Banks have entered a period of increased uncertainty over the last few months. Notation agencies like Fitch have already started to review ratings, and countless banks are either downgraded or being considered for a downgrade. No one is spared, neither small banks nor large banks.

As this unfolds, CEOs are increasingly focusing on certain strategic decisions that will positively impact their balance sheets:

• Increasing capital to meet Basel III
• Assessing assets portfolio to shed more risky classes of assets (e.g., certain CREs)
• Provisioning in advance of an increased risk of default
• Continuously monitoring interest rate risks
• Continually assessing opportunities for acquisitions or disposals

The sum of these strategic moves defines clear areas of focus for banks’ leadership teams. In addition to the strategic decisions managed by the CEOs, senior management must be ready to address several headwinds impacting the industry. The first article in our two-part series looking at the top risks facing banks focuses on inflationary pressures resulting from 1) increased cost of labor, 2) increased cost of supplies (including technology), 3) and increased cost of delivery.

Up to now, inflation has been considered a minor annoyance that companies have to deal with. However, its persistence combined with its amplitude is creating a much higher cost base across all resources used: people, sourced goods and services, and delivery cost.

Increased cost of labor 

When COVID hit and employees started to work from home, the belief was that these new arrangements would yield significant productivity gains. However recent articles show that productivity gains in banking year on year are hovering between 2 and 3% and have declined over time. There are multiple causes of the decline including, costs associated with changing tasks and locations more often, varying working patterns that are not necessarily in synch across the bank, and micro interruptions to deal with personal or family matters. Work-at-home’s productivity impediments can easily be counterbalanced in the office by factors such as wasted time in or between meetings, time commuting, and disruptions created by colleagues. A recent report by the National Bureau of Economic Research states that “COVID is more likely to have had positive effects on productivity in firms where more of the work can be done from home, in firms where sales involve less face-to-face contact with customers, and in firms with more skilled employees. Productivity is more likely to have fallen in firms where it is harder for work to be done from home, where there is more face-to-face contact with customers, and where increases in costs have been larger.” We now have to assume that productivity gains working at home or in an office are identical in a banking environment.

In addition, the U.S. Bureau of Labor Statistics indicates that from 2019 to 2022, labor compensation increased by 5.5% per year in banking and the number of hours worked decreased slightly, by 1.1%. Therefore, continued pressures on higher compensation wipe out any “savings” due to productivity gains. Over time the differential between labor costs and productivity gains is making banking costs higher and higher.

Increased cost of supplies 

The difficulties faced by supply chains in 2023 have many consequences for banks. Costs of goods and services purchased are increasing at least at the speed of inflation with the exception of long-term contracts at fixed prices. In addition, banks are funding supply chain companies who are experiencing more difficult conditions since COVID, thus increasing their risk of default.

40% of the banks’ external expenses are historically in technology. Everyone has noticed an increase in technology spending in banking over the last few years and an even larger acceleration in 2022 (+10% year on year). In a climate where other technology buyers might be slowing their purchases, the largest banking clients have a chance to lock in good prices and rates. However, many micro supply chain disruptions in technology will continue to impact the real price levels for all involved, including banks.

In the real estate area, another large expense bucket for banks, the uncertainty in occupancy and associated services is likely favoring the banks’ negotiators. However, we might experience a reduction in the number of competitors over time which could increase the banks’ overall costs. Another thing they will need to watch are utilities costs which have increased significantly, partly impacted by the Ukrainian conflict, and partly impacted by the switch to renewable energies.

Marketing expenses are also expected to continue to increase beyond the record levels set in 2022.  A survey of Credit Union CMOs shows that they expect to see even further growth in marketing expenses in 2023. Compared to other industries, financial services marketing budgets increased the fastest in 2021 and 2022A significant part of these budgets, more than 60-70%, is externally sourced meaning that banks continue to experience an increase in their sourced marketing costs.

Finally, the cost of independent contractors is a large expense for most banks. And the lack of available talent throughout a large swath of the pool has exacerbated cost pressure in this area. As banks have more of a need for skilled talent, their costs for independent contractors continue to increase. The problem is magnified by the fact that outsourcing to low-labor-cost locations has shown some of its limits in the most recent years.

Increased cost of delivery 

Competitive pressures are leading the cost of delivery for banks to increase. Competition for resources, the fact that existing assets like real estate are chronically underutilized, and the need for banks to incentivize clients to maximize deposits are leading to a significant increase in the overall cost of delivery.

The cost of a hybrid work environment is beginning to be understood by the banking industry. Since the end of 2022, leading banks have been hoping that their staff would return to the physical offices. This has not happened—and will likely not happen except in a hybrid mode for the short run.

An ability to provide a hybrid work environment matters because employers must make sure that their employees can work from home and have an office. Employees who have the option to work from home show up in an office one, two, or three days per week but occupancy rates in large buildings in several large cities remain low, well below 50%.

The multiplicity of technology access methods, despite the widespread use of cloud-based solutions, is only adding another layer to an already complex technology architecture. It generates extra costs and often, additional need for support. For the few banks who can genuinely phase out existing older technologies, the net result is lower costs. But it does not happen very often. Transitioning takes time and is not efficient. In fact, during the period from 2010 to 2018, IT costs in banking as a proportion of expenses continued to increase from 16 to 18.5%. IT spending in banking has continued unabated since (between 8 and 10% increase year on year), well above inflation, and is forecast to continue to increase in the coming years.

Banks are under strong pressure to accumulate as many deposits as possible, particularly as deposits are an important element of capital ratio computations. However, the cost of servicing deposits is increasing as clients expect a return during the new inflationary period. It could amount to a sizeable sum as competition for deposits between banks continues to intensify. Fintech alternatives combined with active social networks facilitate a run on a bank when it takes a simple click to move funds between accounts. Retaining cash and keeping the trust of clients requires very skilled banking labor.

So as pressure on salaries, increase of sourced goods and services, and increase in the cost of delivery loom large, what gives? There is some hope that increased digitalization will play a role in achieving greater efficiency and overall use of funds. And we have seen mostly mid-sized or smaller banks deploy new technologies successfully. We recently talked to the CEO of a regional bank who had multiplied by three the size of his balance sheet while increasing its workforce by a little above 10%. But such gains are rare for large institutions. Overall, employment in the US banking industry has not significantly changed in the period from 2012 to 2022, growing from 1.96 million employees to 2.02 million employees. Some might conclude that banks are using new technologies poorly and that every time resources are freed by new banking technologies, those freed resources are reassigned to other tasks.

To combat inflationary pressures, banks should stay as lean and mean as possible through a quantum change in how they manage their costs. Such a change promises to reduce volatility in income statement performance. In part two of this series, we explore how the ever-more demanding regulatory and compliance requirements, increased need for human and financial resources, and commercial and personal defaults/default risks are impacting the banking landscape.