The general playbook that large Banks have used to generate returns is being challenged at every turn. Efficiencies from centralisation are being offset by the new regulatory focus, while savings from capital models are being eroded by increased use of standardised models, systemic risk buffers and the rising costs of compliance.
In the aftermath of the global financial crisis, we saw Banks retrench around global, universal services to varying degrees, but 10 years on, many are now looking to get back on the front foot. Most can no longer rely on economies of scale to drive strong returns, and need to reacquaint themselves with an old truism: “You can’t be all things to all people.”
It may seem obvious that Banks need to focus on the markets, client segments and product categories where they have genuine pricing power and points of differentiation. Nevertheless, such fundamentals were often overlooked, or at least eschewed, in the benign pre-crisis market conditions that incentivised firms to chase scale while any associated inefficiencies were masked. It is these inefficiencies that are now resurfacing amid today’s more onerous regulatory requirements and a more challenging interest rate environment. Many successful banking strategies now involve a renewed focus on “the core.” Naturally, this means different things to different institutions. For some it means a core client segment, for others a core product set or capability, others still a core geography. It is a trend gaining traction in Europe, with many creating non-core divisions. Even the largest global players are shifting focus and investment spend to markets where they have scale in their chosen products and customer segments.
Becoming more focused is a logical response to the environment that Banks now find themselves in, but it does raise its own set of problems. In particular, it makes Banks more vulnerable to changes in their own market segment.
As the pace of change increases, whether due to innovation, regulation or competition, a bank’s vulnerability increases. In the absence of a crystal ball, the only way that Banks can manage this risk is by embedding flexibility into their operating models to enable them to adjust rapidly to the way they serve their chosen market. In short, more agility is required to ensure that fears about being "too big to respond” are not simply replaced with being “too concentrated to survive”. In exploring how Banks can make their operating models more agile, it is necessary to disaggregate banking into its two core components, “production” and “distribution” since each brings different opportunities and challenges.
Distribution was once an area where size was an unequivocal advantage; a large physical footprint and broad customer reach have acted as barriers to entry supporting entrenched participants. However, this model is being challenged from two sides. Firstly, technology is challenging the volume of bricks and mortar required. Secondly, and particularly in the Retail market, regulatory initiatives such as open banking and PSD 2, which require sharing of data across Banks, challenge the incumbents.
These changes present a threat of intermediation, since they enable new entrants to “own the layer” between the bank and its customers, with solutions containing customisable algorithms. These cater for changing customer behaviours; increasingly focused on quicker, more digital and more personalised service which can only be met through technology. In short, new entrants provide the potential for better service at a lower cost.
Faced with these challenges, Banks could choose to retreat from distribution entirely or, in our view, more likely compete with those providers; by upscaling their own technology options to meet changing customer demand. However, with Fintech and technology behemoths alike showing interest in banking services (if not Banks), partnership may offer a more agile route so distribution may effectively be co-sourced or outsourced.
This could provide a cost effective and scalable distribution model allowing Banks to focus on production, which is more highly regulated and therefore less susceptible to threats from new entrants.
Performance in production is driven by three inputs: innovation, price and flexibility. The first two are self-evident; offering innovative products that suit customer needs at the best price will always be a prerequisite to success. However, in our view, it is equally important for Banks to be able to allocate resources flexibly between products and markets to those that offer the most favourable returns within the context of their long term strategy.
Banks have traditionally been better at innovation than at pricing or flexibility. But as product innovation cycles are shortening (and leaders’ advantages are swiftly eroded), the ability to deploy and redeploy balance sheet resources to the next best option is critical.
Banks need to design an operating model that supports efficiency in pricing and flexibility of resource utilisation. In doing so, they have to move away from the distribution led operating model, where business lines follow customer groups and balance sheet management is an after thought. Such a model too often leads to short term profits that turn into long term drags on profitability, which can tie up capital years after origination, eroding long-term returns.
Banks need to be savvier in how they manage the key constraint on growth and returns: balance sheet resources and capacity. This can be done by rebalancing the power between demand functions (the business lines) and supply functions (treasury and legal entity management). Too often business lines make demands on financial resources to drive promised growth, but are not adequately held accountable if the demand does not materialise, resulting in surplus supply. This inevitably results in feast and famine, where certain business lines have surplus capital while others are starved of the resources for growth. This is caused by scarce balance sheet resources being locked up in the wrong areas, leading to waste and inefficiency.
In our view, Banks should put in place multi-disciplinary balance sheet management functions with a mandate to reduce balance sheet inefficiency and put more tension in the supply and demand process. This allows a more dynamic allocation of resources in the short to medium term whilst ensuring a longer term perspective on balance sheet management beyond the first year of the financial plan. This is already happening in certain Banks, and we can see this developing in an even more radical direction.
We are not suggesting a complete reversal of the current state of affairs to a balance sheet first, business unit second approach. Merely a much greater balance between supply and demand of resources. Otherwise there will be neither the ability nor the political will to reallocate and rebalance between products and business lines in the way we think will be required. Unlike distribution, where one path to agility is decentralisation, agility in production must be achieved through increasing centralisation and power to supply functions.
We have has put forward two linked propositions: that Banks should realign around their "core", and that this must go hand in glove with embedding more agility into the operating model to ensure long term sustainability. To date there has been more concern on the former than the latter, but the true power play comes from investing in and enacting both together. In our view, Banks have the opportunity to refocus their resources at pace to deliver long term, sustainable returns in the future.
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