After a decade of retrenchment, it remains unclear whether banks have adjusted their business models and operating infrastructures to the realities of the post-crisis landscape. Cost-cutting pressure on banks is unrelenting, forcing them to consider new approaches to improving back-office productivity and efficiency. Fortunately, technology offers new opportunities for banks to pool resources and expertise, thereby mutualizing and minimizing operating costs and risks.
After a decade of reform and retrenchment, the banking industry is on more secure footing. Balance sheets and capital levels increasingly reflect regulators’ desire to minimize systemic risk. But it is less clear whether banks have adjusted their business models and operating infrastructures to the realities of the post-crisis landscape. In many cases, the ghosts of the past continue to hamper efforts to cut costs and improve efficiency to the extent required to accommodate lower margins. Nevertheless, technology offers new opportunities for banks to pool resources and expertise, thereby mutualizing and minimizing operating costs and risks.
In June, the Federal Reserve confirmed that all 34 major US banks had passed its latest round of stress tests, enabling them to resume dividends and stock buybacks. In Europe, despite slow progress toward a European banking union, the worries that prompted the initiative are receding. All major European banks achieved core equity tier 1 capital ratios well in excess of regulatory minimums in Q2 2017 (ranging between 11%-16%), significantly higher than five years previously.
Now that banks have pushed through the hard yards of compliance with Basel III’s capital regime, other regulatory deadlines are fewer and further between. Alas, the end of an existential crisis does not herald the resumption of business as usual. Recent financial performance is still well below historical norms, and other sectors. Having inched up steadily in recent quarters, the US banking sector finally achieved return on equity (ROE) above 10% in Q2 2017, albeit with wide differences between laggards (5%-6%) and outperformers (12%-15%). In Europe, the picture is worse. The European Banking Federation puts European banks’ collective 2016 ROE at 3.5%, down from 2015’s 4.3%. With a 9% average cost of capital, the sector is barely breaking even.
Indeed, few banks were looking forward to the Q3 2017 reporting season with much confidence, some warning investors to expect 15%-20% falls in trading revenues, with a lack of volatility weighing on Q2 figures. Once the dust settles on the Q3 numbers, fundamental realities are likely to depress earnings outlooks and book values. The rising costs of meeting steeper compliance obligations and evolving customer expectations will continue to far outstrip revenues, regardless of changes in interest-rate policy or termination of quantitative easing.
We are entering a new era. The era of high leverage, low wholesale funding costs and high margins is over. Pledges on both sides of the Atlantic to review post-crisis reforms to support economic growth may ease transition to the new normal, but will not bring back the good old days. Pressure on banks to continue to cut costs through operational efficiencies will only intensify.
Cutting operational costs is, of course, no easy matter. Compromising on quality of service delivered by the back office is not an option in times of low yields. Indeed, errors, delays and breaks are tolerated less when there is less profit to go around. How then to reduce their stubbornly high cost and frequency, thereby reducing the back-office’s burden on balance sheets, without further damaging customer trust and confidence?
Banks have often tried to drive costs down and efficiency up by shifting responsibility for the back office. But the outcome of banks’ attempts to outsource or offshore has been mixed, at best. You won’t necessarily find the evidence in banks’ financial statements or on their balance sheets, but quality and control have tended to suffer, even when costs have been reduced, which is far from guaranteed. According to a recent DTCC survey, almost 50% of firms still experience moderate to very high costs fixing trade exceptions. Several credible service providers are attempting to build business process outsourcing (BPO) franchises, but the complexities of taking over and managing highly customised processes from a diverse range of banks remain difficult to overcome in a way that achieves both cost savings and productivity improvements for users, and revenues for providers.
This is because years of under-investment have left back-office processes too manual, fragmented and inefficient to be shipped offshore, migrated to a BPO provider or overhauled by enterprise-wide transformation on today’s budgets. Typically, the systems on which processes run are deeply embedded into the fabric of the bank, their origins obscured by the passage of time, causing many to fear the consequences of tinkering with the unknown. While some have succeeded in retiring platforms, back-office systems easily run into the thousands at most global banks, while back-office headcount can be triple that level. Despite escalating regulatory pressures, the risks and costs of wholesale back-office reengineering are too large to contemplate, but the same could be said equally of continued reliance!