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Opinion: Ernst and Young outlines 10 key issues facing banks in 2013
In a new report entitled Time for bold action, global banking outlook 2013-14, auditing and financial services firm Ernst & Young has detailed 10 key issues for the banking industry heading into the New Year. Below is the executive summary from the report, including the 10 issues.
Slowing economies, changing regulatory environments among issues banks face
European policy-makers have agreed to the broad outlines of a roadmap to deliver a banking union for the currency bloc that should break the feedback loop between sovereigns and banks. However, protracted negotiations suggest that the precise elements of the union, as well as the timetable for its full implementation, will be unclear for some time to come.
The prospect of a hard landing in China amplified concerns over the world economy, and a slowdown across the rapid growth markets (RGMs) further damaged confidence levels. Although growth slowed, it appears to have been a softer landing than feared, and there are signs that the economy is starting to rebound. The new leadership will want to start on a positive note, but concerns remain over the property market, loans to municipalities and the potential impact of further problems in the US and Europe on China’s recovery.
In the US, the recovery has been slow but positive, although investment activity slowed down in the run-up to the elections. The results provide some clarity but little certainty on whether the worst effects of the fiscal cliff will be averted. Any temporary measures aside, negotiations between President Barack Obama and Congress need to deliver a credible long-term deficit reduction plan and avoid the politics that surrounded the previous raising of the debt ceiling.
If the fiscal cliff is avoided and there are no further shocks in Europe or China, the world economy is expected to rebound slowly in 2013 and recover more strongly to 3.6% GDP growth in 2014.
However, wary of further setbacks, many businesses and consumers will remain uncertain for some time and be reluctant to commit to major spending and investment decisions. Banks across many developed markets remain undercapitalised and are unwilling, or unable, to write down asset values to more realistic levels and accept credit losses. Many of those same banks will also face the challenge of weaning themselves off central bank liquidity support before the repayment deadlines.
The economic recovery will alleviate some of these problems, but further bank restructuring is likely in the short to medium term. Banks in rapid-growth economies are broadly well-capitalised and focused more on growth than restructuring. Yet the recent credit boom will leave some vulnerable to rising default rates as these markets shake off the effects of the global slowdown. Competitive pressures are intensifying, and growing pains are likely following a period of rapid expansion.
Compounding the impact of a sluggish economic recovery, particularly in Europe, is the still-evolving regulatory environment. It is clear the reforms will fundamentally reshape the banking industry, but many rules remain unwritten and the timetable for completion varies across jurisdictions. Uncertainties around requirements in areas such as resolution planning, over-the-counter derivatives reform and structural reforms will complicate banks’ approaches to how they structure their global business activities going forward.
Causing further concern is the tendency of regulators to adapt globally agreed minimum standards, often “gold-plating” requirements, and to take a protectionist stance. Although understandable, it makes the task of developing new business models and implementing new operating models that much more complex and expensive for the banks. It also has the potential to damage global growth prospects.
Regardless of location or position, it’s a critical time for the banks. Decisions taken now will determine how well they are positioned to benefit from the recovery in developed markets, the new regulatory landscape and the next wave of expansion in the RGMs. Those decisions must result in a credible story for internal and external stakeholders.
They also must result in a sustainable business model that delivers a return on equity that exceeds its cost. There will be many components of the existing model to review and, because most are interconnected, the successful banks will be those that consider them together and make bold decisions across the organisation. In this edition of the Outlook we’ve outlined the issues, challenges and opportunities for what we believe will be the 10 key components for banks to consider.
1. Environment — accept, adapt.
Sub-10% returns on equity offer a stark reminder of the challenges facing many banks, but even where that metric is still healthy, external factors such as persistently low interest rates are disrupting business models. Customers are also disturbing the status quo — they continue to need banking services but are starting to look beyond banks to alternative providers.
Retail and technology firms will continue to capitalise on this. Banks are recognising that incremental change is no longer a viable response to the seismic shift facing the industry. A major overhaul of the organisation will be needed to adapt to the new environment. A few banks have already announced bold repositioning strategies, but many more need to follow.
Balancing multiple priorities, it will be crucial for senior management to devote enough time to the future and not be swamped by legacy issues. Some brands will disappear as consolidation intensifies among sub-scale banks. In Europe, many that survive will be much smaller as deleveraging is expected to shrink balance sheets by more than US$2.5 trillion by December 2013. At the same time, pension funds and insurance companies are desperate for higher yields to offset low interest rates, so we see more collaboration taking place to marry their balance sheets with the capabilities and client base of the capital-constrained banks.
As subsidiaries are sold and branches closed, the ability to serve international customers will be at risk. However, this will present an opportunity for some to innovate, potentially partnering with other banks facing similar challenges in different locations or cooperating with local banks in new markets. Banks also can learn from the experience of other sectors and we expect the more innovative institutions to follow the example of media and utility firms, who share infrastructure.
