Revolutinary Thinking in Retail Banking

Doug Morris, Owner, Morris Glass and Director, The Empire Club of Canada; Raymond Dang, Grade 12 Student, Riverdale Collegiate Institute; Rev. Canon Kimberley Beard, Senior Pastor, St. Paul's On-the-Hill Anglican Church and Director, The Empire Club of Canada; Lucy Vanderwal, President, H&M Canada; Donald Johnson, Consultant, BMO Nesbitt Burns; Dan Cornacchia, Partner, Ernst & Young; Kamal Hassan, Director, The South Asia Group Ltd. and Director, The Empire Club of Canada; Ron Knox, President, Joseph Taylor Inc.; Eileen Mercier, President, Finvoy Management Inc.; and Roselind Lehman, COO, SAP Canada Inc.

Introduction by Bart Mindszenthy

Ladies and gentlemen, welcome to the second in our Banker's Speak series sponsored by SAP Canada.

And since clearly you're interested in banking and bankers, you no doubt saw the recent Globe and Mail article on bank performance. It stated that Canadian banks delivered better stock market performance over the past five years than their counterparts in any other country.

The Canadian domestic banking sector posted an average total shareholder return of more than 23 per cent between 2000 and 2004, compared to second place Australia at a bit more than 18 per cent, and American banks with a combined return of around 9 per cent.

Canada's retail banking is a success story. It has a solid base of customers, a lot of whom embrace technology. In fact, it's the penetration of electronic banking that provides great efficiency ratios. But we're going to hear today why we shouldn't be lulled into complacency based on returns alone.

And we're going to hear it from a man who managed to redefine the concept of banking to hundreds of thousands of Canadians.

When it went looking for a leader to start a new bank in Canada in 1996 based on the novel concept of a telephone bank with no branch offices, ING knew it needed someone with a mixture of proven chief executive and maverick self-starter. And Arkadi Kuhlmann fitted the bill.

Then he was able to replicate his success as President and CEO of ING Direct Canada in the U.S. market, where he launched ING DIRECT in 2000. Again offering simple savings products over the phone and on the Internet directly to consumers, he has built what is today the fourth-largest savings bank in America.

Given his impressive track record, clearly Mr. Kuhlmann can speak with authority about banking without borders, and how we can embrace innovation, technology and regulation to build upon our current in-country success to take a more prominent position on the world stage of banking.

Before leading ING DIRECT in North America, he worked for what were then more traditional financial institutions. However, it was his role as a turnaround artist in those organizations that showcased his ability and foreshadowed his future career. At the Royal Bank, for example, he pioneered electronic banking in the 1980s. At North American Trust, he created a tactical business plan that moved the organization from a $10-million operating loss to a $17-million profit in only two years.

No stranger to the Canadian financial services sector, Mr. Kuhlmann holds several board positions here, including Chairman of the Board of ING Bank Canada, Chairman of the Board of the Richard Ivey School of Business and Chairman of the Board of Foster Parents Plan International.

Ladies and gentlemen, please welcome to the podium of the Empire Club of Canada the Chairman, President and CEO of ING Direct USA, Arkadi Kuhlmann.

Arkadi Kuhlmann

Canadian banks have been and continue to be good for widows and orphans, offering good stock and dividend returns. While shareholders are benefiting, consumers are getting left behind. Canadian banks are slipping in global rankings. If you look at the most recent Financial Times worldwide ranking of banks and insurance companies by market cap, the first Canadian bank entrant is Royal Bank of Canada at number 37. Although this lack of global recognition can be found in many Canadian industries, it is very disappointing in the financial services sector.

But I believe we can, and indeed must do better, or risk the very real danger of "shrinking to greatness."

Today I'd like to talk about consumer trends and technological innovations that are driving change in the banking industry. I also will touch on the regulatory framework that is constraining growth and innovation.

The retail banking landscape has changed at a rapid pace in the last few decades. Customers are now embracing technology that saves them time and money. This paradigm shift has been driven by empowered consumers who are redefining the idea of "customer loyalty" and are more mobile and flexible than ever before. The "do it yourself" mentality is taking hold and sparking successes with companies such as Home Depot, IKEA and Southwest Airlines. This trend will also have a major impact on retail banking in the coming years in the U.S. and Canada.

