8 minute read 22 Oct 2020
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Will your cost transformation drive long-term value or short-term savings?

By Tom Groom

EY Global Client Service Partner

Corporate finance professional. Enjoys running. Father of three wonderful children.

8 minute read 22 Oct 2020

COVID-19 has increased pressure on financial services (FS) entities, but also shifted perceptions of the possibilities for strategic change.

In brief
  • The COVID-19 pandemic has increased earnings pressure on FS organizations, but also shown how quickly and effectively businesses can respond to new challenges.
  • Investors are looking for cost transformation strategies that move beyond incremental improvement.
  • To deliver cost strategies that win stakeholder support, management needs to analyze performance, opportunity and perception gaps – and tell a clear story.

After the last financial crisis, the need for financial services (FS) organizations to do something different seemed clear. The struggle to deliver earnings indicated a need for radical change, whether through consolidation or strategic restructuring. Aside from geographical retrenchment and widespread deleveraging little strategic change occurred. Management focus on global structural reform, concern about execution risk and the broader regulatory agenda impeded meaningful action and taking tactical bottom up action was enough at the time to make a difference.

Now the COVID-19 pandemic has relit the fuse under strategic innovation. By way of example, based on EY analysis, a quarter of UK-listed FS companies issued profit warnings between January and the end of July 2020 – equivalent to a 133% year-on-year increase. The majority cited the impact of the COVID-19 pandemic.

The current environment is highly challenging. Financial services entities are operating in a world of low interest rates. Many clients – whether individuals or corporates – are experiencing financial distress, leading to increasing impairment levels and business interruption claims. The inevitable result is a more intense focus on cost: with income and impairment metrics moving adversely, cost is the main lever that leaders can pull. To illustrate the severity of the situation, we estimate that European FS organizations will need to reduce their cost bases by 25% to 50% simply to maintain their current cost-to-income ratios.

Another big shift as a result of the COVID-19 pandemic is that the possibilities for transformation – what FS organizations can potentially achieve – has been reframed. It would previously have been inconceivable to enable the entire workforce to work from home, to launch new stimulus related products within days, or to onshore previously offshored operations overnight. But faced with the necessity to keep staff safe, maintain productivity and fulfil their role in the economy, FS organizations achieved these amazing things.

So in the aftermath of the COVID-19 pandemic, management teams face a much tougher cost challenge, but have a wider set of possibilities to consider when deciding how to respond. The vision of what can be done has materially changed.

The need for strategic cost transformation isn’t new, of course. Cost-to-income ratios have been an issue for some time, with investors and analysts dissatisfied with the performance of some FS organizations. But in this new environment – where the challenges are bigger but so are the possibilities for change – continuing to “chip away” at costs will no longer suffice. FS leaders need to approach the cost/income equation in a new way.

Understanding market context

Firstly, it’s important to understand your organization’s cost performance in the context of the market. How do your cost-to-income ratios compare with peers? Where are the ratios trending, based on the economic cycle? What are other entities doing to improve their own cost performance?

Gaining insight here lays the foundation for vital gap analysis focusing on three key areas: performance, opportunity and perception.

Identifying performance gaps

Given that all organizations have been focused on cost reduction for some years, it’s a valuable exercise to review the success and impact of past programs. FS entities have implemented various programs involving perhaps improved technology, platform replacements, cloud migration or product rationalization. Were the original goals achieved, or did obstacles along the way result in revised ambitions and more limited achievements? Was any money left on the table?

Even where programs were considered successful in terms of meeting program objectives, the maximum impact may not have been realized: your organization may not have followed through with the wider consequences of these change programs. Did teams subsequently change the way they worked? Were people redeployed into new areas to drive growth? Were suppliers rationalized?

Reflecting on past achievements and frustrations can improve understanding of the type of program your organization can deliver successfully. This insight can be usefully applied to future cost-related programs and when assessing opportunities for future performance improvement.

Moving on to your opportunity gap

Understanding your organization’s opportunity gap involves focusing on how to align its resources most effectively in order to maximize its potential. This means assessing the business across three core lenses: strategic, structural and operational. These are the three key levers that management can pull in order to improve cost-to-income ratios.

