that may be complemented by a fee charged to the customer for this transaction. In order to maximise the revenue opportunity, banks tend to charge higher fees from non-customers. This not only results in better earnings but is sometimes a reason for non-customers to initiate a relationship with the bank. Currency-exchange services provide an additional convenience for existing bank customers and can reinforce the core relationship when o"ered e"ectively to the ‘right’ customers.

Cards – Banks may provide ATM cards or debit cards to their customer as instruments for accessing accounts and making payments. Cards are typically tied to a current account, savings account or loan overdraft facility. This is the most used service for retail banks, and trends show that the number of cards and their use is growing at an astronomical pace. Increasingly cards are serving as a substitute for cash in making payments in retail and other outlets, a phenomenon called plastic money.

ATM cards provide access to customer current or savings account via the bank’s ATM machines or those of other banks in the network. They allow customers to withdraw money and also to perform some other transactions, such as balance enquiries and transfers across accounts. Therefore the ATM access to the account is restricted by the number of ATMs installed by the bank. ATM cards do not allow the customer to make payments at retail or other outlets.

Increasingly, retail banks are o"ering debit cards to their customers. This service enables customers to make payments at retail outlets across the globe. A vast majority of debit cards are


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issued by the banks using the Visa or MasterCard networks. These networks provide connectivity via debit cards to ATMs and retailers on the network. Thus debit cards are much like credit cards, but are backed by the customer’s current or savings account balance instead of an unsecured loan in the case of a credit card.

Cards play an important role in reinforcing the customer relationship as an access and payment means, and they ensure usage of the account. There have been extensive studies that show the positive correlation between card use and loyalty of customers. This service also provides insights into customer-purchase behaviour and thereby information to customise relevant o"ers and promotions. For example, customer patterns showing purchases at fashion clothing shops can prompt the bank to provide o"ers to these customers for more clothes, thereby increasing customer loyalty.

Some banks may charge fees for cards such as annual fees or withdrawal fees but this trend is reducing due to the importance of cards in building customer loyalty and retention. Banks also receive ‘interchange-fee’ revenue when customers use their debit/credit cards for making payments through payment systems, while they incur costs when the customer uses ATMs.

Customers enjoy the security of a substitute for carrying cash when making payments and travelling. This eliminates the need for costly traveller’s cheques as international banking becomes more advanced. They also allow the customer to track expenses and manage cash in one statement. However, there may be fees for withdrawals from other bank ATMs, depending on the country and bank.

Prepaid cards are yet another kind of card service being o"ered by banks. These are cards that are preloaded with a certain !nancial value and can be used at ATMs or retail outlets. These cards provide the customer with added security because if mislaid or stolen, the maximum loss is the extent of the value on the card. Customers use prepaid cards for travelling or to provide children with money in lieu of cash.

New Developments In Payments

Here are some recent initiatives by consumer banks to provide innovative payment opportunities for customers.

(i) Bank of Montreal (BMO) and Monitise announced they have entered into an alliance to develop new mobile money services, using Monitise’s market-leading technology platform that encompasses mobile banking, payment and commerce services. The collaboration builds on an agreement formed in 2010 with Clairmail, the US-based mobile banking and payments provider acquired by Monitise in 2012.

As BMO’s technology provider for the mobile channel, Monitise will work with the bank across its smartphone applications, mobile web o!erings and SMS services, using its platform capabilities to provide added convenience for new and existing customers.

“With the size of the mobile money opportunity growing by the day, and the enhanced experience and convenience this channel provides to our customers, we plan to continue to build on our success in this area to date,” said Andrew Irvine, senior vice president, Bank of Montreal. (Source: La!erty Retail Cards and Payments Insights, January 2013)

(ii) M-Shwari, the Kenyan market’s new micro-loan product, recruited 645,000 savers in a span of three weeks from its launch.

(iii) Orange and China Mobile have come together with a memorandum of understanding, aiming to accelerate the use of NFC-based payments in the future. NFC is an acronym for near !eld communications and contactless communication.

(iv) Safaricom is to o"er mobile bank account services in an e"ort to improve its M-Pesa (pesa means money in Swahili) payment services that were !rst introduced in Kenya and are now


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o"ered in several developing countries such as South Africa and Tanzania and in India (in some markets it is known as M-Paisa).

Interesting Evidence on EasyPaisa in Pakistan

There is evidence of a close correlation between income level and demand for mobile payments in developing countries.

“Most of the EasyPaisa users (69 percent) are living on less than $3.75 per day.”

