Competitive advantage through Customer Engagement in
Risk management
The pension fund sector
Author: Lilian PieperStudent number: S4186915 Email: l.pieper.1@student.rug.nl Supervisor: P.J. Marques Morgado
Co-assessor:
Faculty of Economics and Business University of Groningen
Duisenberg Building, Nettelbosje 2, 9747 AE Groningen, The Netherlands P.O. Box 800, 9700 AV Groningen, The Netherlands
http://www.rug.nl/feb
T
ABLE OF CONTENT
Abstract 2
Introduction 3
Literature review 5
Negative Interest Rate Policy (NIRP) 5
Risk Management 8
Customer Engagement 10
Resource Based View and Stakeholder Theory 13
A
BSTRACTThe sector pension fund is rapidly growing, where pension assets allocation in the Netherlands is in bonds for 49%. Due to the economic crisis of 2008, the value of bonds declined and the European Central Bank (ECB) imposed a negative interest rate policy (NIRP) as respond to the low inflation prosperity. This phenomenon has an impact on the profitability of banks and as a response, banks transfer the NIRPs to their customers. For the retention of customers, Dutch banks depend on the risk of customers reaction on the matter of NIRPs. Much focus is centered on transactional behavior instead of interactional behavior of the customers, also known as customer engagement.
This paper will provide a theoretical approach on how customer engagement affects risk management in the pension fund sector. The research is conducted through a literature review on customer engagement, risk management, resource-based view and stakeholders’ theory. The literature topics are analyzed by the resource-based view theory to provide a conceptual model to gain a competitive advantage. It is expected that customer engagement affects risk management in the pension fund sector. To the already existing literature, further knowledge is provided about retainment via customer engagement on risk management.
I
NTRODUCTIONThe pension fund industry is rapidly growing in the developed and emerging economies. A report from the “Global Pension Assets Study” evaluates 22 of the largest pension markets, among the United States, United Kingdom, Canada, Australia and the Netherlands. This report shows that the assets in 2019 have increased by 15,2 percent up to 46.7 billion US dollars, where 92 percent of these assets are in the top seven pension market including the Netherlands. Although the US has the biggest pension market, the Netherlands has the highest ratio of pension to GDP, namely 187 percent. Furthermore, 49 percent of the assets allocation in the Netherlands is in bonds (Watson, 2020). Since these bonds are subjected to fluctuations in the market and changing economic policies, the value had declined after the economic crisis of 2008. In June 2014, the European Central Bank (ECB) and four other central banks in Europe have imposed a negative interest rate policy (NIRP). NIRPs were implemented as respond to the low inflation prosperity in the near future and used as an aid package for the EU-economies. Banks have to pay a fine and intercept a negative interest rate of -0.5 percent over the excess liquidity stored at the ECB (ECB, 2019). The lack of adjusting some of their costs can be a result of competition mechanisms in combination of the monetary value of retail deposits.
This phenomena with NIRP should have an impact on the profitability of banks as the compensation of their assets decline, while their costs endure consistent. So, the natural responds of these banks are to transfer the NIRPs to their customers. One method used by banks is lowering the savings interest or retail deposit. In the last few years the interest has declined multiple times down to almost zero percent, where the savings account of more than one million euros already facing a negative interest rate in the Netherlands (DutchNews, 2020).
A customer is, according to the Cambridge dictionary defined as “a person who buys goods or services”. The focus of banks were centered on transactional behavior, instead of non-transactional behaviors (Kumar et al., 2010). Non-transactional behaviors are beyond direct transactions, such as customer feedback/suggestions, customer-to-customer cooperation (new product ideas, word of mouth [WOM], social media) and cocreating (Pansari & Kumar, 2017; van Doorn et al., 2010; Verhoef, Reinartz, & Krafft, 2010). The interactional behavior of customers with the bank is being considered as “Customer Engagement”.
In this paper, the theory of resources-based view and stakeholder view have been used to investigate the impact of customers on risk management. Banks are the financial service providers, where customer-centric satisfaction is the success to their performance. Integrating internal resources to the customer-centric perspective on risk management in effort to retain the customer, is essential. Meanwhile customers are an important stakeholder to consider in both areas. While other writers have written about the concept of consumer engagement or risk management, as a self-contained topic or used in another context, a lack of interconnection on this topic is missing for the pension fund sector in the Netherlands. The following research question is developed to provide an answer to this gap:
“How does customer engagement affect risk management for firms in the pension
fund sector to gain a competitive advantage?”
