The past five years have seen some of the most troubling financial times that the world has experienced for nearly a century.
Banking is arriving on a new playing field
Countries, and banks, across Europe have borne the brunt of these challenges, with several requiring bail outs and with many others experiencing double or even tripledip recessions. The problems were caused in part by regulatory weakness, as a British House of Lords report(1) published in 2008 illustrates: ‘The consensus is that global macro-economic imbalances and financial innovation – which amplified the consequences of excessive credit and liquidity expansion – together with failures in regulation, supervision and corporate governance, combined to cause the financial crisis’.
As a result, the banking industry faces game-changing regulations, based on a fundamental review of financial market risk and driven by an updated international consensus, covering both the scale/scope of banking businesses, and the related aspects(2).
Significantly increased expectations from both regulators and capital markets are appearing, even as banks struggle with a range of commercial challenges. As well as dampened market growth rates in developed markets and increasing macrovolatility, ongoing challenges include:
? Heavy financial losses and past burdens, such as large portfolios of non-performing loans (NPL) and goodwill to be depreciated.
? Costs from cutting staff, organisational restructuring, and compliance with new regulation and reporting obligations.
? Substantial jurisdictional risks from increasing willingness to account for past faulty actions. In Europe, this has translated into about EUR 7bn(3) in lawsuits since 2009, a large part of which has been paid.
? Despite capital injections of some EUR 850bn, net Tier-1 Capital is only about EUR 495bn and a further EUR 350bn of capital appears to be required to assure market liquidity (given the same assets).
? Nation states have been subjected to recessive tendencies, with heavy effects on credit quality and the need for impairments/ allowances on balance sheet values.
? Reduction of inter-sector exposure and the run for customer deposits are keeping refinancing conditions highly competitive.
? New trade finance players such as insurers, new intermediation channels and alternative routes to market, as well as ICT/ mobile payment players like PayPal(4), Amazon(5) and even Bitcoin(6), are all unwelcome distractions.
? While banks currently benefit from looser European monetary policy in terms of liquidity, this drives lower interest margins and interferes with market mechanisms, delaying a shakeout of weaker organisations.
The profitability challenge for banks
Based around an altered economic–political consensus covering the role, scale and scope of banking businesses and associated state liability, both pan-European and national regulatory bodies are evolving, from hands-off rule-setters to more proactive monitors of good governance.
The resulting regulatory set-up builds in more stringent supervision and restraint of banking businesses, following newly accepted norms, such as:
? enhanced risk awareness (easing of systemic underestimation and underpricing);
? reduced potential state liability and/or moral hazard;
? lowered leverage and size of banks, to reduce systemic importance of single market entities;
? reduced interdependencies within the sector, to enhance stability of financial markets;
? decoupled dynamics between financial markets and real industry;
? eliminated unregulated business activities;
? refocused business scope towards ‘vintage banking’;
? increased transparency and reporting obligations.
The asset side of the balance sheet faces increased capital requirements to assure liquidity (including higher requirements
on quality of equity), while refinancing challenges on the liability side require a root-and-branch review of refinancing patterns. At the same time, banks are not only looking to manage their own funds, but also to attract equity holders in this increasingly competitive, margin constrained market. As intra-sector liquidity transfer is reduced, the need to balance the structural congruency between assets and liabilities has a dampening effect on innovation, particularly around lending.
The resulting, more conservative attitude to risk-taking and refinancing puts pressure on margins, characterised by:
? larger liquidity, which bolsters a scarcity of liquidity and increased opportunity costs;
? heightened market discipline, therefore structural repricing in debt and hybrid refinancing;
? a run on deposits, due to preferential regulatory treatment, which drives more competition and lower interest margins;
? higher margining and standardisation in over-the-counter derivatives businesses;
? a variety of asset reallocation incentives from capital regimes that favour lowyield instruments, such as government bonds;
? reduced-term transformation.
The overall impact on the sector – to weaken the ability of banks to act as intermediaries for monetary transmission – is causing a shake-up that is nowhere near finished. The extraordinary aid provided by national governments (bail outs) may have delayed the market adjustment process, but this is only temporary and it muddies the waters, making it hard for banks to set clear strategies and stick to them. We are seeing a number of consequences across Europe:
? Money demand is suffering from credit rationing and repricing (i.e. tightened lending standards) due to the risk aversion of banks.
