Financial Services Point of View Ops and IT Investment in the New Decade: Necessity as the Mother of (Re-) Invention Author Dylan Roberts, Partner A common observation about financial services regulation, back in the ’90s and early ’00s, was that regulation didn’t really drive industry practices. As burdensome as Basel II was, many of its requirements (more granular credit rating scales, more quantitative credit models, etc.) were simply restatements of steps that leading banks had taken five or more years previously. And so, it was said, regulation doesn’t shape the business; the business shapes regulation. Times change. While the details of the regulation avalanche triggered by the 2008-2009 credit crisis aren’t yet entirely clear – how the different provisions of Dodd Frank will be interpreted in practice, what the exact requirements of Basel III will include, and so forth – it is increasingly obvious that the impacts will be fundamental, and will drive real, and in some cases unintended and unanticipated, business change. For the banking industry’s profit model, the impacts can be summarized in four buckets: 1. New investment requirements: the need to invest in substantial new data, reporting, and compliance infrastructure 2. Higher operating costs: the need to spend substantially more, year-in, year-out, on regulatory compliance operations 3. Lower revenues: loss of revenue sources (ranging from prop trading on the wholesale side to interchange fees on the retail side) 4. Higher capital levels: substantial increases in capital requirements, on the order of 25% relative to pre-crisis levels, and concomitant reductions in returns on capital These implications (all negative) come on top of economic fundamentals that are already less than rosy for the banking industry. Expectations of further de-leveraging remain high in both the consumer and wholesale sectors. While the consumer leverage ratio has just undergone its most severe contraction ever – falling almost 20% from its peak at the beginning of the crisis – it remains more than 80% above its levels in the mid-1980s, (when there was already plenty of concern about the spend-and-borrow tendencies of the American consumer). We aren’t likely to renounce debt completely anytime soon, but it’s still hard to be optimistic about the growth prospects for credit-related revenues in the foreseeable future. 2 Copyright © 2011 Oliver Wyman The interest rate environment seems similarly hostile: at the end of a 20+ year period during which falling interest rates have generally boosted bank profits, it’s now hard to see that rates have anywhere to go but up. There will doubtless be some positive offsets to all this doom and gloom – banks may levy additional fees in areas untouched by regulation to replace those lost elsewhere, or may push harder on credit pricing; yield curve steepening as rates rise may lift NIM; perhaps investors may even conclude that more heavily regulated banks are safer and therefore worthy of funding at lower expected return levels – but on balance, the outlook seems challenging. This round goes to Cassandra, not Pollyanna. So what are banks, and specifically for the purposes of this discussion, what are bank operations and IT executives, to do? In the short term, the answer sounds a little like: run faster, and in two different directions at once. The new raft of new regulations is creating tremendous pressure to invest in new data, reporting, and monitoring capabilities. Major initiatives include: Enterprise-level investments: stress testing infrastructure, OFR, and FSOC reporting infrastructure, etc. Wholesale investments: development of Swap Execution Facilities (SEFs), move to daily OTC derivatives valuations, etc. Retail investments: more sophisticated modeling of liability behavior in support of liquidity risk management, additional monitoring capabilities in support of consumer protection, etc. These capabilities won’t be cheap, and they aren’t optional. At the same time, the pressure on banks’ profit models is also leading to tremendous pressure to cut costs. As a result, there is a scramble to “chop here, spend there” at many institutions. The majority of large banks in the US have activated or are considering significant enterprise efficiency programs. Copyright © 2011 Oliver Wyman 3 The challenges, though, are enormous. A typical efficiency program targets cost reductions of up to 30%, typically focused in the “overhead” categories that comprise roughly 30% of the institution’s overall cost base. If successful, such programs might yield total cost savings on the order of 10%. Unfortunately, cost reductions of this magnitude probably won’t be enough to restore the profitability of the banking industry – our estimates are that total reductions of up to 25% could be required to lift returns back to pre-crisis levels. So if running faster (and cheaper) isn’t a viable long-term answer, what is? Possibly banks need to find a totally different way to run – which will have even more profound implications for the scale and nature of operations and IT investments. Is the banking industry good at finding new ways of doing things? The record is mixed at best. There have been pockets of innovation, mostly on new products but occasionally on distribution as well: derivatives, structured credit products, the ATM, etc. For the most part, though, the last twenty years of banking history are as notable for the innovations that didn’t occur as for those that did: paperless branches, branch-less banks, E-wallets, low-cost direct securities issuance (e.g., Wit Capital), and so on. It may be, though, that this is finally the right time to consider completely different operating and infrastructure models for banking. Tablet computers were introduced 10+ years ago, and were a resounding flop until Apple’s App Store gave the iPad a raison d’etre. Will regulatory-induced profit pressure similarly give new life to radical low-cost business models, many of which were mooted but ultimately dismissed ten years ago during the e-finance era? Possibilities: As noted above, rationalization or even elimination for some segments of branch networks, requiring accelerated investment in online distribution and servicing; third party distribution partnerships; revival/expansion of electronic wallet, stored value, and other non-cash transaction enablers; etc. 4 Copyright © 2011 Oliver Wyman Simplification of product features and portfolios, creating the opening for extreme streamlining of associated underwriting, pricing, processing, finance, and risk processes Migration to cloud-based IT infrastructures, enabling major reductions in the banks’ current processing and analytics “factories” Importation of productivity approaches from manufacturing and non-services businesses – lean manufacturing, assembly line processes, retail store concepts, etc. Exactly which innovations succeed in the long run, of course, remains to be seen. And most banks probably will not pursue radical innovation, and many will continue to earn positive if unspectacular returns. However, it seems increasingly likely that the truly successful banks of the next decade will be “leaner and meaner” than almost any that preceded them, and will do things not just better, but differently. These changes are being catalyzed by regulation and will be enabled by ops and IT innovation. Copyright © 2011 Oliver Wyman 5 Oliver Wyman is a leading global management consulting firm that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation, and leadership development. About the author Dylan Roberts is a Partner and Head of the Strategic IT & Operations Practice in North America For more information please contact the marketing department by email at [email protected] or by phone at one of the following locations: North America EMEA Asia Pacific +1 212 541 8100 +44 20 7333 8333 +65 6510 9700 Copyright © 2011 Oliver Wyman. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The opinions in this report represent the views of the author(s) and may not necessarily reflect the views of other partners within Oliver Wyman or the company. This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. 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