The financial sector has a poor record on cost optimisation
Increased digitalisation, new regulations and low interest rates have drastically changed the market climate in the financial sector. At the same time, it has slipped behind other sectors in work on cost optimisation, and large investments are now required to maintain good long-term profitability, writes Jonny Eriksson, operational excellence expert at PA Consulting.
In a comparison study conducted by PA Consulting on how effectively organisations in different sectors optimised costs, the financial sector was ranked among the worst at eighth out of ten. When leaders in these organisations are asked to rate their abilities, it is clear that the financial sector has a lot to learn from others in sectors which have extensive experience of surviving a tough market climate and tight margins. The automotive and pharmaceutical industries are best in class, but other regulated industries, such as aerospace and defence, are also stronger performers than the financial sector.
The major Nordic banks made a profit in 2019, but the level of operating costs (C / I ratio) has been unfavourable in recent years, and the trend does not appear to be reversing in 2020. On the contrary, increasing C / I ratios over a longer period are one of several signs that the sector has not succeeded in converting increased revenues to increased profitability to the same degree. This is happening, according to the Swedish Financial Supervisory Authority, at the same time as problem loans have increased, something that may continue in the aftermath of the ongoing pandemic.
Why are banks not succeeding in improving their profitability?
As a result of greater competition, banks have much less scope to increase the net interest margin on mortgages than in previous times. Issues such as security, financial risks and digitalisation have been consistently prioritised at the expense of ongoing cost optimisation. At the same time, competition from fintech companies has put pressure on the traditional players to offer lower prices and customers' demands for service have changed.
Previously, it was argued that the financial sector would adopt a strategy of "running faster and paring back costs". This approach feels outdated today and does not provide the long-term perspective required to sustainably reverse the trend. Added to that is the gigantic challenge facing the traditional big banks in terms of their ability to replace older IT systems with new core banking systems, which in turn makes it difficult to deliver new, more flexible service and product offerings. The status of IT systems is an underlying problem that has been postponed into the future and which brings an increasing technical deficit. This also limits the ability to achieve a long-term and sustainable cost optimisation of the business.
In order to sustainably break the declining profitability trend, the financial sector should develop a strategy that consistently integrates cost efficiency into the business. The strategy should clearly show how large a share of freed-up capital is to be realised in the income statement, and how large a share is to be used to promote innovation, growth and increased customer value.
PA Consulting's survey shows, among other things, that the following areas need to be improved to increase cost efficiency in the financial sector:
- Transparency in unit price - the ability to assess and track the unit cost of processes and products, against budget and historical data.
- Development and technology capability - the ability to balance continued operation of older IT systems with parallel investments in new technology.
- Specification ability - the ability to develop new software in an environment with external partners, with clear specifications and requirements based on customer value.
The financial sector's players need to gain a deeper understanding of where in the value chain they want to act and position themselves in the future, and what the collaboration with other suppliers of products and services should look like. It is fundamental to decide which areas to prioritise. It requires a clear vision from the management and a leadership that continuously prioritises an optimised cost base, which is consistently challenged and screwed on at all levels. This long-term perspective is also something that the European Central Bank highlights as supervisory priority for 2020 by demanding stronger balance sheets and strengthened resilience for the future.
PA Consulting's study shows that there is potential for increased cost efficiency among financial market players in general. It is time for the financial sector to learn from other, more successful sectors in cost optimisation in order to meet customers' new requirements for products and services at a reasonable cost over time.
Jonny Eriksson, Operational excellence expert at PA Consulting