? Money supply is also facing a market environment with more or less distressed conditions regarding capital markets’ refinancing.
A good question to ask is, ‘To what equilibrium of risk/return levels can banking businesses return compared to the past?’ This discussion is ongoing in the banking industry – not least because, thus far, banks are seeing very little return on their equity(7) and are a long way from earning what equity-holders expect. It is our view however that the inferior risk/ return relationship in banking will persist for some time yet. With regulation as the most important driver, banks are finding it increasingly hard to return their costs of equitywhile faced with more conservative risk attitudes and eroding margin structures.
Options for cost efficiency and profitability
With increased refinancing costs, dampened sales, and growing competition and regulatory momentum, banks face a severe dilemma of having to be riskaverse to conform with regulation and rating agencies, which erodes sales potential as a result, leading to a drop in investor confidence and the banks’ valuation.
Until recently, banks have generally been levering down (through the increase of capital and the reduction/realignment of assets) and cutting costs: they have been acting in a more risk-averse and defensive manner. Internally, banks also face a ‘cultural challenge’ to find a balance between incentivising (at times, extremely) high yields for banks, and minimising the
consequent risks faced by society as a whole.
So, how can the industry balance primarily risk-oriented drivers for contraction with profit-oriented drivers for growth, to comply with the competing demands of regulators and investors? The most obvious option is to look for efficiency savings.
Increasing cost efficiency through economies of scale
In order to increase profits in an environment of higher refinancing costs and lower scale, either costs must be reduced and/or costs have to be passed on disproportionally to customers. To put this in context, it is important to acknowledge pre-crisis sentiment – banks felt they had to become larger in order to reduce costs.
Post-crisis regulation and economic policy unfairly restricts larger banks and international expansion, however. This contradicts elementary economic principles and notions of profitability – usually businesses strive to grow, to increase market share and achieve economies of scale.
But what happens in reality? Does size matter in banking, are larger banks more profitable? We can turn to our research to answer this question, using ‘cost-to-income ratio’ (CIR) to represent the operational profitability of a bank, measured as: (operating costs)/ (operating income before provisions for credit risks)
Despite its currently low profitability, we should not expect the banking market to clear up rapidly – monetary policy is impeding competition and delaying any such shakeout. At the same time, we acknowledge that the relation between size and profitability is not so evident. So, where else can cost efficiency be found? Should banks look at reducing their footprint?
Increasing cost efficiency through cost reduction
Given that scaling up is not a valid option for cost efficiency, banks are looking at how they can improve profitability by reducing costs from their own internal structures. Due to the relative significance of staffing and branch networks on banks’ balance sheets, they both present likely candidates for cost reduction.
Considering staff reductions (CIR vs assets per employee)
First, this is due to the structure of higher-levered business models – managing money does not have to be labour intensive. Equally, there is no clear evidence that retail businesses benefit significantly from such measures; meanwhile, lay-offs introduce severance payments and can cause restructuring costs, which reduce any benefits from such a policy and potentially affect income. As a result, based on this research, we do not consider lay-offs to be a significant cost-efficiency lever.
Considering branch consolidation (CIR vs non-staff operating costs per branch)
CIR appears to decrease with non-staff operational expenditure per branch. So branch consolidation or streamlining could be a powerful means to reduce CIR. While this may be true, banks would be wise to consider branches in terms of their broader strategies, for example to act as sales channels for new products(8) or offer direct contact points(9). Banks have an increasing number of options for service provision – including, for example, the provision of services via post offices or petrol stations as well as via online and other digital channels – so branch consolidation decisions should take place within the context of a broader, crosschannel strategy.
The bottom line is that cost savings can be made from infrastructure reduction, but not necessarily from people. Equally, while cost reduction can be seen as a necessary adjustment process in the short term, it can neither counter the effects of weakened income streams, nor provide an ultimate remedy for growth.
Banks must put their best foot forward
New, innovative, higher-value products offer increased margins and therefore a greater opportunity for growth. But where can this innovation come from? Based on our experience of working with banking clients we recommend five main actions (see figure 1). Each one has different levels of sustainability and business impact, starting with improving the cost structure and leading eventually to innovation itself.
