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What Most Banks Fail to See
Business Journal

What Most Banks Fail to See

by Sean Williams and Daniel Porcelli

New regulation in any industry can create uncertainty, slow down progress, and reduce earnings. In the current post-crash regulatory climate, banks are understandably concerned that new regulation means decreased profits. But like it or not, they must learn to operate in a more highly regulated world. By understanding Behavioral Economics 101, banks can realize that while new regulations have their share of burdens, they also come with opportunities to build relationships with customers -- and to build new business.

Beyond merely complying with the law, banks can create a win-win opportunity with customers.

This is all immediately relevant in the face of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which many are calling the most sweeping overhaul of U.S. financial regulations since the 1930s. According to American Banker, "By some estimates, federal regulators must complete 243 rules, largely during the next two years, along with 67 one-time reports or studies and 22 periodic reports." (See "Now for the Hard Part: The Top Five Challenges of Reg Reform" in the "See Also" area on this page.)

Regulators will also have new powers to back up the rules. Among its most important creations, the Dodd-Frank Act established the Bureau of Consumer Financial Protection, with broad powers to regulate many financial services and activities, including mortgage lenders, payday lenders, private student lenders, and providers of credit reporting and debt collection.

Regulations that require changes in customer accounts, rates, fees, or information will likely mandate that banks contact their customers about these changes. This means that banks will have a new opportunity to have meaningful and relevant communications with their customers.

From the customers' point of view, new regulations may mean changes to how their money is handled, the price they pay for bank services, and the service options available to them. For a bank, this presents a unique opportunity to speak to customers about the things that matter most to them and to provide added value. Banks can go beyond merely complying with the law to creating a win-win opportunity with customers.

New options -- and new conversations

From the customers' perspective, changes in the terms and conditions attached to their accounts may be quite complicated. Through communication about regulatory changes, banks could have consultative conversations with their customers about their accounts. For example, new regulations can present customers with options they have not considered before -- options that might have unforeseen effects on the products and services they use, the fees they pay, and the information they receive. Customers might need to select among new products or services, and they could benefit from expert guidance when choosing what best fits their situation and circumstances.

The combination of meaningful dialogue and expert guidance is powerful. For bankers, every new regulation could open the door to substantial consultative conversations with customers. In this situation, customers won't want a canned sales call -- they will genuinely be seeking something their banker is best suited to give them: financial consulting.

Banks that respond by providing useful information and credible advice could deepen their relationships with their customers, building confidence and trust, and ultimately, creating more engaged customers. In fact, in a recent proprietary study, Gallup found that retail customers who believed their bank communicated useful and relevant information were 13 times more likely to be loyal to the bank.

To make the most of this opportunity, banks must develop internal capabilities and prepare their employees to handle these conversations. Most, if not all, new regulations will require banks to explain changes and options to customers. But a mailing alone is not enough -- a brochure is not a meaningful dialogue with customers about their financial choices.

Banks need to be aware that they potentially face a credibility problem when advising their customers. Banks often have an interest in a customer's decision, and customers may believe this taints the bank's advice.

This creates an issue for banks because as behavioral economics tells us, information and credibility go hand-in-hand. In fact, consumers do not separate the information they receive from the source that provides it -- advice from a credible source is potentially useful, but advice from a non-credible source is just noise. Fortunately, behavioral economics also offers ways for banks to bridge their credibility gap. These methods can be applied to any financial decisions their customers need to make as a result of new regulations.

Behavioral Economics 101

Throughout much of its history, classical economics has embraced the "rational agent" model. This view suggests that people make economic decisions based on a rational and dispassionate evaluation of the available evidence before arriving at those decisions. The right decision is the one that maximizes a person's economic gain and minimizes his or her costs.

But real life can be a lot different than what many of us were taught in Economics 101. The fact is, there are situations in which real people's behavior doesn't conform to predictions of classical economics. Their emotional, cognitive, and perceptual processes place limits on how rationally they can view the world around them. These limits have a profound effect on the decisions people make -- and subsequently on the way organizations must think about how their employees and customers make decisions and ultimately behave. Simply put: Emotion can -- and often does -- trump reason.

