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RETAIL BANKING II

RETAIL BANKINGACADEMY

202.Product Portfolio Management

Course Code 202 - Product Portfolio Management

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Course Code 202Product Portfolio Management

Introduction

A full discussion of product portfolio management begins with the identification of the issues involved in product development and innovation. Research has shown that these issues involve assessment of consumer demand through effective customer segmentation; the understanding of customers’ perceived cost of switching banks even if there is a better offer from another bank; and the effect on consumer decision-making when they are faced with too many product choices. These are all worthy of detailed analysis prior to executing effective product portfolio management (hereafter, PPM).

As is emphasised throughout the RBA programme, the Kaminsky philosophy for retail banking is based on the simple concept that bank decision-makers must first look at customers’ long-term objectives and then develop appropriate products and services. Successful product innovation is customer-focused, where the approach is to first always look at banking from the customer perspective and then create products/services. There is nothing revolutionary about this approach. Indeed, it is based on the fundamental economic principle that customer demand creates supply*.

To assess the strength of customer demand, the retail bank must consider at least two factors: firstly, the idea that demand for bank products varies by customer segment†, and secondly, customers’ willingness to switch from their current bank, even in the presence of a more innovative competitive offer, is dependent on factors embodied in the 4C marketing mix and the overall ‘value for money’ (VFM). Customers may be willing to switch for a better bank offer but there can be overwhelming hurdles in their way. These are called switching costs and they may cause customers to forego a better perceived VFM offer from another bank. Indeed, a study‡ finds that to move a loan from one bank to another can lead to fees of about one-third of the loan’s annual interest rate. High switching costs, whether in the form of fees or in terms of personal inconvenience as perceived by the customer, lead to a high degree of customer inertia. This is

* Some economists and other experts have sometimes appealed to Say’s Law (named after the famous classical economist Jean-Baptiste Say), which is sometimes stated as follows: supply creates demand. This is actually a misinterpretation of Say’s Law. Indeed, if it were true that supply creates its own demand, then companies and even individuals have a recipe to be eternally profitable and wealthy. Just create supply and consumers will buy! Markets will not fail. Clearly, this is not a reflection of reality.† We consider the relationship between customer demand and customer life cycle later in this module.‡ Moshe Kim, Doron Klinger and Bent Vale, “Estimating switching costs and oligopolistic behaviour”, Working Paper, Wharton, (2000).


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especially true in retail banking – a high volume business with a high proportion of customers with small balances.

This leads to an interesting question for discussion:

Open Question #1

“Because of high switching costs, banks may keep their prices uncompetitive and not lose customers.”

Do you agree?

Apart from being customer-focused in product development, banks must also understand the value of ‘simplicity of product features’. Banks must become more customer-focused rather than simply being ‘product engineers’. There are several important implications for a bank’s profitability when it is product-focused. In fact, being product-focused may lead to a proliferation of marginally differentiated and unprofitable products. These are listed below and will be fully developed and explained in this module.

Let us look at some behavioural issues involved in consumer decision-making in relation to purchasing bank products. First, a proliferation of banking products that are marginally differentiated will likely lead to a consumer being anxious and concerned about making the correct choice. In this regard, there are at least two issues to consider.

a) First there is evidence that consumers, when faced with too many choices, are often confused and confounded. They often take no decision or may end up making a choice that often leads to regret. In a Los Angeles Times article (March 16, 2009), the headline draws a conclusion: “Too many choices can tax the brain” and the article states that “in fact, some studies show that having to make too many decisions can leave people tired, mentally drained and more dissatisfied with their purchases. It also leads people to make poorer choices — sometimes at a time when the choice really matters”.

Worse still, if too many choices create high perceived uncertainty on the part of consumers, there is a good chance that they will delay their decision unnecessarily. In other words, too many slightly differentiated choices create unnecessary complexity and consumers become confused.

The conclusion: to avoid regret, the consumer postpones the decision.

In addition, Barry Schwartz* argues that there is a direct relationship between the number of choices a consumer faces and the level of anxiety that arises in making a single choice. It does not mean that consumers are better off with a single choice. It means that a proliferation of choices leads to consumer confusion.

The lesson: more is less.

An immediate question relates to whether banks do indeed carry a myriad of slightly differentiated products in their respective portfolios. In other words, is there evidence of product redundancy in the retail banking space?

Let us look at the deposit product space.

Moneyfacts.co.uk reported in June 2011 that the number of savings accounts with a wide range of options in the UK – personal, business and offshore – has increased almost 12 times, from 203 in 1988 to 2,385 as of the reporting date. The annualised increase in the number of savings products over the last five years (ending June 2011) was over 16 percent.

* Barry Schwartz, The Paradox of Choice, HarperCollins (2003).


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An analogous situation exists with retail savings products in the UK. The basic categories of savings products are:

Cash ISAs (Individual Savings Accounts);Instant Access Savings Accounts;Notice Savings Accounts;Regular Savings Accounts; andFixed Rate Bonds.

Within each category of savings accounts, there are many variations. For example, in the category of Instant Access Savings Accounts, Barclays Bank offers Every Day Saver, Monthly Savings, e-Savings and e-Savings Reward.

b) Second, a bank that has an unnecessarily large product portfolio will likely face the stifling cost of complexity. Bank staff will be required to fully understand the product features of a large portfolio, which can increase the chance of a mismatch between bank products and customer needs. In addition, it is likely that IT support for products and processes will be less effective in the case of many products. The bank’s IT network and systems will become more complex and fully utilised. Academic research has shown that a high degree of people and process utilisation leads to a higher likelihood of people mistakes and systems breakdown. Finally, effective data warehousing becomes more challenging since a more robust data collection procedure is required. This problem is exacerbated if channels are not integrated and hence data sources at various customer points of contact become dispersed into data silos.

