The branch banking model

Patrick McKenzie (patio11)

I have long wanted to write about bank branches in their guise of semi-public infrastructure deployed as commercial real estate projects which are funded by private capital, but realized while writing that issue that it assumed too much knowledge of how bank branches operate. So that will be for another day; today, we’ll take you behind the scenes of the place you cash your paycheck.

Bank branches are sales offices

You probably mostly think of bank branches in terms of tellers, ATMs, and routine transactions. This is not why bank branches exist; it is an incidental offering of the bank to secure your business.

Bank branches exist to sell new accounts. They are sited to maximize new accounts and the value of those accounts. They are staffed to maximize new accounts and cross-sells to existing customers (which will often be called “relationships” at a bank). Everything down to the physical layout of branches and sometimes even the relative paucity of non-branch options ("channels" in the lingo, like phone or online banking) is designed to maximize new accounts.

You’d be surprised how few accounts they sell! The typical full-service bank branch costs about $20 million to put into service, with running costs near $1 million a year, and for this… it will generate about 300 new deposit accounts and a roughly similar number of loans. Banks are pretty discreet about these targets, but they appear in both survey data and can occasionally be backed out of public filings.

The lifecycle of consumer(-ish) bank accounts

Why are banks so solicitous about putting sales offices close to you? Because they expect that once they earn your business they will keep it for a very long time.

Churn rates for typical retail checking accounts cluster around 8%. This is in terms of relationships (counting by, typically, the household; banks have views of how income and gender mix which would not endear one to the modal San Franciscan professional). Churn rate is lower when measured in terms of dollar amount of deposits; the more you keep in checking (and, incidentally, the more products you use, like mortgages, credit cards, and the like) the less likely you are to churn in a given year. This means that the bank assumes that, in expectation, well-qualified customers are making a 10+ year commitment.

A commitment to what, exactly? A deposit account will allow a bank to make money via fees, net interest margin, and (if cross-sold with a debit card, which banks train their people to do very aggressively) interchange on the purchases a customer makes. Debit cards are especially important for Durbin-exempt banks; regulated debit card interchange is better than a kick in the teeth but only becomes material for the customers who swipe the most frequently.

Fees tend to be pretty uninteresting intellectually speaking and competition has crammed them down for most customers in the middle class. The “free checking” era largely did away with monthly fees in most markets, largely (and controversially) by replacing them with insufficient funds fees (“NSFs”) levied against people with unstable incomes who overdrew their accounts. This has been an ongoing target of regulatory scrutiny.

The dominant engine for profitability of deposit accounts is net interest margin. A bank’s advantage versus every other business in the economy, and the reason why they are the economy’s major source of credit, is the ability to leverage their capital via the use of borrowed money. Much of those borrowings are cheap or free to the bank, in the form of deposits. Net interest is the difference between the rates banks pay on their deposits and what they take in from their loan book. It fluctuates based on the interest rate environment and other factors, but if you were to estimate it at three plus or minus half a percent, you’d be in the right ballpark.

Note that 3% of a college student’s checking account annually is… not much. Branch banking is about building portfolios of accounts. Some of those accounts will be unprofitable or barely profitable. Some, like many college students, will grow over the years. But most of the retail deposit base is, structurally, older, wealthier depositors who are at or near retirement. In a real sense, the branch exists for them and your ability to use it is a courtesy. (We’ll talk more about branch siting in another issue, as the bank is constrained in how much it can lean into this reality.)

This is also the main reason why branches have not disappeared despite their immense cost and the feasibility of doing almost all bank transactions through other channels. The banks’ favorite customers like them a lot.

The unit economics of bank accounts are fascinating and relatively closely guarded. In broad strokes, the median consumer deposit relationship (across all deposit accounts) generates about $200 a year in revenue. The bank pays almost all of this back in servicing costs; even the stamp for mailed paper statements adds up when statements are monthly and margins are thin.