For the past 30 years, behavioral economics -- led by such notable scientists as Daniel Kahneman, Robert Shiller, Richard Thaler, Angus Deaton, George Loewenstein, and many others -- has documented many of the flaws in classical economic theory. This emerging science challenges the foundational premise of rational economics: that individuals will always behave rationally to achieve the best possible outcome. Instead, behavioral economics emphasizes the role of psychology and the interplay among rational, perceptual, and emotional processes in human decision making and economic behavior.

Gallup's work with organizations around the world has shown that they can improve employee productivity, customer retention, and real growth and profitability by understanding and applying how human nature drives business performance. By accepting human nature and capitalizing on it, organizations can ultimately engage the emotions of their most valuable asset: their customers. Making the most of this crucial aspect of employee-customer interactions holds the key to superior performance and long-term growth.

Customers and Regulation E

For a recent example of how regulatory changes may require new financial decisions from customers, let's look back to 2010, when the FDIC changed the rules for consumer protection from overdraft fees related to electronic fund transfers. Among other things, the updated rule -- Regulation E -- limits banks' ability to assess overdraft fees when customers make automated teller machine (ATM) withdrawals or debit card transactions that overdraw their account. Regulation E also requires banks to get their customers' consent to charge them fees for overdrafting their ATM or debit accounts when funds are insufficient.

A regulatory change inadvertently provided helpful insights into customer behavior.

This regulatory change inadvertently provided helpful insights into customer behavior. From a customer's "rational" perspective, agreeing to an overdraft fee is seemingly ridiculous. Why would customers agree to allow their bank to charge them fees? Yet many customers do agree because they see an upside. Some customers, especially those with a history of overdraft fees, may treat overdrafts as a short-term financial security net. Others prefer not to have a transaction declined despite the reality that it will overdraft their account.

Customers who opt in may have to pay a fee. But some will do so to save themselves the embarrassment of having their card declined in a crowded grocery store, for example. Others, such as small-business owners, would prefer paying a fee to ruining valuable relationships with suppliers. For these customers, agreeing to Regulation E is very much like purchasing "dignity insurance."

Required communications about overdraft fees and protection can be more than a flat notification of a fee structure. Done well, these communications can spark a conversation between bankers and their customers about a service that a customer might genuinely need and value -- and one that might meet a customer's emotional needs.

The "lemon problem"

Despite the information a bank can provide customers about their options under Regulation E or any other rule, banks face something of a credibility gap when offering such information. That's because banks have a vested interest in the customers' decision, and customers know it. If customers believe that the bank's advice is based on what is best for the bank rather than what is best for them, they will definitely be dubious about the bank's recommendations. Imagine what a customer might think when the conversation moves beyond a discussion of basic fees and into the world of linking accounts, bank-offered overdraft protection, or a line of credit to avoid overdrafts.

Behavioral economists refer to this credibility gap as the "lemon problem." To understand it, picture yourself shopping for a used car. Imagine that you have found a car you like, but you have concerns about the car's reliability. The salesperson might assure you that the car is not a lemon and is very reliable. But should you listen?

If you knew the salesperson would tell you the car is a peach if it is a peach and a lemon if it is a lemon, then the salesperson's assurance that "this car is perfectly reliable" would mean something. Thinking about the question from the salesperson's perspective, however, you realize that his incentive is to sell you the car, not to sell you a peach of a car -- so he has an incentive to say it's a peach regardless of its reliability. Based on that evaluation, you'll likely conclude that you are best off ignoring his claims of the car's quality.

The upshot is that the seller will have a difficult time convincing a buyer of the car's quality on his own because the incentive to tell the truth and the incentive to make the sale aren't evenly balanced -- they are asymmetrical. In other words, buyers must weigh the facts as presented against the credibility of the speaker.