Source: State Bank of Pakistan on EasyPaisa, Branchless Banking News, Issue 1, July-September, 2011

b) Save for the future

Savings are de!ned as consumption postponed. This means that consumers will typically allocate the largest proportion of their disposable income to current consumption and the remaining amount is saved for future consumption. Savings usually take place in earnest at the middle of the individual’s life cycle – but we consider these issues in the context of the customer life cycle later in this chapter.

As a consequence, retail banks provide for deposit taking by customers by creating various types of savings products. Indeed, as stated in Retail Banking Overview, “The customer can make deposits through savings accounts that comprise money lent to the retail bank where the lender (i.e., depositor) earns a relatively low rate of return but obtains certain privileges, such as withdrawal when the depositor desires. In several countries, savings balances are insured up to a certain level by government agencies against a bank’s inability to meet its obligations to depositors.* Savings accounts also include time deposits,† which have a speci!ed time period (e.g., 60 days) and which typically pay a !xed interest rate. The funds cannot be withdrawn without penalty before the term of the deposit ends. Certi!cates of deposit (CDs) are examples of time deposits. CDs may be sold, prior to maturity, to other investors in an open market.”

c) Take out personal loan and mortgages

Consumers typically require personal loans to cover, for example, education expenses, travel costs, and purchases of household durables such as refrigerators. Accordingly, retail banks facilitate this demand by providing personal loans to suitably quali!ed loan applicants. This requires that banks underwrite loans by conducting credit-risk evaluation of the potential customer/borrower.

The customer may also require a mortgage that is backed by the real estate asset that the borrowed funds will purchase or a credit card to facilitate payments for frequent routine expenditures. In each of these cases, a detailed review of the applicant’s !nancial health is conducted and a determination made of the amount, term and conditions of the loan.

Secured Loans are loans backed by some form of security (i.e., collateral). For individual customers, such collateral can be a home, car or other asset. They may be used to !nance the actual collateral, as in the case of a mortgage !nancing a home, or a car loan !nancing a car, or they may be secured by an existing asset (such as bonds investments).

Secured loans are attractive for the bank because they are backed by collateral to cover the loan in the event of customer default. Interest is charged by the bank for the funds borrowed by the customer, which is payable over the term of the loan. Hence the repayment amounts of these loans are most often based on the principal, i.e., the initial amount borrowed and the interest charged by the bank.

* Deposit insurance is available for savings limit that varies across countries. For example, this limit is $100,000 across the EU.

† Time deposits are also known as ‘term deposits’ in some countries (e.g., Canada), a ‘!xed deposit’ in India and a bond in the UK.


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In order to follow prudent lending practices, the size of loan o"ered is dependent on the value of the asset taken as collateral and the customer’s creditworthiness. Creditworthiness is determined by the customer’s income, pro!le and track record in repaying loans. Most developed !nancial economies have credit bureaus that track the repayment history of individuals and may assign a credit rating. Banks participate in the information #ow between these credit bureaus, making it easier to make a decision before providing funds to the customer. In several emerging markets, such national credit bureaus do not exist and an assessment of the creditworthiness of the loan applicant is done on a case-by-case basis.

The bank earns interest income in addition to various fees to cover the costs of evaluating the underlying collateral and documenting it in the name of the bank. Additional fee income may be included for things such as drawing the funds down, repayments, early repayment, etc.

While the bank bene!ts from having collateral, we have seen in recent years the risks to the bank of valuing and holding certain concentrations of collateral for the life of the loan. With the collapse of the property market in many countries, banks were left holding large portfolios of real estate that could not be sold to cover the full value of the original loans, leading to many bank failures. Managing or selling these devalued assets can be costly for the bank. This is one reason why it is critical that a retail bank has a diverse asset portfolio that does not have a concentration of a single kind of collateral. This mitigates what is called concentration risk.

Customers bene!t from secured loans because they grant access to money to purchase assets, which the customer would not be able to buy if they were to use their own funds. Also, since these loans are backed by collateral, the interest rate for the customer is lower than if there were no collateral. Even though the secured loans allow for customers to pay over a period of time, customers may prefer to repay the loan as early as possible to reduce the interest cost. This would be the case of mortgages where individuals have the right to prepay a portion of the principal at certain intervals.

Unsecured Loans are loans without collateral that are supported only by the borrower’s creditworthiness. Generally, a borrower must have a high credit rating to receive an unsecured loan. Banks use credit bureau information (mentioned above) to assess customers, besides using other factors like the borrower’s income, assets and other personal factors and pro!le.