L
ITERATURE REVIEWNegative Interest Rate Policy (NIRP)
15th of September 2008, the day that is marked as the start of the financial crisis. On that day, the Lehman Brothers filed for bankruptcy, which caused a shock wave on the stock exchange around the world. The financial market of the Netherlands felt the consequences, resulting in high unemployment and rising government expenses, due to its open economy and international trade (Moerman & Zuil, 2018). Models used to constrain risk were insufficient during the financial crisis. Risk management did not sufficiently take into account the relationship between risks and herd behaviour of investors. Thus, the financial crisis has shown that trust is an important factor for the financial market to exist (De Nederlandsche Bank, 2010).
Upon this day, the consequences are still present in the financial market, even though it has gained in value and trust. The European Central Bank (ECB) introduced in 2014 negative interest rate policy (NIRP) as respond to the low inflation prosperity in the near future. To encourage lenders to invest instead of stalling at the ECB, a negative deposit of 0.5% was given to help and boost economic activity, see figure 1 (Tan, 2019). Designing this policy gave eurozone exporters some assistance and hopefully made imports more expensive (Hessler, 2019).
FIGURE 1
The real economy can be influenced by the NIRP through two banking system channels. The first channel is the “retail deposits channel”, where the negative policy rates are being transferred to retail deposit rates. Banks’ are faced with the possibility of an reduce in net interest margins and profits due to NIRP, while the retail deposit rates are almost at zero percent (Bottero et al., 2019).
This phenomenon is more noticeable for banks whom are dependent on retail deposits compared with other banks, that leads them to weaken the transfer rates to loan rates (Eggertsson, Juelsrud, Summers, & Getz Wold, 2019) and/or less lending and increase in risk-taking (Heider, Saidi, & Schepens, 2019). Additionally, banks with large retail deposits are charging higher service fees to neutralize the effects of NIRP (Altavilla, Boucinha, & Peydro, 2018).
The second channel works through liquid assets and portfolio rebalancing. As described by Bottero et al. (2019) “Negative interest rates penalize the holding of liquid, safer assets, incentivizing banks to rebalance their portfolios from low- or negative-yield liquid assets towards higher-yield assets, such as corporate loans (a “portfolio rebalancing channel”)”. Thus, NIRP affected banks are taking more risk in their portfolios to cover NIRP losses. Basten and Mariathasan (2018) studied the experience of Swiss banks in light of the negative policy rates. They concluded that, while maintaining non-negative deposit rates and larger deposit ratios, banks reduce costly reserves and bond financing. The small liability margins were compensated by higher fees and interest income, but the credit and interest rate risk increased (Basten & Mariathasan, 2018).
Risk Management
As mentioned in the introduction, banks are the financial service providers, where the customer satisfaction is the success or failure to their performance. However, the financial service industry is associated with risk. In the banking sector, risk is a crucial factor for possible events. Risk is the probability of the event occurring multiplied with the consequence of the event (Kouns & Kouns, 2011) or refers to “a possibility of loss, the loss itself, or any characteristic, object or action that is associated with that possibility” (Eleana & Siakas, 2016). It is an essential component of business, while no activity can get profit without risk, to minimize the probability of the risk and vulnerability of the bank (Tileagă, Niţu, & Niţu, 2013).
Consolidated risk management is, on a firmwide basis, a coordinated process of measuring and managing risk, which has two dimensions: coordinated risk assessment and management (Cumming & Hirtle, 2001). Risk measurement is the assessment of risk exposures, like earnings-at-risk, duration gaps, value-at-risk etc. Cumming and Hirtle (2001) refer to risk management as “… the overall process that a financial institution follows to define a business strategy, to identify the risks to which it is exposed, to quantify those risks and to understand and control the nature of the risks it faces”. Tursoy (2018) defined risk management as “the logical development and execution of a plan to deal with potential losses”. In this paper, risk management is being considered as “The process of
identifying and controlling potential risk to reduce the vulnerability”.