This discussion shows that two important principles must be emphasised.

Firstly, product development follows customer needs. Simply put, identification of customers’ needs comes first.

Secondly, product simplicity (in number and features) helps the customer to make a decision whether or not to purchase a bank’s offer. It also enables better IT support.

Open Question #2

“Not all bank products are simple from a consumer perspective. Helping customers understand the complexity of some products can lead to a positive customer experience.”

Do you agree?

Product portfolio management leaders are at the core of cross-functional product teams that include members from all parts of the organisation – marketing and sales, risk management, HR, treasury and finance and operations. Product portfolio managers are responsible for building the right product for the right target market segment and for monitoring the performance of the product on an ongoing basis over the various stages of its life cycle.

Based on this observation, the remainder of this module is organised as follows. Chapter 1 discusses the traditional product life cycle (PLC), which is modified for banking products. The PLC facilitates a periodic evaluation of the bank’s current product portfolio so as to identify products that are potential value-destroyers. Chapter 2 shows how to enhance bank products using appropriate marketing mix strategies and thereby extend the growth stage and delay the maturity and decline stages of their respective product life cycles. Finally, we show how to create a business case for the development of new products in alignment with the bank’s strategy. This module concludes with a summary and multiple choice questions.


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Chapter 1: Identifying Value-Destroyers in the Bank Product Portfolio

In order to identify value-destroyers in a bank’s product portfolio, it is useful to review the traditional product life cycle (PLC) model, which proposes a theoretical evolution of sales over time. Specifically, it is based on a ‘shape assumption’ that specifies the evolution of sales over time is ‘S-shaped’. This assumption implies that sales increase at an increasing rate, reaching a peak level at the maturity stage, and then decline. There is also the ‘stages assumption’, which states that there are four* stages: introduction, growth, maturity and decline. At the same time, profits are negative at the stage of introduction, reaching a maximum level in the maturity stage and decline afterwards. A graph of the PLC model is presented below. Note that after a point (called the point of inflection) on the graph in the growth stage, the rate of growth of sales slows down until it reaches zero growth in the maturity stage.

Unfortunately, by itself the PLC has important limitations.† There is evidence that the S-shaped assumption may not be appropriate. This uncertainty implies that identifying each stage in a prospective PLC becomes difficult. Furthermore, even if one assumes an S-shaped graph, the PLC does not offer guidance on how long a product remains in each stage and on the timing of the product transition into the next stage.

* We omit the planning and development stage of the model. This is because the PLC is for a new or existing product.† These limitations have been recognised many years ago by Dhalla and Yuspeh in their paper, “Forget the Product Life Cycle Concept”, Harvard Business Review (1976).


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202.1 Graph of a Traditional Product Life Cycle

The PLC model was originally developed for tangible products produced by non-financial corporations. Note that the PLC, which is an evolution of sales and profit over time, is a source of market risk for the company.

Does the PLC apply for bank products and services that are intangible and inseparable*?

There is considerable evidence that bank products also have a life cycle reflecting the four stages of sales evolution. But there is one important difference between the PLC for bank products and other types of products and services in non-bank retail industries. Since bank products match customer needs, it is inferred that the time a product spends in any of the four stages is directly related to customers’ life cycles (CLC). In other words, there is a direct correlation between the PLC and CLC.

We explain this correlation in more detail.

The Customer’s Objective and CLC†

In line with the Kaminsky vision of retail banking , bank staff must optimise the customer’s lifetime income by taking into account his/her life cycle needs. As the individual moves along his/her life cycle, there are substantial changes in demographics such as income, age, and marital status so that the optimisation problem is dynamic and must be reassessed periodically.

At any point in the life cycle, the bank professional must consider the remaining expected lifetime needs. It is myopic and therefore suboptimal to consider only the current life stage. Of course, each life stage creates different demand for financial products. Here is a diagram to illustrate this key point:

* The attributes of financial products and services are presented and discussed in Retail Banking I.† The Customer Life Cycle is presented in Retail Banking II and is summarised here to explain the correlation between PLC and CLC.


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202.2 Graph of the Family Life Cycle

This family life cycle graph shows that there are essentially three big stages of life. The first is the accumulation stage where, from being a single person to being married with children, the family begins to accumulate wealth through savings and investment funds. The tolerance for risk is highest in this stage. The bank professional must also take into consideration that in the near future the family may seek to purchase a house and hence would require a mortgage loan. In addition, the family’s needs may include education planning and life insurance.

Lesson

The customer has lifetime needs and the retail banking professional must anticipate and plan accordingly. Do not get bogged down in current customer needs only. Think of all future needs and plan now.

The second stage is where the family seeks to consolidate wealth and so there is less tolerance for risk and a preference for savings and investment products with guarantees. The objective is to preserve wealth and acquire more liquidity.

Finally, the third stage is when the family enters retirement and have estate planning needs. There is greater demand for wills, trusts and annuities and tolerance for risk is at its lowest level.

It is also important to note that the life cycle model shows that the customer has liquidity needs. For example, if the family experiences a shortfall in regular income to meet life cycle needs, then a loan or credit line may be required. If there is an excess of regular income over life cycle needs, then a deposit is made. In other words, the customer sells liquidity (i.e., make deposits) and buys liquidity (i.e., take loans).