Customers want to embrace change. Keeping up with the customer is important for banks because they are voting more and more with their feet on their way out of the branch. While retail banks continue to rely on cross-selling, it really hasn't delivered the expected impact on business results. The value proposition must be better if it is to work, but in most cases the opposite is true. Even innovative marketing concepts such as reward points to improve loyalty are quickly losing their impact.

Empowered consumers are looking for choice. The Internet makes it faster and easier to get product information. Now all you have to do is "Google" it. It's very simple for consumers to comparison shop, and even buy, online. In electronic banking, a decision can be made with a mouse click. This, of course, creates an entirely new set of challenges for more traditional ways to service customers.

The new consumer is forcing most of the value into the products and less into the relationship, which is the opposite of where banks have been focusing their efforts. Customers, however, won't pay for advice for even simple products anymore. In the United States, for example, branch visits, which had a high of 4.4 visits a month per customer in 1995, dwindled to just 2.5 visits in 2003. Yet there are already 80,000 bank branches in the U.S., with 2,000 more being added this year alone. Opening bank branches to gain new customers is a zero sum game. The trend for branch opening in Canada is more muted, with close to 8,000 bank branches primarily holding steady.

In Canada, the market is ripe for further shifts in banking. Canada has a customer base of early adopters and good penetration of electronic banking. Nearly eight in 10 Canadians used their bank's Web site in 2004, with 79 per cent of all customers using online bill payment--the second most popular use of the online channel. This adoption is far outpacing the U.S., where in 2003 just 37 per cent of Americans were banking online and 26 per cent were using online bill pay. In Canada that same year, 53 per cent of Canadians were banking online and 45 per cent were taking advantage of online bill pay. Canadian customers' affinity for embracing technology presents a tremendous opportunity for Canadian banks.

A bank's business should include basic, commodity-like services, as well as a few innovative offerings with reduced fee structures. How can this be done? When applying technology to enhance productivity and redefine products, it's the electronic interaction with the customer that yields the largest gains. The question needs to be asked, which part of the business is being served? Think of Finland and Japan, two countries where consumers and banks embrace technology. While Canadians embrace inexpensive new online options, they are paying high banking fees--an average of C$150, as compared to $102 in the U.K., $84 in China, and a mere $54 in the Netherlands.

I believe customers will not accept this fee structure without better service. Empowered consumers compare competitive offerings and give their business to continuous innovators. To realize these opportunities, strategy, enabling technology, and back office operations must be compatible with the consumer mindset. For example, transparency of products--how they work or their real value--is a complete mystery to most consumers. Today, consumers increasingly want to know what they are buying, compare value, and have confidence in their choice.

Canadian banks are missing the opportunity presented by these consumer trends and adaptable technology. But to be fair, they also face regulatory challenges.

Certainly, I am a strong proponent of any legislation that pursues the objective of safeguarding the stability of the industry. More often than not, however, the spirit of the legislation gets lost and unintended consequences do appear. Sarbanes-Oxley in the U.S. is an example of legislation that was triggered by weak players who did not perform well. It was then thrust upon all businesses, thereby penalizing all players. Canada is sure to follow. Regulation can be a barrier to entry for smaller players and a disincentive for innovators when it means additional costs and complexity of doing business.

There are many examples of prosperous industries and companies that operate virtually unencumbered by regulatory constraints. It is these efficient structures that allow for capital to be matched to ideas, for breakthrough technology to be rewarded, and for savings to be channelled to the strongest results.

The IT industry in the U.S. is a good example. Unimpeded by regulatory roadblocks, it has endured the full force of transformational changes brought upon by innovation and new business models. Free market forces or efficient markets have shaped the IT industry, and have forced industry players to compete on the basis of constant innovation.

Who would have imagined the emergence of Dell as the leading vendor of personal computers when Michael Dell started the company in his dorm more than 20 years ago? Dell is now a dominant force in the PC segment, and is slowly taking its no-inventory and just-in-time manufacturing to other industries.

Another more recent example, just eight years old, is ING DIRECT, which has thrived despite regulatory adversities, while improving upon technology to have a positive impact on consumers and a transformational one on the industry. ING DIRECT has re-energized simple financial products to provide real value to customers. To date, accountholders at ING DIRECT in the U.S. have earned more than $1.4 billion in interest, which is $750 million more than they would have earned in traditional money-market accounts.