Banks are searching for differentiation in customization of processes, product and services (Jones & Womack, 2005). As customers are a risky asset, while they are the main source of cash flow, especially if the size and power continue to grow (Ryals & Knox, 2007). Many businesses have a form or department of risk management, although the intensity differs among the industry. The general overall process is formulated by Tursoy (2018) into three steps:
1. Identify and assessing the potential risk in the banking business;
2. Developing and executing an action plan to deal with and manage these activities that incur potential losses;
Another common assessment focused on customer risk is the use of risk or credit scoring. It is an practical way of evaluating types of risk in a customer relationship (Hoogenberg & auf dem Brinke, 2004). The downside is the measurement of risk, while it measures at one point in time and doesn’t provide the guidance for a long-term relationship (Ryals & Knox, 2007).
Ryals and Knox (2007) identify other types of risk related to customers (defection or purchasing swings), that are not included in traditional risk scoring. In their paper, they developed the relationship risk scorecard that focus on the total loss of customer or reduction. Factors include the number of contacts, how warm the relationship is etc. Managers adjust the forecast of revenue by estimating the probability that future revenues will be achieved (Ryals & Knox, 2007).
Risk can be identified by internal factors within the firm or by factors of customers retention. Narayandas (1998) investigated the satisfaction of customer with the benefits of customer retention (BCR) ladder by measuring behavior intent, such as product quality, trustworthiness of vendor and incentive to switch. He finds that trust has more impact on BCR with less satisfied customers and decrease their intension to switch. Product quality has an increasing impact on satisfaction. Thus, satisfied customers are more likely to stay in the relationship, because of the benefits for the customer and therefor reduce risk of retention.
Additionally, consistency is a key intangible factor. Failure of the promised service by banks leads to a decrease of customer retention, which is considered a risk (Andaleeb, Rashid, & Rahman, 2016). Reichheld and Sasser (1990) agree with the latter, while its important to maintain long-term relationship, increase trust and retain profitable customers.
So, risk management is a cycle of identifying risk, use of factors for risk assessment towards a risk strategy for the possible retainment of customers. The cycle repeats itself to continuously reviewing and act accordingly to manage potential risks. This is shown in figure 2 by the Robson risk management model (Robson, 2019). The relationship between banks or -managers and customers defines the possibility of customer retention. The core factors of risks assessment are trust, consistency and satisfaction that could lead to customer retainment.
FIGURE 2
Customer Engagement
Institutional banks are always competing one another. Most of the focus was primarily on the firm profitability, thus the transaction made between a firm and the customer. Frequency, customer and monetary value are measurement to identify the degree of impact of the transactions on the profitability of a firm (Pansari & Kumar, 2017). As customers changed over time, so were the organizational goals of the firms. With the development of technological innovations, the relationship with the customer became more important. Prior research studies have shown that the focus shifted from transaction into the relationship (or loyalty), based on trust and commitment.
Morgan and Hunt (1994) viewed trust as “… existing when one party has confidence in an exchange partner’s reliability and integrity”. In their paper, they discovered that trust and commitment have a positive influence on the relationship between the firm and customer. As trust is considered to be the pillar of strategic partnership, consumers want to commit themselves to the relationship (Hrebiniak, 1974). Communication, in context of open, honest and frequent, is an important tool for trust to build a strong relationship (Berry, 1995). Berry future explains that customers who develop trust, reduce uncertainty and vulnerability and remain in the relationship. Of course, the opposite implies as well. Commitment is the long-standing willingness to orientate towards or maintain their involvements in the relationship with behavioural intent and psychological attachment (Rusbult, 1983). It exists when the relationship is important to attain the desired result. According to Hur, Kim & Kim (2013) commitment is known “… as the key component of maintaining long-term relationships”.
Contemporary in retail banking, investment in managing customers’ interactions and expectations (physical evidence, process and people) leads to retainment of customers over the long term (Carson et al., 2004).
All the previous mentioned literature, mostly focused on marketing, are the basis for customer engagement to exist. The verb “to engage” has several meanings according to the Oxford online Dictionary (2020), such as occupy, involve, participate or pledge. These words have all behavioural meanings. In the literature, there is no general definition of Customer Engagement. Pansari and Kumar (2017) describe it as an progress to the stage of engagement when the relationship is satisfied and has emotional bonding. While Vivek, Beatty and Morgan (2012) look at the intensity of an individual’s activities, which either the customer or the organization initiate.