What is the lesson here?

Product life cycle for financial products is correlated to customer life cycle, during which the customer buys and sells liquidity. Simply put, as customers travel along their respective life cycles, there is higher demand for some products and less demand for others. But less demand for a bank product does not necessarily signal to the product manager that the product is entering the decline stage. The reason is that there is a dynamic flow of customers across the CLC: as some customers leave one stage, others enter. While it is recognised that the PLC for financial products is correlated with CLC, which itself is subjected to demographic changes (e.g., extended retirement stage), the shape of the PLC is uncertain. The height and length of the four stages of the PLC are also ambiguous. For this reason, product portfolio managers must apply experience and expertise to identify potential value-destroyers and implement actions to mitigate this problem. Quantitative statistical techniques are likely unreliable.


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Identifying Potential Value-Destroyers

Banks have many products (savings and loan categories) and so product managers have to evaluate products on two dimensions – individually, for current and expected future financial feasibility, and also as part the bank’s product portfolio. For example, the product may be marginally profitable but it may be an essential part of a product solution demanded by customers and is profitable as a bundle. The product manager typically has three important roles. These are:

a) identify potential value-destroyers on both an individual product and portfolio basis to decide whether the product should exit the portfolio.

b) extend the growth stage and delay the maturity and decline stages of the PLC for individual products through innovation and marketing mix strategies.

c) create new products to fill a gap in the market that is identified by a SWOT analysis.

We now consider a) above, the process of simplifying the bank’s product portfolio by identifying products that are value-destroyers and deciding whether they should exit the portfolio.

Here is a Case for Radically Streamlining the Product Portfolio presenting by Dick Harryvan, ex-CEO of ING Direct.

“Now is the time for fewer products done well, not more products for all.”

The credit crisis has heavily damaged the image and trust placed in retail banks. In reaction, regulators passed more than 14,000 new rules and regulations during 2011, according to the Financial Times. The increased standards related to compliance, risk management, client orientation with due care and higher capital requirements put major pressures on the operations of retail banks, including increased overheads. Radically streamlining the product portfolio can be a major contributor to addressing these issues. It can greatly increase client orientation with reduced mis-selling, improved compliance and risk management, and can result in significantly higher profitability.

Retail banks typically have 200 to 300 products that they still actively market. If you ask how many products generate 80 percent of the revenues, it is usually less than 20 products. Having so many products can put real pressure on proper execution in operations and IT, resulting in increased expenses. For sales and service staff, such a large number of products cannot really be fully understood. This increases the risk for poor service and mis-selling to customers, which damages the image and can result in ever-increasing regulatory sanctions. At one banking institution, it was found that (actual) profit was actually 160 percent of reported profit. Fully 60 percent was eliminated through value destruction by subscale or poorly priced loss-making products.

So, radically streamlining the product portfolio can have a major impact on retail banking profit. This is all the more important as profit is the key source for meeting increased regulatory capital levels at the moment, because it is not an opportune time to raise capital via the equity markets. The increased overheads because of new regulations and compliance standards are likely to make the number of subscale products that are loss-making even greater than before. This further increases the opportunity to improve results by radically streamlining the product portfolio.

Analysing which products have been successful in reaching scale is the starting point for radically streamlining the product portfolio. This process also gives additional insight into customer preferences and into ways to improve the attractiveness of other products. All products contributing less than three percent of revenues should be critically reviewed from the point of view of both the customers and profitability. The aim is to eliminate those that are unprofitable. By having fewer products, an institution can focus more on increasing the revenue of the remaining products, thereby achieving economies of scale and boosting


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efficiency and profitability. Fewer products with more scale also create more economical opportunities to further automate processing, which in turn enhance operational efficiency and benefit customer service.

Being among the most efficient providers of retail banking will be paramount in the future to remain competitive, particularly in an environment that is becoming more and more automated and less personal. The increasing ability through the internet to compare bank offerings and the increased ease to switch, anonymously if desired, will make efficiency and competitiveness all the more important. However, being more efficient does not have to come at the expense of excellent service and the customer experience. Fewer and generally more automated products reduce mistakes, for which correction typically is 15 to 20 times more expensive than doing it right the first time. The sales and service staff’s greater knowledge of a lower number of remaining products will improve the customer service experience and reduce the risk of potentially expensive mis-selling. Importantly, staff engagement, critical to providing excellent service, can improve thanks to more focus and better product knowledge, enabling representatives to provide better service. In fact, less is more from a staff and customer point of view. Better customer experience leads to greater customer satisfaction, a better image and better customer retention, which greatly benefits bank profitability.

Overall, the average customer lapse rate at retail banks is approximately nine percent on an annual basis. But for example, at ING Direct, which excels in few products and excellent service, the lapse rate is only about five percent, or roughly half the industry average. In all of its markets, ING Direct customers rank it either first or second among all financial institutions based on the net promoter score. This clearly provides an indication of the improvement in the client lapse ratio with a simultaneous potential positive impact on customer appreciation. Just a one or two percent decrease in the annual customer lapse rate can have a major impact on results within a few years. Acquisition costs for new customers to replace those leaving can be reduced, while scale efficiency and profitability within a focused product portfolio will increase further.

In conclusion, streamlining the product portfolio can lead to major profitability improvements in the range of 30 to 50 percent. It leads to staff with greater knowledge of the fewer remaining products. This, together with higher staff engagement thanks to focus and better service, enables even further improvements in the customer service experience. Satisfied customers can reduce the customer lapse rate significantly. This all supports the desire to increase scale and operational efficiency per product – a critically important step in an increasingly impersonal internet age when offer comparison and switching becomes increasingly easy. At the same time, the increased demands related to compliance and risk management are also supported by streamlining the product portfolio. A critical review now of all products generating less than three percent of revenue, from a customer and a profitability point of view, is essential to the future of every retail bank.