Banks face a similar problem when discussing Regulation E -- or any other new regulation, product, or service -- with their customers. Banks have an incentive to convince their customers to agree to allow overdraft fees. Customers in turn are right to be suspicious of the information the bank provides about the pros and cons of agreeing, about what their service options are, or about what bank-offered solutions will best meet their needs.

The solution

So how can banks change the conversation from price to advice? How can they move from sending customers a brochure on fees to advising them on the option that best meets their financial and emotional needs? And how can they do this while coping with the tremendous changes in a new regulatory environment? Here are our recommendations:

Many voices will compete for the customer's ear. Proactive banks can be opinion leaders.

First, banks must recognize that merely complying with new regulations represents a lost opportunity. Mailings alone are not enough. Direct communications may be required by the new regulations, but a bare-bones listing of facts from the bank won't earn a suspicious customer's trust. As the lemon problem suggests, if customers doubt the bank's intentions, they won't trust its facts either. Actual conversations between the bank and its customers are necessary to build trust.

Second -- and within the limits of each regulation, of course -- banks should recognize the consulting nature of these conversations. New regulations present an opportunity to initiate conversations with customers not only about the new regulation but also about customers' spending, accounts, and financial goals. These discussions might even result in customers purchasing a new product or service. But for bankers to build toward an advice relationship with their customers, those customers must see discussions with the bank as much more than "sales calls."

Phone representatives who speak to customers about their choices under Regulation E, for instance, should not be incented to sell customers overdraft protection or any other fee, product, or service that will make the bank money. This helps circumvent the lemon problem by freeing representatives to listen to customers' needs and addressing them. And representatives can honestly tell the customer that they personally do not have an interest in the customer's decision one way or the other -- they really are just there to help.

Third, the best representatives will be those who can genuinely communicate that they have customers' interests in mind. Customers will find information most credible when it comes from sources that are aligned with their perspective, which is to make good choices under the new regulations. Representatives who can see things from the customer's point of view will be the most credible sources of information.

Representatives will need training not just on compliance (such as reading the approved list of options, terms, and conditions of the new regulation) but also on relating to the customer (such as personalizing the situation and empathizing with the customer). In the case of Regulation E, an extreme but useful method is to staff phone centers with people who have had overdrafts themselves.

Fourth, banks must strategize about the conversations that representatives will have and the customers they will have them with. It's likely that representatives will have to cover compliance issues for each new regulation. For example, conversations about Regulation E must include a description of the new rules and the customer's options. But the conversation shouldn't stop there. If the bank representative can help customers think through their options, they may deepen their understanding of how they handle money and how their accounts really work.

The bank can benefit from these insights but only if representatives are ready to serve as experts in these conversations. If possible, banks should research what their customers know about and expect from each new regulatory change so they can anticipate customers' questions and be prepared with answers. Banks could also compare these findings with existing segmentation strategies to help prioritize outreach efforts and tailor the conversations to the needs of each customer group.

Fifth and most importantly, banks should be proactive. Banks should create infrastructure and build capabilities to advise their customers. In addition, banks should address new regulations early and if possible, anticipate them to prepare, research, script, and staff appropriately. The sooner banks have these conversations with customers, the better.

What's best for the customer?

Regulatory changes are often complicated and politically charged. Many voices will be competing for the customer's ear, but proactive banks can be opinion leaders. Banks that move beyond fearing regulations to considering how they can capitalize on them will have a strategic advantage. Those that want to use the opportunity to build customer engagement should think about how new regulations will affect their customers, consider whether there is any upside for customers rather than for the bank, and decide how best to advise customers on realizing those potential benefits.

New financial regulations will create a real burden for banks. By better understanding a few simple behavioral economics principles, however, banks can move beyond communicating new rules, specific details, and customers' options to engaging in relevant conversations with their customers. These conversations, conducted effectively, can give banks an opportunity -- and a competitive advantage.


Sean Williams, Ph.D., is a Senior Practice Consultant at Gallup.
Daniel Porcelli is a former Managing Consultant at Gallup.

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