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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:
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 inflationary pressures resulting from 1) increased cost of labor, 2) increased cost of supplies (including technology), 3) increased cost of delivery and ever more demanding regulatory and compliance requirements, and 4) increased need for human and financial resources. Additionally, senior management must 5) closely monitor commercial and personal defaults/default risks to avoid taking last-minute conservatory measures. Considering all the factors above, 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.
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.
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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