Putting this recommendation into practice:

Step 1:Attribute a percentage of total revenues to each category of products. Decide on a cut-off point per product. Dick Harryvan’s three percent share of total revenues for each product is only one recommendation. Portfolio managers must decide their own cut-off point. If there is a product that falls below three percent total revenue share, then consideration should be given to removing the product from the portfolio.

Step 2:For products identified under Step 1 an analysis of profitability should be made with proper attribution of revenue and expense.

Provide an answer to the question: for lossmaking or marginally profitable products, are there feasible actions that can increase their respective share of portfolio revenue above three percent


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in a profitable manner?

Step 3:Establish if the products from Step 1 are really needed from a customer point of view.

Would elimination result in a major negative customer response or can other existing products address the need as well?

Step 4:Remove all the poorly performing products that cannot feasibly increase revenue share above three percent and for which negative customer reaction cannot be mitigated.

The above analysis creates criteria for product exit from the bank’s product portfolio.

Lesson

Streamlining the product portfolio can lead to major profitability improvements in the range of 30 to 50 percent. This is a priority for product managers. Do not add new products on a portfolio with redundant and/or value-destroying products.


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RETAIL BANKINGACADEMYCourse Code 202 - Product Portfolio Management

Chapter 2: Enhancing Existing Products and Developing New Products

In Chapter 1, we considered the decision process that a product portfolio manager may follow to identify products that are redundant or are value-destroyers.

We now consider two other strategies for effective product portfolio management. These are as follows:

a) Enhance existing products in the bank’s portfolio by applying the 4Cs marketing mix strategy; and

b) Identify a market opportunity (i.e., a gap in a market segment) and develop a new product.

We discuss each of these strategies in turn.

Enhance Existing Products in the Product Portfolio

Product managers can take actions to increase consumer demand for its existing products by application of one or more of the factors of the 4Cs marketing mix strategy for financial services*. A product manager enhances an existing product by creating incremental value-added attributes that arise by an application of one of (or a combination of ) the following: competitive pricing, channel convenience and accessibility, unique promotion and communication or product modification. In the next section of this chapter, we consider new product innovation where the emphasis will be on substantial (rather than incremental) product modifications that change the core risk structure of the existing product.

We present a graphical illustration of the effect of enhanced bank products on the PLC. Note that the PLC of the bank product before enhancement has shifted upwards reflecting the potential for an extension in the growth stage and a delay of the maturity and decline stages. This is the main benefit of creating value-added product attributes: extending the PLC of the product, which reduces the normal customer attrition rate that occurs in the decline stage.

* The 4Cs are defined as follows: Convenience, Customer value, Cost and Communication and are presented in the Marketing Module of Retail Banking I.

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202.3 Effect of 4C Marketing Mix on PLC

We present some examples where product managers in retail banks globally have enhanced bank products by one or more of the 4Cs of the marketing mix strategy.

Using Bank Apps for Customer Channel Convenience

The accelerated pace of digitalisation in banking has provided product managers with a unique opportunity to manage the PLC. The utilisation of banking apps* is currently a very popular way of achieving this objective. Specifically, banking apps add another dimension to the traditional product: customer convenience, one of the 4Cs of a marketing mix strategy for financial services. A recent statement by the president and CEO of ING Direct illustrates the role of bank apps in providing customer convenience and accessibility.

“Our Android App is a prime example of our promise to make saving money easier and simpler for all Canadians,” said Peter Aceto, president and CEO at ING DIRECT Canada. “When we launched in Canada nearly 14 years ago, we challenged the status quo of banking by offering Canadians a new way to save without brick and mortar branches. Our mobile banking suite, which now includes the Android App, enables Canadians to do their banking when they want and wherever they are, with ease.”

Lesson

By enhancing traditional bank products and services through the 4Cs of marketing mix strategy, banks create customer convenience and accessibility. This customer benefit becomes a switching cost for customers and reduces customer attrition rate. The effect is to delay the maturity and decline stages of the PLC.

Using Digitalisation for Competitive Pricing

We now show how digitalisation and bank apps can enhance the product via another factor of the 4Cs marketing mix strategy: cost to the customer. The long-run profitability of a bank is increased by a reduction in operating costs that arises from a migration of transactions to virtual channels and advisory services conducted in physical channels. The product manager can manage the PLC for its product portfolio by discounting its price without sacrificing its profit margin. This is illustrated for loan pricing as follows†:

* The American Dialect Society recently named the term “app” its “word of the year”. App is a shortened slang term for a computer, tablet or smart phone application.† This formula is presented in the Products module of Retail Banking I.


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Underlying Profit = (r – c) X – OPEX – PROV where X = loan amount,r = rate charged on the loan,c = cost of funds backing the loan,OPEX = operating expenses, andPROV = provision for loan loss.

From this equation, we see that if the product manager reduces the rate charged on the loan by an amount that is equal to the percentage change in operating expenses, then the underlying profit is unchanged. The product portfolio manager can manage the PLC of products by reducing the cost to the customer without sacrificing its target profit margin. The likely result is an extension of the growth stage and a delay of the maturity and decline stages.