1. Improving cost efficiency
The lowered risk/return relation in banking businesses increases cost pressure and facilitates the need for gaining operative efficiency. More than ever, banks must challenge existing cost structures in order to stabilise operating profits.
Challenging existing processes and cost allocation often proves beneficial to cost efficiency as it enables resources to be more appropriately targeted. One option is the outsourcing of non-critical business processes – but this requires a comprehensive view of existing processes, to permit identification of processes (or process elements) that can be outsourced meaningfully.
Proposition: Employ cost reduction as an effective strategy, but recognise it is not an answer to all problems.
2. Standardisation and/or industrialisation
The cost problem needs to be handled strategically. To make a real difference, banking businesses need to address their often-quoted lack of standardisation in terms of processes, products and infrastructure. Where such activities have been started (for example, in standardised product areas), they can be built on with further streamlining of processes and infrastructure, enabling better use of automation.
The goal of such initiatives should be to deliver more process-oriented and modular structures, as these enable individual elements of the operative service-chain to become more scalable, predictable and cost-efficient, resulting in higher productivity and faster time to market. Moreover, self-contained, modular business models can evolve – such initiatives lead, finally, into the refinement of the business model focus and the revaluation of the vertical range of integration.
Proposition: Process orientation and a modular approach enables specialisation and allows for further business model transformation.
3.Product portfolio optimisation – diversification
Besides risk management improvements, the broadened and more stringent nature of regulation implies margin pressure on many banking businesses. Diversification offers a route to continued stability of profits, and therefore reduces overall business risk, particularly for private banks and savings organisations.
In response, banks can first assess the effects of regulation on different businesses in order to understand the nature of their existing portfolios. This provides a foundation to adjust portfolios with a view on their own core competencies.
Proposition: Revaluation and optimisation of the product portfolio is a necessary reaction to regulatory pressures.
4. Embrace opportunism – even regulation can yield new products
The dynamically evolving regulatory environment does not only affect margins. It transforms business dynamics in many banking industries, and impactson processes and their costs, IT and otherinfrastructure. While this creates challenges for the sector, it opens up opportunities for new products and services to be created.
Banks in a position to respond to the changing market ecosystem through faster product time to market may be able to steal a march on the competition. This does not have to be about ‘pure’ innovation – rather, understanding the market direction and reacting accordingly, which may even help to drive the reorganisation of the market itself.
Proposition: Use the new regulatory environment as a basis for new services and business cases – engage proactively with new regulation to identify underserved opportunities.
5. Business innovation means going beyond traditional market areas
Every industry has a tendency to commoditise, so it is up to banks to keep ahead of the competition. Ultimately, banks wishing to survive in the long term will have to create new products that add significant downstream value to their customers.
Increased specialisation, well-defined modularity, more flexible processes and appropriately standardised interfaces all provide a foundation for business and product innovation. This includes business processes running across company borders, with both internal and external service virtualisation and open innovation – opening up services so that other can build on them.
Proposition: Develop the income side of the business by creating new, highmargin products focused on reaching new markets.
Not consolidation, but reorganisation of (transindustrial) value chains
While banks struggle to act as a channel for monetary transmission, even as regulations and monetary policy evolve in kind, this climate stimulates alternative intermediation channels that gain ground through technological innovation and operation in less regulated areas. Examples include:
? Increasing emergence of new players in sales financing – large corporations that accumulate large financial reserves and have good credit standing can increasingly compete in refinancing conditions. Automotive firms even securitise and sell these credits, so they do not have to refinance them with their own credit standing.
Competition from ICT players, which increasingly penetrates payment-handling aspects of the banking business (mobile payments, for example), which accumulates deposits as a result (e.g. PayPal).
? Insurers investing in new financing vehicles, such as credit funds (a new trend in Germany/ Continental Europe) thereby augmenting or even eliminating banks as financial intermediaries.
? Online retailers are testing their own currencies – for example, Amazon(10).
? ‘New’ currencies are emerging, such as Bitcoin(11).
