The primary rationale behind the wave of mergers in the 1990s—to achieve substantial economies of scale by exploiting technology and deregulation—is naturally weakening. For most large banks, further expansion won’t necessarily yield dramatic scale-based savings in systems and product-development costs. So although mergers will continue to take place, opportunities to create substantial value have diminished and relatively fewer deals will pack the punch of the 1990s. Executives of large banks must look for new ways to increase earnings.
Until recently, the solution was falling interest rates, which fueled unprecedented profits from mortgages and credit cards.1 But with rates beginning to rise, banks will have to look elsewhere. More compelling value propositions are required if banks are to compete with the nonbanks and specialists that have flourished in many markets. Like the best retailers, banks must differentiate themselves by understanding the needs of their customers and giving those customers a distinctive experience. Banks should also boost their performance the old-fashioned way, by improving productivity—something that will become vital as their payments businesses, representing a substantial share of industry profits and operating expenses, shrink with the falling use of checks.
To succeed in these tasks, banks must innovate in their...