Lesson

Digitalisation and banking apps provide an opportunity for the product portfolio manager to manage the PLC by extending the growth stage and delaying the maturity and decline stages. This is done through 2Cs of the 4Cs marketing mix model: Convenience of access and Cost to the customer.

Incremental Product Innovation

In October 2013 Santander Bank, a wholly-owned subsidiary of Banco Santander, introduced the first current account in the United States where the bank pays the customer for conducting regular banking transactions. Specifically, the bank pays the customer $10 for making direct deposits of $1,500 or more each month and another $10 for paying two bills using the bank’s online bill pay service. The direct deposit without the required bill payments will earn a bonus of $10. Monthly bonuses of either $10 or $20 are deposited in the customer’s ‘extra20‘ current account. “By listening closely to consumers, we were able to develop a product that helps customers meet their financial goals and savings needs,” said Alison Rourke, who as director of consumer banking at Santander led development of the product. “We’re excited to introduce a banking product that is competitive, innovative and will really stand out in the marketplace.” (Yahoo Finance, 28 October 2013)

We have presented examples showing how the product manager can positively affect a product’s PLC by introducing one or more of the 4Cs of marketing mix strategies for financial services. We now discuss the key issues in the bank’s new product approval process and the leadership role of the product manager in this regard.

New Product Approval (NPA) Process

What is a new banking product? The literature does not provide a consensus definition of a new banking product and, to add to the ambiguity, some experts have included enhanced banking products (as we have defined above) as part of their definition of new products. An example of a more general definition is provided by the Lloyds Group, which defines a new product as a new or amended product that introduces a significantly different risk profile at group or business level.

We separate enhanced or amended existing products from new ones. Accordingly, we define new products as those having two key characteristics. These are presented below with respective examples.

1) The product fills a primary need in the market in which the bank operates.

“Primary need” refers to a gap in the consumer market that is not a fad or transitory in nature. In addition, competitors have not addressed this consumer need as yet – so the need is unfilled. Furthermore, the market potential is sufficiently profitable for the bank to consider developing


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and launching a new product.

Here is an example of a gap in the consumer mortgage market in Singapore.

Market research by OCBC Bank of Singapore in 2011 showed that 59 percent of private property owners surveyed did not have mortgage insurance. This was found to be surprising, since with rising property prices property owners were taking on larger amounts of mortgage loans and credit risk for the bank can migrate to very high levels. In addition, evidence revealed that customers typically lacked knowledge of the insurance product and were reluctant to pay mortgage insurance premiums in addition to their regular mortgage loan payments. OCBC saw a market opportunity and introduced a new mortgage insurance product (OCBC Bank’s Mortgage Protector Advantage). This product allows the customer to pay annual mortgage insurance premiums but with a customer benefit: the premiums are fully refunded to the customer at the end of the policy if no claim is made.

Another characteristic of a new banking product is presented in 2) below:

2) An existing product that is substantially modified for a new or existing channel in a new or existing market segment.

Note that the key characteristic is ‘substantially’ modified so that the core risk structure of the traditional counterpart is quite different. Here is an example.

Hana Bank, the third-largest bank in South Korea, introduced a ‘One Click Mortgage’ at the beginning of 2011. It was the first fully straight through online mortgage product in the local market: this product can be fully processed in five steps, from e-application to e-closing by leveraging on the country’s online real-estate registration system that was introduced in 2007. Consequently, customers are able to get a final decision on their mortgage loan applications faster and more easily relative to manual processing. The bank also benefits from a reduction of product and process complexity with a concomitant reduction in operating costs.

Observe that the core operational risks from processing a mortgage loan application in a bank branch, accompanied by manual verification of customer information, are different for straight through processing.

Basel and New Product Approval Process

What is meant by “New Product Approval Process”?

It is interesting that the Banking Code drawn up by the Netherlands Bankers’ Association defined a new product approval process as the procedure “by which the bank decides whether a particular product will be produced or distributed at its own expense and risk or for the benefit of its clients. This process comprises extensive testing in relation to aspects of the duty of care and risk management”.

We discuss the two crucial issues in a new product approval process: risk management and duty of care.

The role of risk management is emphasised by the Basel Committee on Bank Supervision (BCBS) in the document titled Principles for Enhancing Corporate Governance (October 2010, Paragraph 88). This states that “banks should have approval processes for new products. These should include an assessment of the risks of new products, significant changes to existing products, the introduction of new lines of business and entry into new markets. The risk management function should provide input on risks as a part of such processes. This should include a full and frank assessment of risks under a variety of scenarios, as well as an assessment of potential shortcomings in the ability of the bank’s risk management and internal controls to effectively manage associated risks. In this regard, the bank’s new product approval process should take into account the extent to which the bank’s risk management, legal and regulatory compliance, information technology, business line, and internal control functions have adequate tools and


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the expertise necessary to manage related risks. If adequate risk management processes are not yet in place, a new product offering should be delayed until such time that systems and risk management are able to accommodate the relevant activity. There should also be a process to assess risk and performance relative to initial projections, and to adapt the risk management treatment accordingly, as the business matures”.

At least two other crucial issues arise from this paragraph.

First, the importance of risk management in the new product approval (NPA) process is underlined by BCBS: it is an absolute requirement to have all systems in place or else the new product offering should be delayed. The main point is that a bank’s risk exposure is increased when it enters new markets, develops new products or implements new process or IT systems.

Second, if a product is introduced in the market, monitoring of risk and product performance relative to initial forecasts is paramount. The reason is that risk can migrate to higher levels as the product life cycle (PLC) transitions from the introduction stage to the growth stage.