2. Reputation — restore, protect.
If the first step is to appreciate the scale of change affecting the industry, a close second is to recognise the poor state of its reputation. Although customers are broadly satisfied with their banking relationships, the industry as a whole remains tarnished by the events of the last few years. Further regulatory and compliance issues in 2012, such as LIBOR and anti-money laundering, and the slow pace of reform within banks have provided further ammunition for critics.
Banks also need to restore their reputation with investors. Developing and delivering on a future strategy that is credible is a start. Implementing compensation models that encourage a longer-term view and recognise a lower-return environment will further improve shareholder relations as well as shareholder returns. Going forward, the reputation lens is going to be an ever-more prominent filter for banks as they adapt their organisations to the new environment.
Some banks are already talking openly about restoring their reputations and taking steps to reduce the scope for future damage. Others will follow a similar approach as current models are overhauled during the next few years. Assessing new product opportunities in the context of public perception, shareholder benefit and reputational risk should become the norm.
The industry also needs to shift from a reactive to a proactive stance. Demonstrating the crucial role that banks play as intermediaries for businesses and institutional investors such as pension funds will help. So will improving the approach to managing business conduct and assessing customer suitability before another compliance breach forces change.
3. Culture, behaviour, reward — alignment.
For many banks, the scale of the transformation required will resemble the turnaround of a business in distress. Restoring their reputation may address problems with external stakeholders, but the challenge of change will require significant internal efforts as well. The industry has a reputation of over-compensating in some areas, jumping from rapid expansion to drastic cuts.
Adapting the organisation to the realities of the new environment will involve cuts, but more nuanced changes, such as a shift in behaviour, will also be crucial. Boards and senior management recognise that a cultural shift is required. However, more of them need to articulate and communicate a vision for the future that is relevant and motivating to staff, particularly given the restructuring initiatives to cut costs and personnel.
This will be crucial in the coming months and years as more key employees suffer from project fatigue. We should also see much more attention paid to managing potential conflicts in behaviour between different parts of the business. Restructuring compensation models should be part of that behavioural alignment process, as some firms are already demonstrating. The balancing trick over the coming months will be to deliver a new approach that reflects the financial realities of the organisation yet also provides enough of a long-term incentive to protect the franchise in high-risk areas.
4. Customer — requirements, expectations.
Businesses and consumers may still be wary about spending and investing, but the changes to the customer landscape go beyond the cyclical and beyond reputational issues. The structural dynamics across segments are also changing. As banks look to effect behavioural change within their organisations, they should incorporate shifting customer requirements and expectations into this culture-changing process.
Traditional banks also need to expend greater effort to engage successfully with customers, including via social media. Compared to new, alternative providers, they have had limited success to date, but we expect more to invest in building a credible presence on these channels to move beyond corporate feeds and sponsored advertisements.
However, agile organisations, free from lumbering bureaucracy, will be more likely to succeed. As sales and service delivery models come under review, banks should also be exploring how to translate some of the consumer focused mobile applications into new solutions for business customers — both small and medium-sized enterprises (SMEs) and major corporations.
These innovations will strengthen relationships, but credit provision will remain fundamental to protecting the corporate banking franchise. Undercapitalised banks will face difficult choices as they look to deleverage, but their future business model may need to exist without that franchise if they impose short-term restrictions on customer credit facilities.
5. Product mix/product dilemma.
Margin compression is becoming a feature across banking markets as regulation, capital requirements, funding costs, lacklustre demand, low interest rates, price competition and shifting buying patterns all affect profitability. Scale or niche expertise is increasingly crucial and, as we’ve seen already, so are customer expectations. With cost-income ratios in excess of 80% for some, tough decisions can no longer be deferred.
Over the coming months and years, we will see more banks scale back their global footprint and reduce their product portfolio. And in capital-intensive areas such as fixed income and commercial real estate, we’ll also see cuts to wealth management capabilities as low returns and increasingly intense competition deter those without a strong reputation. To some degree, these decisions will be more of an art than a science as banks try to predict where the strongest future revenue opportunities will materialise and outguess each other on which areas to cut. It will be survival of the strongest, but some will also be lucky.
Agreements or partnerships with third parties, such as pension funds but also other banks, are also likely to increase as banks strive to maintain full-service capabilities. Those that are based or invested in the RGMs will face a more optimistic future. Net interest income is being squeezed and non-performing loans are creeping up in some cases, but the growth potential from new and existing customers is significant in both conventional and Islamic banking products.
On the corporate side, the capital markets will continue to develop to support business expansion and infrastructure investment (the Asian Development Bank predicts US$8 trillion over the next 10 years). More local banks will strive to emerge as regional leaders, and we can expect further build-out of their capabilities and their footprint as they exploit domestic and international trade-flow opportunities.
6. Pricing — old challenges, new models.
The increased cost of securing funds to lend is being compounded by the additional capital charges imposed under Basel III and the emergence of binding liquidity and leverage requirements. At the same time, customer behaviour is changing and expectations are increasing. Multinational corporations understand the challenges facing the banks, but they’re also looking for unwavering commitments to credit provision and pricing models that are consistent across markets.