In 1997, ING DIRECT Canada launched operations and began offering Canadians choice and a clear value proposition. To date, we have paid out C$1.2 billion in interest to Canadian customers. By the end of 2004, ING DIRECT globally had raised C$240 billion in deposits (160 billion euro). During the same time, Canada's largest bank, Royal Bank of Canada, managed to grow its retail deposit base by $27 billion. This 11:1 ratio is a strong testament to the potential of growth possibility unleashed by customers and realized by a new entrant.

The ING DIRECT model has exploited technology to provide a better customer experience that is not only more secure, but also protects customers' privacy while driving down operating expenses. In the U.S., ING DIRECT operates at one-third the cost and produces one-half the revenue of a traditional retail bank, yet still yields returns that meet shareholders' expectations. A return on equity of 11 per cent, return of assets at 1 per cent, and an efficiency ratio at 38 per cent compare very favourably to industry standards for a four-year-old bank. The ING DIRECT model could have been done by a Canadian bank.

However, Canada's environment of regulation doesn't support the kind of innovation typified by ING DIRECT. In this environment, traditional players post very strong returns and have a stranglehold on the national market. The average ROE for the top-five Canadian banks is 17.39 per cent, and 88 per cent of all Canadian bank assets are held by the top-five banks. Leveraging this protected and dominant position, banks generate a major share of their total earnings by aggressively cross-selling into a captive retail market.

New entrants are either dissuaded from entry or eventually forced out of the domestic market. Safety and soundness are often used as a blunt instrument when looking at new ideas. Whose job is it to find the diamonds in the sand? We only need to look at how many new, successful retail banks have survived and prospered in the last 50 years in Canada.

Now you may ask, "What's the problem, if Canadian banks are extremely profitable?"

The problem is that over time, regulatory restraint erodes a bank's ability to compete against new players. A marketplace that is protected and profitable has no incentive to hone competencies for venturing onto the global stage. A cumbersome regulatory framework creates a market that is characterized by slow adoption of available technologies, higher fees and service charges, and domination by a few players. The result? We see little growth. So the real question is, "How sustainable is profitability on a global scale without growth and innovation?"

The real danger inherent in a highly regulated environment is the phenomenon known as "shrinking to greatness." Yes, we have profitable players, but our large Canadian banks are faced with a decreasing global marketshare. For example, the top-five banks were able to grow their total asset base by just 7 per cent over the past three years. This compares to 46 per cent for their U.S. counterparts. Investors reward profitability, but they also seek companies that offer continuous and strong growth prospects. The total assets of the U.S. peer group exceed those of the top Canadian banks by a ratio of approximately 4:1, while their market capitalization has swelled to a multiple of more than 6.5.

Capital markets are predicated on the notion of mating capital with ideas to drive change. The investment community considers the quality of a bank's earnings by looking at both profit and growth potential. For example, Canadians have lived with restrictions in their investment choices for RSPs. We applaud the recent budget proposal to eliminate the foreign investment cap to allow Canadian consumers to vote with their dollars on both the future growth and profit potential of any company, thereby opening up the competition for capital. In the end, this will put positive pressure on the Canadian banks.

In a highly regulated environment, new entrants and strong performers are punished by regulations made necessary by the behaviour of a few weak players. The same is also true in related fields, such as technology, where innovative new companies can't realize their potential marketshare. Consequently, Canada has been unable to widely develop a growth environment for banking and information technology.

It is my firm belief that over time the tide of globalization will roll over restrictive regulation, and will expose many deficiencies in light of international competition. It will take the concerted effort of all constituent groups--regulators, traditional banks, and new entrants--to prevent erosion of free market forces.

What part can regulators play in ensuring that Canada's banking industry remains globally competitive? Regulators must be prepared to be flexible, to allow banks to adopt innovative business models and accommodate competition.

Regulators also need to modify their focus on track records, which can be tough for new entrants. I believe there are ways of substituting measures of soundness--as determined by internal controls and operational excellence--for track records, especially when they are backed by additional capital and the strong support of an international or institutional shareholder. Non-traditional banks are often part of a larger global financial network.

It's also important that regulators take into consideration the relative credit risks of traditional banks with diversified asset portfolios, compared to those like ING DIRECT with more restricted asset portfolios. Although the direct banking model involves a smaller number of asset classes, it also involves lower risks within those classes. Asking new entrants to look like existing ones is like asking an automobile to look like a horse and wagon.