From a strategic perspective, is your organization operating in the right markets? Should it have a presence in all its current country locations? Is it targeting the right clients? Are we in the right lines of business? Is the product portfolio too big or too small? Does the business need to scale up in some areas in order to improve its return on its cost base? Is it so sub-scale that exiting the market would be a better bet?

Alongside these big strategic issues, there are also structural questions to consider. Do we need to add or remove capabilities to deliver the strategy? Does the organization have the most appropriate legal entity status and capital structure? Is its organizational structure still fit for purpose? Where are operations established? Is there scope for more offshoring or are there good reasons to bring more activities onshore? This is a particularly pertinent question in light of the resilience challenges experienced during the COVID-19 pandemic by some captives and outsourced services providers in lower cost locations.

The third – operational – lever looks at how the organization does what it does. Are there processes that could be redesigned or automated to improve efficiency? What benefits could be gained from increased digitization of data? Could the business work with suppliers in new, more flexible ways?

Pulling the strategic and structural levers will require senior executive sponsorship, and potentially regulatory approval, whereas operational levers will be available to all COOs and heads of function.

Addressing the perception gap

The perception gap is arguably the most important of the three “gaps” in the current environment – reflecting the rapid and dramatic changes resulting from the COVID-19 pandemic. Last year’s strategy based around a three-to-five year cost target may no longer meet investor and analyst expectations. Strategies based around ongoing incremental and steady improvement in cost-to-income ratios are unlikely to impress – not least because, after years of cost cutting programs, further significant improvement may be hard to achieve. Even where FS businesses have made progress in reducing costs, the goal posts have moved. Stakeholders know that the possibilities for substantial and rapid change have increased – and that the pressure for change has also risen. They are looking for a more inspirational message than one of gradual cost reduction.

CEOs and CFOs need to articulate how they are planning to transform their cost base strategically. They need to be transparent about their current position and what they are aiming to achieve.

If the right strategy is no longer about simple cost reduction, the story that CEOs and CFOs tell will likely be more nuanced than in the past. An alternative, new strategy may be anchored in scalability (ensuring that costs don’t grow in line with income) or flexibility (ensuring greater resiliency rather than single operating model or supplier reliance) or transparency (simplicity, ensuing appropriate understanding for all stakeholders or investors) in addition to the traditional anchor of ‘reduction’.

Addressing the perception gap essentially involves reframing the organization’s cost performance goals. It requires clear and coherent explanations of why these new goals make sense and how they will be achieved. New yardsticks for assessing progress will need to be established. If the core goal becomes scalability, strategic replatforming, or cloud migration may be the best indicators of positive momentum. If management want to build a more flexible business, evidence of the nature of outsource arrangements and the ability to hire talent in a more fluid way could indicate success. The financial impact of such changes may not be revealed quickly in financial statements, so their value will need to be communicated clearly.

Extracting maximum value

Extracting maximum value from these cost strategies isn’t just about sound program management or the use of clear key performance indicators. It’s as much about evolving the roles of all members of c-suite.

Extracting maximum value in terms of market credit depends on generating understanding of and support for the new cost strategy. COOs will therefore have a key role in the story-telling process, helping CFOs, and CEOs to tell the investor story. They still need to ensure that programs to increase cost transparency, flexibility and scalability are being implemented appropriately. They still need to monitor progress and measure success. But they will also need to ensure that investor relations and senior executives can deliver powerful analyst presentations that convey the coherence, subtlety and detail of the new cost strategy – making sure they can talk about “what” the cost base is as much as “how much” the cost base is.

Summary

FS businesses have been under pressure to improve cost ratios for years. The COVID-19 pandemic has made strategic cost transformation even more important, but also shown what can be done at times of crisis. FS organizations need to take another look at cost strategies, understanding that goals based around gradual cost reduction may no longer satisfy investor expectations. They need to understand market context, before undertaking key analysis of past performance in cost reduction programs and looking for new opportunities. Communicating new cost transformation strategies clearly is then vital for addressing any stakeholder perception gaps.

About this article

By Tom Groom

EY Global Client Service Partner

Corporate finance professional. Enjoys running. Father of three wonderful children.