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Considerations When Introducing a New Product or Service at a Community Bank
by Teresa Curran, Senior Vice President and Banking Supervision and Regulation Division Director,
Federal Reserve Bank of San Francisco

When I meet with community bankers in the 12th District – which encompasses Alaska, Arizona, California, Hawaii, Idaho, Nevada, Oregon, Utah, and Washington – one recurring theme in our discussions is the challenge of maintaining core earnings. With today’s low interest rates, community bankers must frequently look beyond the margin or spread. Cutting costs or raising fees on existing services, however, can only go so far. Consequently, many community bankers are rethinking business strategies and are developing new products and services.

Traditionally, new products and services have offered great opportunities for community bankers to innovate, connect with their customers, and provide value-added service. Choosing the right product or service for the institution and its customers, however, can be easier said than done. We have found that successful management teams and boards of directors typically identify and mitigate risks before considering and introducing new products and services. When risk is not identified and mitigated in advance, the unintended consequences can be costly to resolve. In this article, I will discuss some factors that management and the board should take into consideration before introducing a new product or service. In particular, I will highlight a few areas where an ounce of new product planning may be worth more than a pound of cure.

The Repeatable Process

Management teams that successfully identify and roll out new products and services typically have a documented, repeatable, and auditable process to guide their decision making. In practice, this often means that the board approves and the management team follows comprehensive new product policies and procedures, documents decisions sufficiently, and ensures that all relevant functions within the organization appropriately engage with one another.

Management and the board are wise to assess the sufficiency of their new product policies and procedures. They may want to consider whether these policies:

• require management and staff from various functions – including compliance, accounting, risk, internal audit, and line management – to vet, review, and recommend new products and services for senior management or board approval;
• cover the investigative stages of new products and services as well as the approval and deployment stages;
• require that operating policies and procedures are updated to provide clear guidance to staff on how to comply with all legal or regulatory requirements associated with the new product to avoid violations of law and undue exposure to legal liability prior to product introduction;
• address and mitigate risks throughout the product life cycle, including pricing, marketing, distribution, accounting, and ongoing service and maintenance; and
• require a post-decision review to determine whether the new product or service met the expectations and assumptions used to support the decision.

Management and the board should also ensure that the organization’s culture encourages constructive dissent and robust dialogue around all issues. This could be evidenced by documenting dissenting viewpoints or considerations along with the new product recommendation.

Strategic Fit for the Institution and Its Customers

When institutions merely enhance existing products and services to meet customer demand, the resulting "new" products or services may not have a notable effect on the institution’s risk profile or business processes. In other cases, however, community institutions enter new business lines, such as offering trust or wealth management services; expand into a new delivery channel, such as the Internet or mobile banking; or expand into new markets or new loan or deposit products, such as rewards credit cards or consumer remote deposit capture. When going beyond the boundaries of the institution’s existing business model, successful management teams typically first think of new products and services in the context of the institution’s strategic direction.

Strategic questions that management and the board would typically consider in this initial step of the process could include the following:

• How did we learn about this product? Did a current vendor suggest the product to complement our existing products? Did a new vendor cold-call on management? Are our competitors or peers in other markets offering the product? Have our customers asked for the product?
• Is this an established product or service, or is it "bleeding edge" (an extremely new or innovative product or service with higher uncertainty as to consumer acceptance) or "leading edge" (a proven product or service that is still new enough that it may be difficult to implement or support and where customer acceptance is still building)? If it is bleeding edge or leading edge:
  • How quickly is the product or service likely to evolve?
  • What will be the cost of keeping pace with the evolution?
  • What is the likelihood that our customers will value the product tomorrow?
• Do our personnel have the skills and capacity to deliver the product and service effectively? If we retrain our current employees and/or hire people with those skills, will we also have to change our compensation practices for consistency with other companies offering the product? Will we be changing the culture of the company?
• Will this product or service complement or cannibalize our existing products and services? Will it enable us to attract and retain new customers?
• Where do we see ourselves as an organization in three, five, or 10 years if we do or don’t offer this product?

In addition to considering the product’s strategic fit with the organization, successful management teams consider the institution’s customer base. In particular, these banks review the new product from a fairness perspective, asking, "Does the new product or service benefit the consumers and communities we serve or does it diminish their capacity in any way?" Or, stated another way, "Are we benefitting at the consumer’s expense?" When assessing fairness, management teams typically ask a number of questions, including:

• Do our existing customers have a need for this product or service, or are there less expensive products that would better serve our customers’ needs?
• Are features, risks, and terms of the product explained clearly and conspicuously, or are they buried in a lengthy document full of "legalese" that makes it difficult for the consumer to make a truly informed choice?
• Are fees or penalties structured in such a way that unsuspecting, unsophisticated, or vulnerable consumers could experience financial difficulties from which it would be difficult to extricate themselves?
• Are there financial incentives for bank employees to offer this product over other products that may also be suitable for the consumer?
• Is this a product or service we would recommend to our families?

If a potential product or service appears to be a good strategic fit with the organization and its customers, only then do successful management teams delve into the more tactical aspects of the decision.

Risks and Mitigants

It is often tempting to focus disproportionately on the benefits of a new product or service and less on the potential risks. That is why it may be helpful to first consider the risks of a proposed new product before selling oneself on the benefits.

Successful management teams consider the costs and risks of a new product or service very broadly, looking at all risk dimensions across the organization. While a new product or service may appear to fit into a particular risk niche – a loan product may primarily affect credit risk, whereas a new delivery channel may primarily affect operational risk – the interconnectedness of all aspects of a community bank cannot be ignored.