A fairly new approach is the understanding of, determination of and measure up to the customers preference (Hahn, Metcalfe, & Rundhammer, 2020). Somehow similar is customer experience (CE), which is process-oriented satisfaction idea instead of an outcome-oriented. In the book of Schmitt (2003) is customer experience “… the process of strategically managing a customer’s entire experience with a product, service or a company”. In every step (or touchpoint) of the customer journey (process), the customer connects with the company by engagement for its experience. The framework of CE exists out of five steps: analysing the experiential world of the customer, building the experiential platform, designing the brand experience, structuring the customer interface and engaging in continuous innovation.
Creating positive experiences at multiple touchpoints in the journey will increase the performance of the company (Lemon & Verhoef, 2016). Nevertheless, customers’ desired service quality and experience are the pillars of financial success of banks. During the financial crisis, consumers expressed their negative experiences, which resulted in damage in the financial sector. To protect the bank’s financial sustainability, CEO’s are more aware of the need for long-term relationships to retain their customer base (van Doorn et al., 2010). By offering value-added services, improve service quality, functional quality, and security, customer experience will improve (Mbama & Ezepue, 2018). For this reason, is customer engagement, based on the previous mentioned literature, defined as ‘The
There are many models concerning customer engagement, like the cxLoyalty’s customer engagement model which provide a process starting at the interest of customers towards loyalty and their drivers (CxLoyalty, 2017). Others focus on the customer journey which concentrates on the experience of customer while interacting with the company (Følstad & Kvale, 2018). In this paper, the customer engagement hierarchy (CEH) model of Gallup is used, shown in figure 3 (O’boyle, 2019). These elements increase the level of customer engagement and go beyond standard customer satisfaction (Catlin, 2019). The factors provided from the literature are trust, commitment, investment and experience, which can be placed in this framework.
FIGURE 3
Resource Based View and Stakeholder Theory
Resource based view (RBV), introduced by Wernerfelt (1984), is a framework where resources can be a source of competitive advantage for a firm. A resource can be identified as “anything which could be thought of as a strength or weakness of a given firm”. Examples are brand names, in-house knowledge of technology, trade contracts, machinery etc. Diversification in resources has to be positioned where barriers can be built up, to make it directly or indirectly difficult for others to catch up (Wernerfelt, 1984).
Barney (1991) continued with the concept of RBV to identify firm resources to gain sustained competitive advantage. Firm resources include all assets, capabilities, processes, attributes etc. that improve efficiency and effectiveness of a firm. The resources can be tangible (physical assets) or intangible (like the relationship with a customer). To gain a sustainable competitive advantage a resource must be heterogeneous (each company has different capabilities), immobile (resources can’t be transferred) and comply with the four indicators of the VRIN-framework (Valuable, Rare, Imperfectly imitable and non-substitutes). A more recent view of the VRIN-framework is the evolvement into the VRIO-framework. The non-substitutes element is changed into organization, which is the ability of the firm to exploit the resource (Barney, 1995).
As the relationship with a customer is an intangible resource, the Stakeholder Theory could be integrated. The Stakeholder Theory is a theory of business ethics and organizational management that addresses values in managing an organization (Freeman, 2015; Lin, 2018). It shows the interconnecting relationships between a company and their stakeholders. Stakeholders are “any group or individual who can affect or is affected by the achievement of the organization’s objectives” (Freeman, 2015), divided into internal and external stakeholders. Internal stakeholders are owners, employees, and managers and external stakeholders are customers, investors, suppliers, and communities.
However, the RBV only focus on the resources inside the company to position itself in the market. It doesn’t consider forces from outside the company and what is needed according to the market. Secondly, the theory is missing segments on how firms cooperate on applying firm and customer resources together (Kim, Song, & Triche, 2015). Customers capabilities and resources are essential for the value in the service provider’s value proposition (Möller, Rajala, & Westerlund, 2008). Möller et al. (2008) express that providers should not only focus on their own capabilities and competitive advantages, but integrate clients’ experiences and capabilities.