In retail banking, credit risk dominates other forms of credit (market and operational risks) and so it is typical for risk managers to invest more time and effort in identifying, measuring and mitigating this source of risk. However an often-neglected risk in the new product approval process is operational risk.

In part for this reason, Principle 7 in the BCBS document, Principles for the Sound Management of Operational Risk (June 2011) recommends that senior management should ensure that there is an approval process for all new products, activities, processes and systems that fully assesses operational risk.

To further emphasise the role of the operational risk manager, an internal international conference on operational risk at a global European financial services company stated that:

“The product approval process is aimed to ensure that adequate controls are put in place to manage the inherent risks associated with new products, related processes and systems implementation and other initiatives. Amongst others, the product approval process also facilitates modification of existing products and helps to ensure compliance with applicable local and regulatory authorities”.

Advice for a Product Manager

The operational risk manager must be included in the new product approval process.

Duty of Care

While risk management may be viewed from a bank’s perspective, the product manager must consider, with equal importance, duty of care with respect to prospective customers. This means that the bank must have adequate processes in place to ensure that customers’ interests are central to new product development.

Importantly, the principle of duty of care extends also to existing products in the bank’s portfolio. The product manager must also ensure that existing products match customers’ needs. If not, they should be restructured. Note that this is a different although related reason from the one put forward in relation to streamlining product portfolios to eliminate product redundancy or value-destroyers.


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Advice for Senior Management

Appoint a suitably qualified bank professional to serve as a dedicated customer advocate. The product manager should ensure that this professional is included in the new product approval process.

Make the customer the centre of new product development process.

We now describe a model for a new product approval process in banking. The literature has created theoretical models that comprise between five and seven stages, ranging from idea generation to final product launch. However, these models were developed mainly for tangible products of non-financial corporations. In this section, we adapt the main principles of these models in retail banking.

New Product Approval Model

We present a diagram of a new product approval model for retail banking below:

202.4 The New Product Approval Process with Forecasted PLC

We comment on this model.

a) The model may be figuratively compared to a funnel that narrows in width as the process moves along the four stages. The start of the process is sometimes called the ‘fuzzy stage’. This indicates that the product manager faces the highest degree of uncertainty at the start of the new product approval process in deciding which idea or concept will likely lead to an innovative product that will meet customers’ unfilled need and create long-term value for the bank.

b) At the end of each stage, the product manager has to make a go/no go decision. When compared to a) above, we see that the decision to exit the process is more difficult at the later stages in the process – e.g., after product development. This is because as more time, effort and money are expended, sunk costs are created and behavioural banking has shown that high sunk costs are a barrier to exit.

We now describe each stage in the process.

Idea Generation and Screening

A new product approval process begins with idea generation, driven by creative thinking on the part of bank employees and other stakeholders. Many banks have created innovation centres where select bank employees with appropriate levels of expertise and experience have the highest degree of flexibility in thinking ‘outside of the box’ that will lead to highly innovative customer-centric products. An example of this approach is demonstrated by the recent Nedbank Sandbox initiative.


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Nedbank SandBox for Idea Generation

(www.itweb.co.za. October 2013)

Nedbank launched an innovation laboratory called Sandbox for bank employees to generate new ideas that could potentially led to new product development.

“The new offering will allow Nedbank staff to unleash their creativity and entrepreneurial spirit to experiment with new technologies, trial their business ideas, and initiate product concepts,” says Nedbank.

Nedbank CIO Fred Swanepoel says the bank aims to spur staff to innovate better and faster. “By collaborating across Group Technology (GT) and Nedbank, and continuously improving processes, the goal was to find ways to land ideas sooner, better and faster.”

Patricia Maqetuka, of Nedbank Group GT, says the ideas and products that stem from the Innovation Lab environment will eventually roll out to Nedbank’s 500 branches countrywide. “We want this technology to eventually be available for all – and everywhere – whether you go to a branch in Pampoenstad or a branch in Sandton.”

The staff ‘sandbox’ also reinforces the bank’s obligation to give its employees an empowering environment where they have the freedom to contribute to the bank’s ultimate strategy and vision, he says.

The product manager will conduct a process of idea screening that is intended to limit the number of ideas generated in the first phase and to decide which ideas should be considered for a more detailed business case. Criteria for screening are include:

a) Will the idea lead to an innovation that is incremental or is a game changer?

b) Does the bank have the core skills and expertise required for a successful transition of the idea to product development?

c) What is the expected degree of complexity in the product development process?

The Business Case

The next stage in the new product approval process is to create a business case for the ideas that remained after screening by the product manager and a select group of stakeholders. A business case provides support for the product manager to make a decision to seek resources from senior management to proceed with the development stage. As stated by BCBS above, the business must indicate that, if adequate risk management processes are not yet in place, a new product offering should be delayed until such time as systems and risk management are able to accommodate the relevant activity.

The Business Case is a key decision-making document that can stop the new product development process before any significant amount of resources is committed. This can avoid the negative consequences of the sunk cost bias.

Note that the development stage (which refers to the R&D process for tangible products) corresponds to the combination of idea generation and screening as well as the business case stages of the model shown in 202.4

A business case comprises the following considerations:


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Composition of Business Case Team

The product manager will put together and lead a cross-functional (i.e., multi-disciplinary) team of bank professionals who will conduct risk management, create financial projections with appropriate scenario analyses and give a predominant role in the process for duty of care. The crucial members of this joint team will be determined as we discuss the main components of the business case.

