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BirdsEye View

 The airline industry has undergone huge change in recent years following deregulation.  Much like banks after the Financial Modernization Act, if not before it, they are facing competition they never thought would be in their space, from restaurant chains like Hooters to Virgin Records, which is now a major airline.  Banks have been put in a similar position, with grocery store and retailing chains as well as other segments entering financial services with vigor, low costs and capital.

As pricing eroded in the airline business with low cost producers such as Southwest, Jet Blue, Air Tran and others, the major carriers continued striving to protect their most valued customers through extensive loyalty programs.  Those programs truly changed customer behavior.  We all know that often we’d accept a longer lay-over or an inconvenient connection just to protect those precious miles…  It appeared that those frequent flyer programs did indeed achieve their goal of building a fence around the airline’s most valued customers.

The problem was:  those customers who quickly advanced up the loyalty program ladder, from bronze to platinum, were not the most profitable customers.  Instead, they were those customers who flew the most miles or the most segments; in other words, those customers who created the most volume, not value, for the airlines.

The customers who qualified for elite status on the airlines’ loyalty programs were, in fact, less profitable and more expensive customers.  The program taught the customers to maximize segments, not direct routes.  Every customer stopover is an expensive proposition for the airline:  multiple baggage handling points, multiple customer touch-points and no incremental revenue.

The banking parallel is striking:  if you ask your own branch managers who are their most profitable customers, they’d rarely be able to name one.  The people most frequently mentioned are those who visit the branch most often, eat the donuts and drink the coffee.  They are seen a lot, but their balances may be low and service intensity (and costs) high.  Many banks don’t even know who their most profitable customers are until they install a reliable profitability system.  It appears that the airlines were in the same position.  They had compelling loyalty programs, but they were rewarding the wrong customers and the wrong behaviors.

As a result, a top-level customer could be one who has flown over 1 million miles, all on discount tickets, with an average price per segment of well under $100 and average annual profitability of about $10,000, while another customer, with segment average price of over $800 and lifetime miles of only 500,000, would be considered much less valuable even though their revenue contribution exceeded $80,000 per year.

The questions they really needed to ask were:  what is the lifetime value of each customer; who should we invest in; and how to we help transition customers from less profitable behaviors to more profitable ones?  It’s the old volume does not equal value equation with which we all struggle.  The banking parallel is having $1 million in low margin CDs vs $250,000 in free checking.  The volume equation will identify the former as the more profitable customer, while in reality the latter customer is much more profitable as a provider of interest-free funds (and even more so when rates start rising!)

Some airlines have figured this out, and are changing their loyalty programs to reward those customers who are most profitable.  For example, they changed the qualification formula from miles and segments flown to miles times price formula, such that the higher the fare, the more miles you get, plus no credit for deep discount miles (on which they lose money).  In addition, some changed their upgrade programs to encourage buy-ups and slow upgrade earn velocity to less profitable customers.

Another example of moving toward value from volume is changing program elements to provide incentives to change behaviors by eliminating rewards for flying many segments (thereby reducing customer handling costs) and allowing customers to carry over miles beyond a specific level for the next year (to reduce the impetus for the customer to start earning miles on another airline once they reached their ceiling with their first carrier).

Banks can learn several lessons from the airlines story:

1.    Competition does have a significant, often permanent impact on pricing, which may compel some to change their business models and overhead structure (i.e. reduce the efficiency ratio)

2.    Volume does not equal value (a CD customer is not equal to a money market customer)

3.    Loyalty programs do work to change customer behavior (occasionally with some unintended results)

4.    Building longer-term affinity is key, and can be achieved by rewarding more profitable customers with items they value most (such as interest rate and other value pricing models) while tying it into longevity (i.e. how many years have they been a bank customer at a particular deposit or loan level, excluding mortgages).

As always, the devil is in the details, and developing a loyalty program goes way beyond relationship pricing.  The good news is, the airlines have already made some of the mistakes, so we don’t have to repeat them!