Differently, the stakeholder theory considers only the internal and external stakeholders. The focus of the company lies in delivering value to the majority of the stakeholders to be considered successful. As the theory does not take all internal resources into account, potential benefits could be lost. Additionally, the theory is limited in pleasing all stakeholder simultaneously due to large and diverse groups and in power discrepancies between stakeholders (McGew, 2020).
Risk management can only be valued according to the VRIO-framework as the process can’t be viewed as a stakeholder. The different elements in the process are resources that improve efficiency and effectiveness of a firm. However, the model of Risk Management is general knowledge to the public and any company can use the same basis. The company has to improve and personalize the basis model in order to create a competitive advantage with the process.
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ESEARCH DESIGNFor this paper, a literature review has been done based on the philosophy of interpretivist. To create a broad view and an understanding on the matter, an interpretation of the already existing literature was needed. Many researchers have done literature or empirical research on factors of customer engagement and risk management in the bank industry, but the reverse way of customers influencing risk management hasn’t been done. An interpretation of their findings and possibly create new findings or perspectives, were necessary to answer the research question: “How does customer engagement affect risk management for firms in pension fund sector to gain competitive advantage?” The research question starts with “how does”, which implies a literature or inductive approach on the matter. The literature has been found by the search engine “SmartCat”, “EBSCO”, “Google Scholar” and “Business Source Premier”. Given the research question, I started with the three main topics to find archival data. I was searching for general qualitative information, like the description of the topic and how other writers view this terminology or possible frameworks. Used terminology was “Risk”, “Risk management”, “Customer”, “Customer bank industry”, “Risk management in bank industry”, “Negative Interest Rate” etc. Before I started to read an article, I read the abstract to find the essence of the paper, keywords (if it was related to my research) and writers (to find possible relationship or contradiction).
While reading their articles, reports or working papers, different perspective, typology, factors or research came forward. Some were relevant to use in this article or to investigate more, while others were useless. When compiling the literature on the topics, I was narrowing down the definition and function of the topic, to build to a strong argumentation on the matter. Different terminology was being used in the search engines like “Customer engagement”, “Risk management process” and “Customer experience”.
A
NALYSISThe process of Risk Management consists out of 4 steps; Risk Identifying, Risk Assessment, Risk Strategy and Risk Evaluation. Risk is the probability of the event occurring multiplied with the consequence of the event (Kouns & Kouns, 2011). The process starts with the identification of the certain risk. As the risk is being identified, a Risk Assessment must be executed to determine the probability and consequences of the risk. Then, policies and procedures are being developed in the Risk Strategy element and being evaluated in the Risk Evaluation. The outcome of successfully integrated this model is customer retention and cost reduction, which could lead to a competitive advantage for the firm.
Risk Identifying is the first element, where resources are used to find the potential risks associated with the event. Risk Assessment is the second element, where resources will determine the probability and consequences of the risks. For Risk Assessment to occur, the risk has to be identified first. Customer Trust is “… existing when one party has confidence in an exchange partner’s reliability and integrity” (Morgan & Hunt, 1994). The results of the Risk Assessment will be better, when customer trust has a positive relationship on the Risk Identifying to Risk Assessment causality. Trust is the critical factor for developing confidence as the base in the Costumer Engagement Hierarchy model of Gallup. It can’t be transferred as it is based on the exchange of reliability and integrity. Therefore, it reduces the degree of potential risk in the Risk Assessment, because trust reduces uncertainty and vulnerability (Berry, 1995), and is considered to be the pillar of strategic partnership (Hrebiniak, 1974).
Secondly, Customer Investment is the customers’ interactions and expectations (physical evidence, process and people) of provided services (Carson et al., 2004). The results of Risk Assessment will be better, when Customer Investment has a positive relationship on the Risk Identifying to Risk Assessment causality. Investment is the component for developing the second level “integrity” in the CEH model of Gallup. When the organization treats the customer fairly, it is investing in the service to reduce risk and increase financial success (Andaleeb et al., 2016). Therefore, it reduces the degree of potential risk in the Risk Assessment, because customers will invest more in the relationship.
H2: Risk Identifying delivers a reduced degree of potential risk in Risk Assessment when Customer Investment is present.