We must continue to move toward co-ordination and synchronization of regulations across international borders, as with Sarbanes-Oxley on governance and Basel II on regulation. At the same time, we need to make sure that the consequences for all parties--shareholders, consumers, peripheral industries--are taken into account before international regulation is implemented. Rather than waiting for complete overhauls in the overall regulatory system, we need to move faster with simple revisions to continue to foster innovation, growth, and improve competitiveness. Free competition should be facilitated at any cost, as long as the viability and soundness of the industry are not threatened.

While global regulatory co-ordination might be beneficial, it's not clear whether regulation such as SOX and the Basel II capital adequacy standards will end up being entirely positive. For Canadian banks, Basel II could help by providing a meaningful reduction in capital requirements. On the other hand, Basel II may impose stricter capital requirements for banks engaged in riskier lending practices. It looks like the risk on balance is worth the cost on Basel II.

The Bank Act in Canada must be simplified. While a number of reforms have been incorporated, the Bank Act has steadily grown from 316 sections in 1984 to 991 sections as a result of changes in 2001. Similarly, the approvals required for new foreign bank entry into Canada are unduly complicated and need further streamlining. The act should allow for mergers between major Canadian banks or for the foreign takeover of a Canadian bank, to encourage more competition. It could be expanded to allow banks to offer all financial products. We should also lift the restriction on retail deposit-taking by foreign bank branches. As we think about regulation, the question we must constantly ask is, why not move ahead?

Furthermore, Canadian regulators can help Canadian banks be more innovative by increasing their capabilities in assessing risk, thus helping to reduce structural costs that banks can pass on to consumers. Corporate capital tax remains the most damaging form of taxation as it penalizes corporations that are growing by taxing the capital they hold, thus inhibiting capital growth and investment.

And let's not forget regulation that protects the consumer. With the increase in electronic commerce, we must have legislation around issues such as identity theft. During the one-year period from 2002 to 2003, total losses to individuals and businesses related to identity theft in the United States were estimated at approximately US$53 billion. In Canada, the losses for 2002 were estimated at approximately C$2.5 billion. While the PhoneBusters National Call Centre for reporting and helping identity theft victims in Canada is a welcome step, we need robust legislative framework to deter this crime. Since 1998, the U.S. federal government and nearly all states have adopted a number of measures to address identity theft. In Canada, there is no generalized offence called identity theft. I would urge a federal mandate to combat this serious crime that hurts consumers and destroys confidence in electronic commerce.

I would also urge a speedy review of the 2001 legislated Personal Information Protection and Electronic Documents Act (PIPEDA). We must harmonize the currently disparate exemptions for collection, use and disclosure of personal information without consent, and eliminate any ambiguity for banks and businesses.

We need to streamline Canada's various regulatory bodies and eliminate overlap, duplication, and inconsistency. I encourage the creation of a national regulator. The recent efforts to streamline CDIC and OSFI regulations and operations are a welcome start, but more needs to be done. I also support the CDIC lowering its risk premiums and increasing the limit on protection of savings. Yet if these productivity gains are to go to consumers, we need to increase competition.

Canadians are no strangers to successful innovation. Remember the "CanadArm" and the "Avro Arrow"? A more modern example is Cirque du Soleil. We certainly should be able to replicate this thinking in retail banking. As we have seen many times before in the U.S., Canadians buying their way into a new market will generally not ensure long-term success: rethinking and reshaping the business will.

The time has come for some revolutionary, not evolutionary thinking in retail banking. We cannot stop the winds of change. We must embrace consumer trends. We must adopt technology that improves the customer experience. We must deliver services that align with what customers want, and those they are willing to pay for. We must adopt a more flexible and open regulatory environment. When we do that, we will be able to hone the core competencies we need to meet free market forces and win on the global stage.

And let's open the door to new entrants, too. Let them take risks, be visionary and bold. Competition will only sharpen Canadian banks and increase choices for consumers. I look forward to seeing the next innovative model launch, like ING DIRECT, in Canada. Thank you.

The appreciation of the meeting was expressed by Kamal Hassan, Director, The South Asia Group Ltd. and Director, The Empire Club of Canada.