Since the interest rate charged to customers is always a re#ection of the risk taken by the bank, unsecured loans bear a higher interest rate for the customer. This is because of the lack of collateral in the case of default. Due to the higher interest charged, these loans provide signi!cantly higher interest income to the bank, assuming the borrower does not default. They also may include various sources of fee income, such as for late payments, penalty interest, processing fees, repayment fees, draw-down fees, etc. But robust underwriting of credit risk is required, and charging a high interest rate for an unsecured loan does not adequately deal with credit risk. The selection of customers is more important as demonstrated in Course Code 109, Credit Loss Management.

As part of prudent lending practice, banks may make provisions for loan losses in the form of reserves, which are put aside to cover future potential losses. They also invest heavily in credit-risk-evaluation processes and technology in providing these loans to the market. This is relevant for both secured and unsecured loans but takes a higher priority for unsecured loans, since they are more risky for the bank.

Term Loan – As the name suggests, this type of loan structure is for a !xed term. The customer borrows a sum of money (the principal) from the bank and contracts to pay it back over an agreed period. The repayment is normally in equal monthly instalments (EMIs) where each EMI is part principal and part interest. As the term of the loan continues, the outstanding principal diminishes to zero at the end of the loan period.

Banks generally o"er term loans to retail customers for the purchase of assets. These are often secured loans, e.g., home loans or car loans. The bank earns interest on the loan and may charge a processing fee or an early repayment fee. Since these are !xed-term loans, banks can forecast


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the term of all loans to match the term of balance sheet deposits. Customers take term loans to purchase assets that they would not be able to buy due to the high upfront value of the asset.

Revolving Credit Line – A revolving credit line is a line of credit at an agreed limit, which typically can be drawn at any time. These loans are more #exible than !xed-term loans, in that they can be repaid based on minimum monthly repayments, and the outstanding balance can be carried forward from month to month, as opposed to having to pay o" the loan in a !xed period. These lines may be secured or unsecured. For example, a credit card is an unsecured, revolving line of credit that uses the card itself as the main means for transacting. A home-equity line of credit is a common form of a secured revolving line of credit. It is usually accessed using cheques or by transferring money to a current account, and is backed by a property as collateral.

From the bank’s perspective, the pricing of these loans is based on the collateral availability, which is why unsecured revolving lines of credit have higher interest than secured. For example, credit cards have a high interest rate since these are unsecured revolving lines of credit. The bank receives both interest and fee income. However, the revenues and costs to the bank are harder to predict based on the #exibility of the drawing and repayment of the loans.

From the customer’s perspective, the revolving credit line is attractive in terms of #exibility. If the customer has low funds in a given month, they can pay the minimum amount due and still be in good standing. Interest is based on the extent of use of the credit facility and the number of days it is used. The costs of interest on large amounts over a long time can be excessive, especially in the case of (unsecured) credit card debt.

Overdraft – An overdraft is essentially a loan or credit line linked to a current account for use when the account is overdrawn. It reduces anxiety, allowing customers to automatically borrow from a bank account when there are insu%cient funds in the account.

Generally, owing to the nature of this service, customers use it for covering gaps in funding, and not as a regular source of funds. Overdrafts can also be secured or unsecured in nature, which determines the interest charged.

From a bank standpoint, the overdraft is an attractive product since it results in relatively high interest income for short periods charged by the day. Since use of overdrafts is often contingency-driven, a customer is willing to commit to a higher interest rate to cover emergencies. Banks often charge fees for using the overdraft.

From a customer standpoint, the overdraft allows them to continue spending and not worry about penalty fees for insu%cient funds on cheques, or having a payment rejected while shopping. On the other hand, the combined costs of daily interest charges as well as overdraft fees may outweigh the bene!t. If repaid promptly, the overdraft may still be less costly than a credit card.

In some countries, such as Germany, overdrafts on bank accounts have traditionally been more popular than credit cards as a means of short-term !nancing.

d) Make investments

Individual consumers may require wealth-management advice, and retail banks provide investment products such as stocks, bonds, mutual funds and ETFs (exchange traded funds) to meet customers’ needs. The main reason is that the bank’s advisory role may create a demand for such investment products in order to achieve the aspirational goals of the customer’s retirement plan.

Retail banks also provide wealth-management services for private banking clients. Some of the wealth-management services include savings, discretionary portfolio management, establishment of trusts, inheritance as well as tax planning.