Risk Management Function

With respect to risk management it is noted that risk is multi-dimensional. This means that a credit risk expert is not necessarily an expert in operational risk. Hence the multi-disciplinary team should include risk specialists in, especially, credit, operational risk and compliance risk. The primary function of the risk professionals is to identify all sources of risk, obtain appropriate measurement indicators and propose actions that will serve to mitigate them.

It is noted that the level of risk associated with developing a new product can be very significant. But this reality should not lead to the decision to maintain the status quo since this could lead to strategic risk. For this reason, the new product development team led by the product manager should also include a business expert who is able to assess potential strategic risk. This risk arises when the proposed new product is not aligned with the bank’s strategy or risk appetite framework.

Duty of Care

Duty of care is a principle that must be given a central place in the business case. For this reason, the dedicated bank professional who is appointed as customer advocate must be actively involved in the creation of the business case. In order to contribute meaningfully to the business case, this bank professional must have an end-to-end holistic view of retail banking and understand that the only source of long-term value creation for the bank is positive customer experience delivered in a consistent manner by professional and ethical employees.

Market Demand

The cross-functional team should also include professionals from the marketing and sales unit. Market risk arises from actual demand for the new product being less than that projected in the business case. Accordingly, effective marketing research is crucial to estimate the size of the potential addressable market. While banks can data-mine their internal databases for customer insight, it is also important to seek information from external sources. With traditional methods of market segmentation and methods for collecting data (e.g., structured surveys) coming under attack for subjectivity bias, actual customer behaviour and expressed customer sentiments about the suitability of bank products and quality of customer service have emerged as very important for effective marketing research. Customers’ preferences should enter the bank’s new product approval process as early as possible; using social media to solicit customers’ input for co-creation can help to mitigate market risk. In the end, the marketing professional should provide an assessment of the market potential: this is a market research activity.

Financial Forecasts

Financial projections are based on the assumption that the product is developed, tested by a focus group and then introduced into the market. At this time, the product is supported by a dedicated advertising and promotion campaign.

Obtaining annual or quarterly financial forecasts for new products, as opposed to existing or enhanced products, is extremely difficult. There is simply no historical data to project into the future. This is the difficulty of making forecasts, as opposed to projections where the latter are based on available past data. But some useful financial statistics can be obtained.


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The marketing professional will typically obtain an estimate of the market potential for the new product based on both quantitative (i.e., data mining to obtain customer and market insight) as well as qualitative research (drawn from, for example, focus groups) in order to establish the average customer propensity (i.e., willingness) to purchase the bank offer. The estimated market potential is sometimes called the ‘addressable’ market.

Here are some key financial statistics:

a) Total revenue potential = market potential X average customer propensity to buy.

This is the total revenue potential over a forecasted PLC for the new product. As indicated above, the evolution of forecasted sales over a PLC is highly uncertain. Therefore the product manager is advised to take a conservative approach and create a ‘zone of uncertainty’ that is addressed by considering potential scenarios. Some experts create a range that is 10 percent higher and lower than the expected sales in each stage. Here is a graphical illustration of a forecasted PLC with a zone of uncertainty.

202.5 PLC with Zone of Uncertainty

The finance professional, in conjunction with marketing and sales, will forecast quarterly sales ($) for the new product for the introduction and growth stages using the PLC with its zone of uncertainty. The decline stage is excluded since, as shown in the typical PLC (Graph 202.1), the level of profits begin to rapidly decline and may even fall below zero in the maturity and decline stages.

Here is an example to illustrate the procedure where the following assumptions are made.

• At time zero, we aggregate the value of all resources expended in all stages before product introduction*. In our example, this value is $100,000†;

• The introduction stage will last two quarters followed by a growth stage of six quarters (2-year time horizon to reach maximum sales level);

• The introduction phase is accompanied by a marketing campaign; we assume an equal amount of investment in marketing the product in each period of $250,000;

• In the growth phase, growth rate of sales is highest up to the point of inflection (see Graph 202.1) and is reduced afterwards; we assume a 30 percent quarterly growth rate for the first four quarters of the growth stage, followed by 10 per cent in the next two quarters. There is negligible growth in the introduction stage;

* We realise that there are time value of money issues neglected. The benefit of our assumption is simplicity.† Note that the assumed monetary values are only for illustrative purposes.


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• For purposes of simplicity, support costs during the growth phase are assumed to be negligible;

• The zone of uncertainty in the expected PLC is calculated as a reduction of 20 percent of forecasted sales for the lower PLC and an increase of 10 per cent of forecasted sales for the upper PLC.

The projected sales and costs are presented below (values are expressed in thousands of dollars). We calculate how long (in quarters) it will take for the bank to break even if senior management decides to introduce the product. Of course the time to break-even depends on the assumptions that are made with respect to the timing and amount of costs and sales. We calculate time to break-even based on expected sales forecasts as well as a pessimistic and more optimistic case. The finance expert on the product management may also conduct further scenario and sensitivity analyses on expected growth rates, discount rates, number of quarters before growth in sales is stabilised and so on.*

In our example, the time to break even for the normal (i.e., expected) case is the fourth quarter, which is two periods into the growth stage. The more pessimistic case, which permitted a 20 percent reduction in expected sales for each period, shifted the time to break even to the fifth quarter. For the optimistic case, where we assumed that sales would be 10 percent higher in each period, there are higher profits but there is no material change to the time to break-even.† The product management team will take note of the following key points:

* The time to break even is calculated by the finance professional based on present value calculations. In this case, we assumed a discount rate of eight percent.† Some may think that the optimistic case should break even at a time just before the expected case within the same fourth quarter. But to make such a strong statement one is implicitly assuming that the distribution of sales is uniformly distributed. This does not confirm to reality.


