4 minute read 10 Feb 2020
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How banks can free up capital to invest when profits are weak

Authors
Jan Bellens

EY Global Banking & Capital Markets Sector Leader

Passionate leader on innovation in financial services, especially in emerging markets. Global citizen. Keen traveler.

Karl Meekings

EY Global Banking & Capital Markets Lead Analyst – EY Knowledge

Believer in a progressive and purpose-led banking sector. Interested in the future of banking. Germanophile. Medievalist.

4 minute read 10 Feb 2020

In 2020, banks will face a trifecta of challenges - cutting costs, investing in transformation and managing the risk on their balance sheets.

This article is part of our Banking in the new decade series.

The EY annual analysis of the world’s top-performing banks – those that consistently deliver return-on-equities (ROEs) above their cost of equity – reveals that high achievers know the importance of cost leadership.

Between 2016 and 2018, the largest 200 banks globally reduced their cost base by approximately 5% on an inflation-adjusted basis. Most of these savings came from low-hanging cost optimization opportunities, which are now maximized.

But, costs continue to rise faster than revenues and achieving further efficiency gains will be difficult in 2020, which analysts predict to be a challenging year for banks. COOs must think differently about how to rapidly cut costs to both boost profitability and free up investment for the next wave of digital transformation. Four areas of focus can help guide efforts.

COOs must think differently about how to rapidly cut costs to both boost profitability and free up investment for the next wave of digital transformation.

1. Focus on marginal costs

Why do banks that have long focused on cost reduction still invest heavily in nonstrategic areas, such as know-your-customer (KYC), legal and financial crime?

For most banks, it’s because cost indicators are set against budget outlays; and cost reduction targets are set against parts of the business with the biggest budgets, rather than being focused on productivity. This means banks continue to own these non-core and non-value-adding activities, which increase the overall complexity of the organization. In essence, banks typically focus on reducing 4% of 50% of the cost base, rather than 90% of 4% of the cost base.

Instead, banks must build a clear view of what’s value accretive, and what isn’t, and the basis for that should not just be the budget required for the activity. Simply because an activity is less costly does not mean it creates more value. For banks to identify the right value accretive activities, they need to strike a balance between rationalizing the denominator (input cost) and optimizing the numerator (output value).

The core elements of driving a value focus will include defining the right metrics, developing measurement frameworks to identify and assess the potential value and cost of opportunities, and establishing strategies to deliver on opportunities.

But, doing this can be challenging. While a benefits case may seem clear, the implicit impact on the organization may not be, due to a lack of adequate metrics and frameworks. Building this understanding requires banks to consider all dimensions together, including financial resources, physical assets, data and people. It requires more granular data on additional costs (both direct and indirect) attributed to the growth opportunity. It also requires an understanding of the existing operations of the banks and additional complexity that an opportunity or investment could bring.

Banks that do this well make it an ongoing priority. One leading Taiwanese bank has set up a designated unit focused on continually re-examining operations to find opportunities to improve and streamline.

2. Reassess non-strategic activities

Outperformers rapidly reduce costs to create capacity to innovate, even in challenging market conditions. Many do this through outsourcing, use of an industry utility or managed services, which can be a more effective and value-adding way to run non-core but critical activities. Another option is moving non-value adding products and services to third-party vendors or automating them, cutting unprofitable products or collaborating with specialist providers to deliver those services that are critical to your client, but which you can’t deliver profitably.

For example, investment banking divisions can free up capital by automating manual processes within post-trade, reducing siloed collateral management, and leveraging the right partners to improve strong data quality and reduce inconsistent trade representations and overall business risk. 

3. Stop the leaks

The more complex an organization’s processes, the more likely it is that revenue is leaked. This can occur particularly post-merger, after frequent system changes, and complex integration processes. Within retail banking, we see leakages across the product set, but especially in areas such as current accounts, credit cards and consumer credit or with bundled products, where fees are not consistently charged.  These leaks can be small at an individual level but add up to a significant loss – we’ve seen banks lift their revenues by double-digits just by applying rules correctly.

Beyond stemming the leaks, banks must be sure that every product set and every client is adding to the bottom line to maximize revenue generation.

4. Prioritize legacy system challenges ahead of innovation

Banks cannot maximize returns on their investment in digital channels without first addressing challenges around legacy accounting and booking systems, data reconciliation, and a common view of the customer. These challenges include an inability to run in real-time, which stymies the development of the new services and experiences customers demand. Nearly 50% of banks do not upgrade old IT systems as soon as they should, according to a recent report by the UK’s Financial Conduct Authority (FCA)1.

Only once the legacy issues are addressed can the industry adopt a more agile approach and lean thinking for investment allocations, and have a DevOps approach to implementation. To achieve this level of agility, decisions need to be made quickly, and the level of bureaucracy and ideation to implementation and delivery timelines should come down. Other drivers which will enable agile decision-making are the simplicity of the organization and strong internal technology.

Today, most banks are better prepared than they were a few years ago to build a simpler, agile and future-ready organization, but need to create capacity to continue to invest in transformation initiatives. Fixing these key issues first will lay the groundwork for later investment in innovation and create a more effective and resilient organization in the long-term.

Invest now to prepare for the upswing

Creating capacity to invest will be critical for banks in a challenging operating environment. If profitability declines, the investment that can be committed to transformation initiatives will be limited, placing an institution at a disadvantage to competitors. Catching up is likely to be costly. Those that emulate high-performing banks to drive new efficiency measures now can free up the capital that allows for investment in transformation at the bottom of the cycle – ensuring they are well-positioned for success in an upswing.

Summary

COOs at high-performing banks know that how you cut is just as important as how much. In 2020, banks that focus on reducing marginal costs, stemming revenue leakage, and making sure every product (and client) adds to the bottom line will be best positioned to fund investment in transformation. 

About this article

Authors
Jan Bellens

EY Global Banking & Capital Markets Sector Leader

Passionate leader on innovation in financial services, especially in emerging markets. Global citizen. Keen traveler.

Karl Meekings

EY Global Banking & Capital Markets Lead Analyst – EY Knowledge

Believer in a progressive and purpose-led banking sector. Interested in the future of banking. Germanophile. Medievalist.