People are often extremely surprised that banks spend a lot on account servicing. The $20 million real estate project which exists for the pleasure of ~2,500 people has only the cheapest Bic pens and discount coffee! Clearly it's close to free!

An aside: A surprising portion of the intellectual effort of retail banking divisions is on getting more people to opt for paperless delivery. My favorite example of this is the very large Japanese bank which for various reasons thinks it needs to send a certain type of paperwork to customers and record a printed reply. It spent many millions of dollars inventing a system which would allow the bank to print the received reply on behalf of the customer and thereby save one of the two stamps needed for the process. Lest I be accused of making fun of Japan here, I will note that the United States Postal Service has an employed senior official whose only job is making sure the largest banks in the U.S. don’t go paperless-by-default.

But, again, retail banking is a star search model: the median relationship isn’t nearly as important to the bank as their top 10-20% of retail relationships are. Importantly, those top 10-20% are almost exclusively “the mass affluent”; they’re retirees, dual teacher families, software engineers, small business owners, and doctors, not real estate moguls or billionaires. The industry aggressively segments based on wealth and somewhere around $10 million or so a bank doesn’t want you talking to their regular branch employees anymore; you’ll deal with a different breed of commissioned sales professional who carefully presents as a different social class than most branch employees.

Small business banking

Most banks structure small business banking in the same part of the organization as consumer (retail) banking, due to their sales and service models being very similar. Small business branch banking is… largely not a very good experience. It basically can’t be, given the bank’s cost and revenue models.

They can’t afford to deliver most forms of specialized offerings throughout their branch network, and so almost all small businesses receive lowest common denominator service. Small business accounts, even ones which touch subjectively a large amount of money, are not very lucrative for banks to service.

The typical small business is thinly capitalized and pays out almost all of its revenue every month. This means a business with almost $10 million in annual turnover, which is about the cutoff for a bank to consider a business small, probably has an average balance of only $400,000. That works out to in the neighborhood of $1,000 a month of revenue for the bank. This scales down linearly with the business’ turnover; most small businesses have only 5-10% as much turnover.

Phrased like this it might surprise software people that small businesses are bankable at all; the typical SaaS founder would go apoplectic if someone suggested putting a constantly staffed office within about a mile of every customer to charge them $50 a month.

Larger banks treat small businesses largely as a necessary detail to attract wealthy retail depositors, because a large portion of wealthy people own or operate businesses. Two particular forms are extremely interesting to them: real estate, because mortgages remain a major contributor to their businesses, and medical professionals. (Note that the culture which is banking, and the opinions of regulators and other stakeholders, would strongly counsel keeping small business banking open even if there were no direct business case for it. This is not the only line of business for which this is true. Savings accounts for children are more a statement of values than a product.)

What's the commonality between real estate and medicine? Why court medical professionals, and not e.g. lawyers or gardeners? One reason is that medical professionals, as individuals, generally over-accumulate cash relative to other career paths. They are willing to either keep it in checking or invest it based on the recommendation of bank-based financial advisors.

The other reason is that, while the rate of medical professionals working in their own practices is declining, a medical practice with licensed professionals is a proverbial license to print money. That printer has equity value and is durable and resilient in a way that individual professional careers are not. Many professionals will “buy into” their practice or buy out the equity of a retiring partner; many banks make a speciality of writing large, relatively low-risk, collateralized loans to enable this.

All of these factors are superior to those present with more typical small business loans. Banks would originate almost no loans to acquire small businesses but for government programs like e.g. Small Business Administration loans, which effectively use the banks as interfaces to government financing. (The covid-era Paycheck Protection Program economy-wide fiscal airdrop was similarly executed through banks, and one of the reasons it was characterized as loans was to maintain sufficient plausible deniability that bank stakeholders could say “Yes, this is clearly banking business” with a straight face. Banks are, in addition to being private enterprises, a policy arm of the government; this is the thing I think crypto enthusiasts are rightest about.)