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The longer an investment in a new product takes to break even, more than likely it will not be a profitable investment. For this reason, it is common for decision-makers to view time to break-even as a measure of market risk. The quicker it takes to break even, the less the risk to profitability.

Note that time to break-even is when the discounted value of cash inflows is equal to the discounted value of cash outflows.

Market risk refers to the likelihood that actual consumer demand may differ from expected consumer demand for the new product

We have completed our analysis of the business case. The product development team will decide on the final step: product development and subsequent beta testing. The product development team will be guided by the business case – risk management mitigation strategies, duty of care, target market and capital constraints and initial financial forecasts. In addition, HR will develop compensation plans for sales people that stimulate both financial performance and customer experience. Finally, a beta testing* completes the process before introduction in the market.

Summary

This module considered the fundamental issues involved in effective product portfolio management in retail banking. First, the product portfolio manager must conduct periodic evaluation of the bank’s current product portfolio so as to identify products that are redundant or are potential value-destroyers. Useful criteria to conduct this evaluation were presented. After streamlining the product portfolio, the product manager is faced with two options: first to create incremental value for existing products using appropriate marketing mix strategies (and thereby extend the growth stage and delay the maturity and decline stages of their respective product life cycles); or second, to create a business case for the inclusion of new products in the portfolio. For both new and existing products, this requires a robust new product approval process that is driven by a multi-disciplinary team that examines key issues such as risk management, duty of care and financial feasibility.

* A beta test uses a focus group of existing and prospective customers to assess customer propensity to buy. The product manager may also use an alpha test with a beta test. An alpha test is based on a focus group of internal employees.


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Multiple Choice Questions

1. All of the following statements in relation to a strategy of streamlining a bank’s product portfolio are correct except:

a) There is a potential for significant profitability improvements in the range of 30 to 50 percent.b) Bank staff will have a better knowledge of a smaller set of products. c) There will be less stress on the bank’s IT systems and networks.d) There will be a lower requirement for compliance and risk management.

2. A large number of slightly differentiated products in a bank’s product portfolio lead to product portfolio complexity. Which of the following statements summarises the product manager’s assertion that product portfolio complexity can increase operational risk?

a) A large number of slightly differentiated products can create anxiety and confusion for customers.b) Product portfolio complexity makes it more difficult for bank staff to fully understand product features, which can lead to a mismatch of bank products with customers’ needs.c) There is more stress in the bank’s IT systems and networks increasing the chance of people errors and systems breakdown.d) Complexity hides products that are value-destroyers.

3. With respect to the Product Life Cycle (PLC), which of the following statements is incorrect?

a) The PLC is assumed to be ‘S-shaped’. b) The PLC is assumed to comprise four stages: introduction, growth, maturity and decline.c) The PLC does not offer guidance on how long a product remains in each stage.d) In the maturity stage, it is assumed that the growth rate of sales is positive and increases at an increasing rate throughout.

4. The president of a Canadian retail bank stated that “our mobile banking suite, which now includes the Android App, enables Canadians to do their banking when they want and wherever they are, with ease.” This strategy reflects which of the following strategies for effective product portfolio management?

a) Streamline the bank’s existing product portfolio.b) Enhance the product life cycle (PLC) of existing products.c) Create a new product with new core risks.d) Invest in new IT systems and networks.

5. Which of the following initiatives for effective product portfolio management best creates channel convenience and accessibility independent of time and location?

a) Investment in mobile apps b) Incremental product innovationc) Price reductiond) More efficient bank operations


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6. BCBS has underlined the importance of risk management in a bank’s new approval process. In particular, BCBS recommends that, if a new product is introduced in the market, the product manager should monitor risk and product performance relative to the initial forecasts. The reason for this recommendation is:

a) The bank’s risk exposure is increased when it enters new markets.b) The bank’s risk exposure is decreased when it enters new markets.c) Product risk migrates to different levels as the product life cycle (PLC) transitions from one stage to another.d) Product risk naturally increases over the PLC.

7. It is recommended that senior management of a retail bank appoint a dedicated professional to be a consumer advocate in the multi-disciplinary team that conducts the new product approval (NPA) process. This recommendation reflects which one of the following considerations in a business case?

a) Risk management b) Duty of carec) Market demand d) Financial projections

8. It is recommended that for a new product approval (NPA) process the product manager should assemble a multi-disciplinary team to create a business case. The main reason for this recommendation is best described by which of the following:

a) A large group, as opposed to a smaller group, of bank professionals will lead to a complete business case.b) Risk is multi-dimensional. c) An NPA process requires a consideration of various functional areas of retail banking.d) It permits each functional area to be held accountable should the product fail to meet expectations.

9. One of the metrics considered in forecasting financial performance for a new product is time to break even. Which of the following statements is incorrect with respect to time to break even?

a) The product is expected to earn positive profit after the time to break even is reached.b) If the time to break even is deemed by the product manager to be overly long, then the risk to break-even is likely high. c) If the time to break even is short, then market risk is likely high.d) Time to break even when the discounted value of cash inflows is equal to the discounted value of cash outflows.

10. Principle 7 in the BCBS document, Principles for the Sound Management of Operational Risk (June 2011), recommends that senior management should ensure that there is an approval process for all new products, activities, processes and systems that fully assesses:

a) Credit risk b) Market riskc) Liquidity riskd) Operational risk

Answers

1 2 3 4 5 6 7 8 9 10

d c d b a c b c c d
