This year has seen many banks taking the cost-cutting task of reducing their workforce—for many large banks, this is an annual exercise. But while the approach to these layoffs has essentially remained unchanged for the last decade or two, the spread of job losses since January 2023 is larger than usual. All of this, despite bank management having access to much more information that could better guide some of these difficult decisions. Banks need to evolve beyond indiscriminate layoffs and make informed decisions backed by data and insights.

Beyond personnel overages, banks are pressed to get their costs well under control for the foreseeable future. The second article in our two-part series looking at the top risks facing banks focuses on the ever more demanding regulatory and compliance requirements, increased need for human and financial resources, and commercial and personal defaults/default risks to avoid.

Some of the resources freed by the efforts mentioned above are added to governance and compliance teams. A recent Thomson Reuters report shows that under no scenario are bankers planning for less reporting, governance, or compliance. On the contrary, these areas are expected to increase “slightly more” or “significantly more” from where they are today.

And there is still work to do to meet core and emerging banking supervision and expectations in 2023, which means that banks are still catching up with their regulatory backlogs. Since COVID, onsite examinations have returned and require significant banking resources. The Federal Reserve Board and the Office of the Comptroller of the Currency expect banks to prioritize their requests. As a result, banks need to strengthen governance and controls. The same tidal wave of reporting is present in the European regulatory bodies.

The main areas that require renewed attention include data governance and reporting, cyber and IT risks, consumer protection, BSA-AML, and sanctions enforcement.

In 2023, banks are also experiencing renewed focus on managing emerging financial risks including the “new” climate-related financial risk whereas many banking regulators are drafting recommendations for all FRB-regulated institutions. Banks should also expect that the recent emergence of Generative AI will create new requests by the regulators to ensure that banks use the proper guardrails to protect financial markets and consumers.

At the end of the day, the cost of compliance is very high and even higher, proportionally, for small banks. Industry estimates place the cost of compliance at 3% of non-interest expenses in large banks and more than 5% for small banks. These costs continue to grow, forcing banks to allocate resources to activities that, although may stoke the trust of the financial system, do nothing to increase revenues directly.

Based on the uncertainty generated by interest rates and, in general by a perceived fragility of the economy, it is likely that defaults will increase at some stage. Although the risk for consumers has marginally increased over the last 12 months, it is considered to be quite stable. However, defaults for corporate clients represent a major risk and potential cost for the banks.

One segment that deserves special attention is commercial real estate. Real estate specialists estimate that the dollar amount of loans that have been made to the real estate industry in recent years and that could be at risk of default is around $1.7 trillion between 2023 and 2027. 70% of these loans are owned by banks. Market news indicates that in May 2023, 3.38% of commercial office loans are already seriously delinquent. It is a ticking time bomb. Estimates are that some commercial real estate values would drop by 40% in 2023 in large cities. Furthermore, refinancing risk is very high, with higher interest rates. Bottom feeders are patiently waiting for the risks to materialize to grab devalued properties. Banks are a crucial part of the commercial real estate lending process: banks lend to commercial real estate entities; banks sell and purchase commercial mortgage-backed securities or bonds that are supported by property loans; as a result, banks have placed risky bets in commercial real estate both in their lending practices and in their holdings of mortgage-backed securities.

The market has taken notice and has started to punish the banks that have undertaken the highest risks. The storm could be severe. The fall of Signature Bank, which had the tenth largest portfolio of commercial real estate loans in the U.S., has exacerbated the situation. So has the default by Brookfield on its $168 million loan and the merger of Banc of California and PacWest, whereas PacWest’s profile was quite similar to the one of Silicon Valley Bank. These banking profiles could spurn a merger wave across the industry, both for regional banks and for larger institutions.

In other commercial segments, JPMorgan and Goldman have put aside $3.36 billion as credit loss reserves in the first quarter of 2023. This is in stark contrast to 2022 when banks released unused credit loss reserves put aside for COVID-related events. There is a growing fear that defaults will increase in corporate areas and that the cost could be high, very high.

Now that we have summarized some key challenges for banks, we begin to understand how important pursuing a focused cost agenda could be. As risks and costs continue to increase significantly for most banks, bankers can reduce volatility on their income statements by limiting the cost increases in the face of uncertain revenue projections. We would expect the most cost-efficient banks to be rewarded by the markets.

Most banks engage in cost-reduction programs, including workforce reduction on a project basis, yet continuous cost-reduction is now a tool available to banks. Typically, a bank will hire a consulting firm, assign some personnel to become “cost czars,” define the scope of the engagement, and give all (temporary) powers to the “cost czars” to achieve results in a short period of time. This process – often painful for the employees – achieves short-term results. But like any diet, the benefits of this approach disappear all too quickly. In addition, most bankers are used to these short-term programs and have devised strategies to weather the cost-reduction programs with minimal interference. But banks now have another option, continuous cost management.

Continuous cost management addresses some of the embedded costs such as those resulting from (1) the friction between business lines and service groups, (2) poorly designed interconnected processes inside and outside the banks, (3) lack of consistency in handling customers, (4) unaddressed differences in the performance of people or processes, and (5) a lack of elimination of unnecessary tasks, among others.

Some banks are beginning to migrate to a continuous cost management philosophy, looking at costs on an end-to-end basis, e.g., cost per account, cost per policy, etc. By establishing a baseline and realistic targets, measuring continuously how costs are changing, addressing any unwanted situations in a timely manner, instilling genuine cost management rigor, and leveraging enterprise data on a continuous basis, any significant variation can be identified, and its root causes addressed. In this way, cost management becomes part of the regular operation of the bank, requiring no special projects, consultants, or cost czars. The effort becomes less traumatic for the organization while providing more long-term impact.

Our era allows us to exploit near real-time data, and, therefore, the continuous monitoring of meaningful cost metrics and the available drill downs in our highly digitalized environments. Cost monitoring is painlessly introduced and improvements are continuously achieved. More importantly, cost consciousness becomes a key function of the bank. As banking product managers need to plan and deliver on a P&L, they can better do it by knowing the costs that affect them with a high degree of precision, with real impact, and with control.

Finally, we are at the door of exploiting the extreme digitization of banks. It allows them to introduce continuous cost monitoring for the majority of their costs. Although very few banks have begun this journey, it may be time for others to follow suit.

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