So, what do banks of all shapes and sizes need to do to start on the right foot and strengthen their market positions? The answer cannot be to ignore or to fight against such developments. While the involvement of new players may be seen as a risk to the traditional banking industry, it also creates a significant opportunity – to engage with lateral industries and use integration points to develop the higher-value, higher-margin products that both industry and customers need so much.
To engage with this opportunity requires banks to open up. In practical terms this means:
? Making business processes, business models and internal value chains more open for innovation.
? Reviewing sourcing strategies, and engaging more directly in external partnerships and value chains to add value to commodity products.
? On a technological level, opening APIs to existing systems and working with open-data platforms, while looking at new advances in technology – some refer to this as ‘open innovation’.
? Focusing on customer interaction and how services can be enhanced to increase customer value.
Overall, these are simply enablers or prerequisites for the bigger goal – to put banks into a position where they can join a broadening, diversifying ecosystem of networked organisation and dynamic value chains. From our perspective this means looking outward, to learn from other industries that are more advanced in process automation. Like it or not, the banking industry is far behind in this endeavour. In order to move forward, banks need to rebalance the banking agenda at a strategic level and change their behaviour from within.
Delivering a foundation for growth
There is currently a sea change occurring in the banking industry. Banks can no longer act in isolation on the principle that bigger is in some way better. We know from our research that this is not the case. Meanwhile markets and customer behaviours are getting increasingly dynamic, so banks have to make the decision as to whether they respond to this new context.
From our research we recommend five actions, which lead from dealing with the immediate issues to delivering a platform for innovation and growth:
1. Employ cost reduction as an effective strategy, but recognize it is not an answer to all problems.
2. Process orientation and a modular approach enable specialization and allow for further business model transformation.
3. Revaluation and optimization of product portfolios are necessary reactions to regulatory pressures.
4. Use the new regulatory environment as a basis for new services and business cases – engage proactively with new regulation to identify underserved opportunities.
5. Develop the income side of the business by creating new, high-margin products focused on reaching new markets.
In order to respond to the structural profitability challenge, banks will have to find new answers by innovating and creating customer value. Technological advancements offer new business opportunities for agile/dynamic players across industries – while other industries have continuously reinvented themselves, the banking sector has remained backward and now lags far behind.
1) ‘The future of EU financial regulation and supervision’ Parliament, House of Lords, London, UK, web, European Union Committee, 14th report of session 2008-09, 17/06/13, http://bit.ly/13TcYFa
2) ‘Financial Transaction Tax under enhanced cooperation: Commission sets out the details’, European Commission, Brussels, Belgium, web: press release, 14/02/13, http://bit.ly/11puKfu. Contacts for further information: Emer Traynor and Natasia Bohez Rubiano.
3) In this paper, and other BearingPoint Institute literature, short scales are used for large numbers, i.e. one billion is one thousand million, 109.
4) ‘PayPal gets a global boost but eBay sinks on weaker guidance’, Trefis, Boston, MA, USA, web, Trefis team, 18/07/13, http://bit.ly/13YBPHF
5) ‘Business | Amazon launches its own currency to make it easier to spend on the Kindle’, Wired, New York, USA, web, Sarah Mitroff, 02/06/13, http://bit.ly/1aDNFpq
6) ‘Finance | Markets | Why Bitcoin prices are stuck in a holding pattern’, businessinsider.com, Business Insider, New York, USA, Rob Wile, 18/07/13, http://read.bi/18v1ENE
7) ‘Banking isn’t working’, Euromoney, London, UK, Peter Lee, 04/11, http://bit.ly/fHeAzq
8) ‘Can cross-channel offer Europe’s retailers a more certain future?’, BearingPoint Institute Report, Issue 003, London, UK, Kay O Manke, 09/13, http://inst.be/003XCR
9) ‘Crédit Agricole’s app store: co-creation accelerates the cooperative into digital era’, BearingPoint Institute Report, Issue 003, London, UK, Michel Goutorbe interview, 09/13, http://inst.be/003CAS
10) ‘Business | Amazon launches its own currency to make it easier to spend on the Kindle’, Wired, New York, USA, web, Sarah Mitroff, 02/06/13, http://bit.ly/1aDNFpq
11) ‘Bitcoin – Open source P2P digital currency’, Bitcoin, USA, web, date accessed: 07/08/12, http://bit.ly/160zE1Y