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e) Support cash management activities

Cash management is a service o"ered by retail banks for its small and medium-sized enterprise (SME) customers that includes liquidity management, where banks optimally balance cash requirements with investment of excess cash reserves. One popular method for conducting liquidity management is via a sweep account. A sweep account links a commercial current account to an investment account, which comprises money-market investments. In simple terms, excess cash (i.e., above a pre-determined target level) is automatically invested. The investment account is partially cashed-in when the company’s cash position falls below the target level.

f ) Provide third-party accounts

In order to provide additional !nancial services to their customers, banks also o"er products in conjunction with third parties, such as insurance companies, investment managers, advisory services, appraisers and others. Banks take on the role of distributors or advisors, and carry these products in their suite of o"erings.

O"ering these products to their customers allows banks to provide more investment options to customers without having to ‘manufacture’ these products. Banks may o"er life insurance from ABC Insurance Company, for example, without having an insurance company of its own. Banks earn commission/fee income from the third party for o"ering these products to the bank customers. They may also charge a fee for advising the customer on investment choices and recommendations.

Banks have to be extremely selective in o"ering third-party products because they may face reputational risk if the product is unsuitable or an inferior investment option. Careful selection of providers and their products is vital.

Customers have the bene!t of other products without needing to associate with multiple service providers. The customer also bene!ts from third-party products in terms of pricing because banks are often able to seek deeper discounts from providers.

Third-party products are often o"ered to customers by customer sales representatives (CSRs) who view the customer relationship holistically. After understanding all the needs of the customers, CSRs may o"er these products.

The Link to the Customer’s Family Life Cycle*

It is clear that as consumers move along their respective life cycles, their demand for bank products to meet their changing needs will also change. Indeed, demographic trends shape customer needs and attitudes and so banking products o"ered must adapt in order to match customers’ needs.

The traditional life cycle theory of savings states that the typical consumer borrows in the early stages of his/her life, saves in the middle age and then dis-saves (i.e., winds down savings) in the last stage of life. See, for example, Hogarth† (1991). This theory was !rst proposed by Franco Modigliani (Nobel Prize winner for economics) and basically states that people accumulate wealth in their early years for consumption in their later years. There is no consideration of wealth transfer to the next generation.

The life cycle theory was seen to be restrictive and lacking real life validity.

* This is di"erent from the ‘customer life cycle’ that we consider in the module titled Relationship Management. This is the case where the customer evolves over !ve distinct steps: reach, acquisition, conversion, retention, and loyalty. It is similar to the customer continuum model from prospect, customer, client and, !nally, promoter.

† J. M. Hogarth, “Asset management and retired households: savers, dis-savers and alternators”, Financial Counseling and Planning, 2, 93-122 (1991).


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Open Question #3

Why do you think that the life cycle theory of savings lacks real-life relevance?

Out of the weakness of this model, the family life cycle model, which looks at a wide range of family !nancial characteristics and expenditure patterns, found favour.

The family life cycle creates a demographic segmentation that tracks a typical family over time. This is summarised below:

Wealth

Accumulate Consolidate Retire/Transfer

Single Married Married with children

Approaching retirement

Retirement

103.2: Family life cycle demographic segmentation

First Stage – Wealth Accumulation

From the early stages of life – as a single person to being married with children – the family starts to accumulate wealth through savings and investments. Some degree of risk-taking is incurred based on the family’s tolerance for risk. Accordingly, there will be a demand for products such as savings accounts and mutual funds. The next phase of marriage will continue with wealth accumulation but may also bring in a demand for a mortgage loan when the family has children. There may also be a requirement for specialised savings and tax-deferred products to facilitate education planning. Throughout this period, there will be a demand for payment products such as current accounts and credit cards.

Second Stage – Wealth Consolidation

In this stage, the family is approaching retirement and with increasing age, the family’s tolerance for risk taking declines. Portfolio and retirement planning advice is the main focus. Some experts contend that a degree of retirement planning began in the !rst stage since real assets such as the family’s house are part of retirement planning consideration. Of course, the demand for payment services and credit cards continues.

Third Stage – Retirement/Transfer

The third stage is retirement and the family needs change to estate planning, such as the creation of wills and trusts for wealth transfer to heirs and others. The family’s investment portfolio will likely change to a higher proportion of cash and so there will be increased demand for savings


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products, annuities and money market mutual funds.

Open Question #4

Consider an SME and create a graph of a life cycle for this !rm. Provide explanations.

In the early stages of the life of this !rm, what type of banking products would be most in demand?

As the company becomes !nancially successful, what type of banking services would be most in demand?


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