For example, mobile or Internet banking can not only create a variety of operational risks but also lead to increased liquidity risk (e.g., funds can move at the click of a button), compliance risk (e.g., inconsistent or incomplete disclosures), and reputational risk (e.g., negative publicity from a data breach), among a host of other less obvious risks. New home equity products may allow consumers to lock in part of their variable-rate line of credit at a fixed rate but can also lead to increased sensitivity or credit risk (e.g., the consumer is locked into a higher payment even if rates fall), operational risk (e.g., if systems cannot account for the dual product), and compliance risk (e.g., if disclosures are incomplete or inconsistent with actual practice).

Risk-related questions that management and the board would typically consider include:

• Will this product or service increase, decrease, or leave unchanged aggregate or specific risks? If it will increase risk in one or more risk dimensions, is the new level within our already established risk tolerances?
• What steps can we take to mitigate risks to an acceptable level? Are there industry best practices we can consider?
• Will the new product or service cause changes to our financial position, including the calculation of regulatory capital ratios?
• Do we have or can we acquire the staff expertise to adequately manage and control the risk in the new product or service as well as the risk in our established portfolios of products and services?
  
  

Regulatory Compliance

Community banks operate in a highly regulated industry, and successful management teams assess whether new products or services fully comply with applicable federal and state laws and regulations. The scope of permissible products and services may be limited by the institution’s chartering authority and can vary depending on whether the activity is conducted in the bank, the parent company, or a subsidiary of one or the other. Management teams are encouraged to discuss new product and service proposals with their regulators to determine whether an application or notice may be required.

In addition, certain regulatory issues carry increased risk. First, the new product or service may raise concerns about the fair treatment of or impact on consumers. Therefore, concerns about fair lending and unfair or deceptive acts or practices (UDAP) should be addressed early in the process and monitored after the product is introduced.

The new product or service may also affect the institution’s Bank Secrecy Act/anti-money laundering (BSA/AML) profile. A successful rollout of a new product should include early consideration of BSA/AML issues.

Finally, when considering regulatory compliance, successful management teams also consider the regulatory compliance profile of third-party vendors used to develop, deploy, or service the product. While management can appropriately decide to outsource some or all of the operational aspects of the product or service, they cannot outsource the responsibility for complying with laws and regulations. A robust third-party vendor management and oversight process will evaluate all applicable risks, including those related to information security, privacy, and compliance with all applicable laws and regulations.¹

In addition to compliance considerations, the nature of the proposed product or service may affect the bank’s Community Reinvestment Act (CRA) profile. For example, a bank that targets niche markets, offers only unique or specialized products and services, or uses nontraditional delivery channels should consider how it is helping to meet the credit needs of its local community. At our Reserve Bank, we advise management teams to evaluate the potential effect of new products and services on the bank’s ability to meet the credit needs of its local communities prior to implementation. A bank may want to consider submitting a CRA strategic plan to its regulator for approval. A best practice is to periodically review the bank’s performance and assess its goals relative to the performance standards contained in the CRA and its implementing regulations.

Regulatory compliance-related questions that management and the board would typically consider in this step could include:

• Has the product or service been reviewed for compliance with applicable federal and state laws?
• Has the product been reviewed from a consumer fairness standpoint?
• Will an application or notice need to be filed with our federal or state regulator(s), and, if so, do we have the necessary information to submit with the application? How will that affect our lead time?
• Will the new product or service affect our BSA/AML risk profile?
• Will we use third-party vendors for any aspect of the new product or service? If so, do we have a sufficiently robust vendor management and oversight process to ensure that the vendor complies with all applicable laws and regulations?
  
  

Financial Costs and Benefits

Community bankers are adept at conducting financial analysis of borrowers, and the same rigor can be applied to the financial analysis of proposed products and services. It is useful to challenge the financial assumptions underpinning the new product analysis, considering scenarios where customer adoption and sales are less than expected or certain key costs are higher than expected. Sometimes even seemingly minor variances in key assumptions can significantly affect profitability. It is also important to document the analysis and provide a record for back-testing.

After completing the cost-benefit analysis, management and the board would typically consider the following questions:

• Do the assumptions underlying the financial analysis appear reasonable?
• Does the financial analysis adequately capture scenarios other than the best or most likely scenario? Can we live with those alternative outcomes?
• Have all assumptions and projections been documented and can they be back-tested?
  
  

Bringing It All Together

After the proposed product or service has passed the strategic fit test, the risks and regulatory compliance issues have been identified and evaluated, and the numbers have been crunched, management and the board are faced with two final questions:

• Do we thoroughly understand the purpose, risks, and benefits of this product or service?
• Do the potential benefits, both financial and nonfinancial, associated with the new product or service outweigh the costs of (i) developing, providing, and servicing the proposed product or service; (ii) mitigating the identified risks; and (iii) complying with applicable laws and regulations?

If the answer to either question is "no," then the disciplined new product review process may have saved the management team and board much financial and risk mitigation pain further down the road. As Steve Jobs once noted, "Deciding what not to do is as important as deciding what to do. That is true for the companies, and it’s true for products."² But if the answer to both questions is "yes," then it’s time to move forward!

Final Thoughts

Over my many years in bank supervision, I have found that community banks are most successful when they connect with their customers and communities and provide value-added products and services that are both consistent with their mission and needed by their customers. While the prolonged economic recovery may be placing inordinate pressure on banks’ earnings, taking a long-term strategic focus rather than just following the pack when considering new products and services should help ensure the continued viability of the community banking model.

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