Banking District (Photo credit: bsterling)
The global banking industry is facing challenging times. The financial crisis—coupled with the determination of regulatory authorities not to put taxpayers on the hook for another round of bailouts—has led to a proliferation of new regulatory measures. Indeed, the scale and pace of banking regulatory change is unprecedented. Large banks must deal with multiple jurisdictions and multiple timetables for new regulations. There are higher penalties for non-compliance and the regulations themselves often reflect a new tone of public and political opposition to banks.
In the main, banks have not shown themselves to be well-positioned to respond to these challenges. Many banks have engaged in cost-cutting initiatives, but few have made the material structural changes needed to operate profitably in this new environment. Effectively addressing these complex and interrelated challenges will be central to banks’ ability to regain and maintain high performance.
Regulation is one part—albeit a major part—of the challenge facing banks. However, we believe that for banks and other financial institutions to achieve high performance in the years to come, they will need to transform their operations and structures while addressing three significant and inter-related challenges in parallel:
1. Increasing profitability and lifting returns on equity. While regulatory initiatives multiply, the underlying environment for banks is anything but welcoming. From 2000 to 2007, the developed economies’ top performing banks had an average return on equity of 26 percent. Today, many of these same banks are looking at returns in single digits; as a result we are seeing dramatic shifts in the banking landscape— with most forced to reduce the size / footprint of the institution in one or more dimensions to focus on areas which can deliver profitable and sustainable returns.
With future revenue and return on equity levels uncertain—and former revenue generators such as structured products or proprietary trading curtailed—many banks now have smaller balance sheets, less leverage and fewer opportunities for potentially profitable risk-taking. Capital also remains a major concern, tied closely to regulatory demands for larger reserves, but also to banks’ desire to protect themselves in the event of unforeseen difficulties.
2. Simplifying infrastructures that are too complex and costly for current operations. In the growth years banks rarely had to focus on operational efficiency. Financial institutions which operated for years with high margins and strong returns have had little reason to worry about efficiency. New businesses could be started quickly with limited supporting infrastructure; tactical fixes were applied as the norm and addressing root cause issues was put off to some point in the future.
As banks added organizational complexity, (e.g., people, operational procedures, systems and data flows) to cope with growing, new and constantly changing businesses, it is now increasingly apparent that the systems and processes which were scaled upwards in the good times are not scalable downwards in these more challenging times. Financial institutions are coming to grips with a new reality: Their infrastructure and cost base must be resized and restructured for leaner operations.
3. Effectively implementing far-reaching and complex new regulations. Broad-ranging regulatory reform will affect every aspect of banks’ business models, operations and infrastructure. Regulations are becoming more complex and require more management attention—and much more investment and resources—for an appropriate response. It is becoming increasingly clear that the historical approach to dealing with regulation will not work. The regulatory landscape is crowded and there are numerous initiatives scheduled for both short and medium-term implementation which need to be addressed through more integrated plans – both across the regulatory horizon, but also with a business based view on the impact to the organization.
The near horizon includes recovery and resolution plans or so-called “Living Wills”; short selling regulations; and the Volcker rule under the Dodd-Frank Act, which limits banks’ proprietary trading activities. Other regulatory initiatives such as Basel III are more far-reaching in their coverage; however, they have relatively long implementation timelines. Financial institutions should take immediate action but also need to plan holistically to align regulatory change with the firm’s own strategic direction. Isolated tactical solutions result in inefficiencies and wasted investment over the medium and long term.
The “to-do” list for banks is imposing. At a minimum, financial services firms will need to set up effective governance for their regulatory programs; transform and align finance and risk functions; revamp current client on-boarding and data collection processes; establish stronger frameworks for operational risk; and develop crisis management plans. In addition, regulations impose stronger efforts aimed at curbing financial crime, including anti-money laundering measures and development of solutions for compliance with the Foreign Account Tax Compliance Act (FATCA). These encompass extended reporting structures and new Know Your Customer (KYC) processes, and will require a significant level of investment and resources for both U.S. and non-U.S. banks.
Financial institutions increasingly recognize that regulation is no longer a secondary concern but is now a primary consideration in determining strategic direction and long term positioning of the bank. High-performing banks will seek, not just to be compliant with new rules and regulations, but to integrate their investment in regulatory response with the changes needed in the business model and operations, ultimately developing a market focused solution that leads to profitable growth in a new environment.