Risk Assessment is the second section where resources will determine the probability of the risks associated with the event. Risk Strategy is the third element of the Risk Management process, where policies and procedures are being developed into an action plan to deal with the risk. Action plans can only be created when the probability and consequences of the risk are defined.
Customer Commitment is the long-standing willingness to orientate towards or maintain their involvements in the relationship with behavioral intent and psychological attachment (Rusbult, 1983). The outcome of Risk Strategy will be better, when Customer Commitment has a positive relationship on the Risk Assessment to Risk Strategy causality. Customer Commitment can lead to the third level in the CEH model of Gallup, where they are proud to be a customer. By respecting and providing encouragements towards customers, customers will commit to the organization and become loyal. Therefore, it increases the possible customer retention strategy, because for customers the relationship is important to attain the desired result.
Risk Evaluation is the fourth element of the Risk Management process. The taken actions of the Risk Assessment element needs to be identified and examined. By doing so, challenges and / or successes will be found for the continuation of the action plan and possible appliance in other areas. Risk Evaluation can lead to Customer Retention, when the evaluated action plan has more successes than challenges.
Customer Experience is “… the process of strategically managing a customer’s entire experience with a product, service or a company” (Schmitt, 2003). Customer retention will increase, when customer experience has a positive relationship on the Risk Evaluation to Customer retention causality. The journey for the customer is the key element. The customer connects with the company by engagement for its experience at every step of the process. This could lead to the final level of the CEH model, passion. By engaging with the customer for continuous interaction and creating innovation, the customer feels passionate for the company. Therefore, it increases customer retention, because the process is turned into a process-oriented satisfaction idea instead of an outcome-oriented.
H1 + H2 + H3 + H4 +
C
ONCEPTUAL MODEL Risk identifying Risk assessment Risk strategy Competitive advantage Customer trust Customer investment Customer commitment Risk evaluation Customer experience CustomerC
ONCLUSIONIn this paper the theoretical impact of customers engagement on the risk management process has been examined in context of the pension fund sector. Prior research has been conducted about the concept of risk management and customer engagement, but the impact of customer engagement on risk management in the pension fund sector was an unknown area. In a customer-centric society, customers engagement can deliver a competitive advantage in order to be the success of the banks’ performance. From this perspective the following research question has been established:
“How does customer engagement affect risk management for firms in pension fund sector to gain competitive advantage?”
In the previous chapter, four hypotheses are identified and analysed on grounds of the literature review. Based on the analysis, the factors of customer engagement, trust, investment, commitment and experience, have an impact on different elements in the risk management process. In order to create a competitive advantage, customers should be integrated as a stakeholder and a resource. Of the four factors, trust and investment must be in place first to have an effect on the risk management process. The two factors are connected with the base and second level of the CEH model to reduce the degree of potential risk. In order to perceive a higher level of customer engagement, commitment and experience can only be present when the first factors are applied. Therefore, the following two hypotheses are acknowledged:
H1: Risk Identifying delivers a reduced degree of potential risk in Risk assessment when Customer Trust is present.
The relationship between the company and customer is the most important element. Companies should map the overall risk management process before including the factors of customer engagement. Establishing a relationship with the customers is valuable for the success of the company through the creation of shared value and risk reduction. By integrating the different factors of customer engagement, the foundation of the CEH model will be build. Managing and maintaining the relationship is a challenge for most companies, but necessary for their survival. Including customers as stakeholders and as a resource results into customer retention and costs reduction, which leads to a competitive advantage.
Theoretical discussion
As a reflection on the theoretical use of literature in this paper, it has provided the base for customer engagement and risk management. The compiled framework sets the base and needs to be altered into the context of the specific task. Other sources on the matter could have been used for a deeper understanding of the theory or a different insight. The choices represent the outcome of the paper, even though a different understanding could be found.
Limitations
Future research
There are a number of gaps in our understanding concerning customer engagement in risk management. This would benefit from future research, including evaluation of theory and testing that has been established here:
1. More methodological research on different models and approaches concerning customer engagement and risk management. Other theories could provide a broader understanding and provide a more cohesive model to gain competitive advantage;
2. Empirical research to provide the analytic justification of this theoretical paper;
3. In-depth exploration of how the factors of customers engagement can be implemented into the risk management process. Future research might give a better understanding of critical touchpoints in the relationship;
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