Capital- and liquidity-constrained banks will find those demands increasingly difficult to meet. Conversely, those that can invest in developing their data models will be able to use more effective allocation and pricing of capital and liquidity to differentiate their product offerings to clients. Pricing models for retail customers vary considerably across markets, and many customer pricing models are still dependent on cross-selling assumptions.
However, regardless of the exact pricing model, most consumers are unhappy with the current approach and, with more customers becoming multi-banked, those old models will cease to add up. As competition intensifies across markets, customers become less loyal and alternative providers enter the market, there is a clear opportunity for differentiation. Might one organisation step up to offer a groundbreaking “new deal,” and will that organisation be a bank, a retailer or a technology firm?
As banks adapt to the new environment, many operating models and structures are no longer suitable. Previous incremental changes must now give way to more fundamental restructuring. In some cases, old structures will be too expensive and too complicated for a much simpler future business model. Shrinking to fit will be a challenge, but it will also offer those banks an opportunity to dismantle bureaucratic silos that may impede adoption of a single culture.
In other cases, rapidly expanding organisations have outgrown their old operating model and will require more formal systems and procedures. Regulatory requirements will also influence future structures as supervisors expect global organisations to be much more globally connected.
Banks should treat this as an opportunity to reshape the organisation to better suit their customers’ needs as well as their own. Structures that remain aligned to products and functions will not be able to support a bank’s efforts to provide customers with a more transparent, consistent and comprehensive service. In all cases the new structure, including the customer-facing aspects and the “engine” that supports them, will need to reduce costs and deliver much-improved operating efficiency.
Further outsourcing and off-shoring will continue but, conscious of concentration risk in some locations and concerns from supervisors, banks will also be exploring alternatives. We’re likely to see more innovation emerge around in-house provision and the use of lower-cost onshore locations. In some RGMs, there’s also considerable scope to share more back office infrastructure across the industry.
8. Location — physical, virtual.
Many banks that invested heavily to give themselves global scale and reach are now poised to abandon much of that footprint. Some, such as European banks under pressure to focus on core services in core markets, have already started the retreat from international corporate and investment banking activities. As new regulations take effect, including local requirements for foreign banks to replace branches with subsidiaries, others will follow with potentially severe consequences for their corporate banking franchises.
The proposed European Financial Transaction Tax may further damage banking in the region. As some international banks retreat from the RGMs, the gaps will increasingly be filled by domestic and regional banks, further expanding their international capabilities and following their corporate customers into new markets. For retail banking, branch networks will see significant expansion across the RGMs, particularly in major population centres.
Elsewhere, ATM technology will be leveraged to provide “automatic” branches. And as the explosive growth of smartphones continues, more customers (both remote and urban) will also use mobile applications. In both developed markets and RGMs, the evolution of the branch experience will continue. Most customers prefer a self service approach for basic transactions but expect personal contact for advice and complex solutions. Given the cost of branch infrastructure, more banks should be encouraging this division, and we are likely to see more transformation projects.
Banks are facing multiple stress points on their technology. End-of-life issues and years of under-investment are now being compounded by the multitude of new regulations already placing considerable stress on banks’ data and reporting platforms. Cyber security is also an ever-more prominent issue, particularly with outdated systems and data storage requirements that seen to grow exponentially. Instead of incremental fixes and add-ons, a few banks have acknowledged that an enterprise-wide approach may be the only viable solution.
Although the up-front investment will be significant, this will be outweighed by much improved efficiency and organisational effectiveness. Last year’s Outlook said that technology will emerge as a key enabler and differentiator. As more system failures hit the headlines during 2012, that statement is perhaps even more relevant. We’re not sure how many more banks will be bold enough to commit to such a program, but more should be. The investment should also yield both direct and indirect revenue benefits.
Better-suited systems will enable staff to deliver much improved customer service. More directly, banks can learn a lot from other industries, retailers in particular, and have an in-built advantage as they collect far more data than single retail organisations. Using advanced data technology to track and analyse client activity will enable banks to provide much more targeted services and solutions to both retail and business customers.
10. Mobile money — finally a tipping point?
After a few false starts, we believe the combination of new platforms, customer expectations and industry innovation has finally brought us to a tipping point in the mobile money journey, both for banking and payments. Most banks have already embraced the revolution to some degree. Some have been particularly enthusiastic, developing new products that leverage contactless payment technology and launching new mobile applications.
Mobile banking is often at its most sophisticated in some of the RGMs, where a lack of physical branch infrastructure has been the catalyst for innovative mobile services. However, not all of those first movers have been successful. With the exception of complaints management, mobile banking offerings continue to cause customer dissatisfaction. Ongoing security concerns, among both retail and business customers, will play a part in that. The laggards will need to move quickly to develop an offering that meets customer requirements, but they can learn from previous mistakes to improve functionality and delivery.
As more banks commit to the significant investment required, they will also need to persuade customers to use the new services. We should see more banks experiment with a “carrot and stick” approach to encourage a behavioural shift away from more expensive traditional channels.