Staffing bank branches

If you’ve ever seen Mary Poppins, you might remember a famous scene (and wonderful ditty) set in a turn-of-the-20th-century British bank. It had dozens of employees conducting the quiet symphony of ledgering and deal-making, lead by a prim and proper expert who was a leader in his community.

This is not the reality of bank branches these days. As banks got more sophisticated about using information technology, rather than deploying all bank functions to substantially all branches, they largely centralized them and made them available to branches via telephone or computer applications. Many things you go into a branch to do will actually be done on your own telephone while a banker helpfully points out which buttons to push. This even includes account opening in many places! (There exists a truly excellent writeup of the history of this deskilling of the branch workforce for the U.K.; similar essays could be written about the United States or Japan, though Japan has lagged by a few years.)

While it varies based on market and whether the branch is “full service” or one of the newer concepts, a typical bank branch will have about six employees: one manager, one to two tellers, and the remainder bankers.

Tellers handle routine bank transactions. They’re almost entirely substitutable by ATMs (automated teller machines) but, in a graph which never fails to surprise people, absolute employment has increased since the ATM has rolled out. (This is largely due to an explosion in the number of branches offsetting a reduction in tellers per branch.)

Titles for bankers depend on the bank but could be “community banker”, “personal banker”, “private banker”, or similar. They are basically all commissioned sales representatives who are generally in a high-pressure sales environment, with the branch manager being a quota-driving line sales manager.  Bankers will, for historical reasons, handle higher complexity routine transactions (like e.g. wire transfers) than tellers will, but they are discouraged from spending their time on transactions except to the extent necessary to sell more accounts.

In the past, branch managers were far more akin to CEO of their branch, with substantial authority to influence underwriting decisions on loans or make accommodations for customers; this is largely on the wane. At most banks they are sales player-coaches with some vestigial customer service and regulatory functions. (You can still use a branch manager to achieve an escalation of a routine issue into a bank’s call tree, because they likely have a special number for that, but for anything over low single-digit thousand dollars you should just escalate immediately to paper addressed to someone the bank will trust to make consequential decisions.)

If you’ve ever wondered why you were ambushed upon walking in and directed to a banker for something you’d normally do at the teller window or ATM, sales quotas are why. Bankers have a script to read to see if your needs have changed recently. If they aren’t aggressive enough about sourcing business, from people walking in the door or from calling existing customers or new prospects, they will be replaced with someone who can meet their quotas.

This quick sketch of the realities of incentives at bank branches should suggest a good analogue for you: while a branch might have the professional vibe of a doctor’s office or be opposite the street from a fast food restaurant, the business it is closest to in character is actually a cell phone store. It’s a high pressure sales environment, with most of the sales professionals not exactly being industry experts, where substantially all of the money is made “on the backend” (over time) of service delivery lasting many years.

Will branches change?

Technically-inclined people have been confidently predicting the death of the bank branch since I used Prodigy to access the Internet. While covid likely accelerated the transformation, we’re likely to see not a vanishing but a continued gradual decline of branch networks and more experiments with different branch experiences.

Non-full-service branches are popping up in many places, sometimes as new builds and sometimes as shrinkflation of existing branches. These generally cut staffing down to three to four people, often partially by sharing a branch manager with other locations. It remains to be seen whether this is going to be a permanent part of the mix or whether they are expensive investments in educating marginal users how to sign up for online banking. Somewhat surprisingly to technologists, only about half of the deposit base has figured out online or mobile access.

Apps are, of course, getting better all the time. Covid was a real accelerant in particular to the ability of banks to do account opening online; this was once something of an advanced feature and has now become de rigueur at banks up and down the technical sophistication spectrum. We will inevitably see increasing pressure to move account opening online, even if “online” means “on your phone as you’re standing in a branch”; the marginal improvements in utilization really matter due to how expensive square feet and person-hours are relative to pixels.

Now that you’ve had a quick primer in branch banking, you can come back later for an extended dive into the real estate side of it. See you then.

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I write about the intersection of tech and finance, approximately biweekly. It's free.