After a decade of reform and retrenchment, the banking industry is on a more secure footing. Balance sheets and capital levels increasingly reflect regulators desire to minimise systemic risk. But it is less clear whether banks have adjusted their business models and operating infrastructures to the realities of the post-crisis landscape. In many cases, the ghosts of the past continue to hamper efforts to cut costs and improve efficiency to the extent required to accommodate lower margins. Nevertheless, technology offers new opportunities for banks to pool resources and expertise, thereby mutualising and minimising operating costs and risks.
In June, the Federal Reserve confirmed that all 34 major US banks had passed its latest round of stress tests, enabling them to resume dividends and stock buybacks. In Europe, despite slow progress toward European banking union, the worries that prompted the initiative are receding. All major European banks achieved core equity tier 1 capital ratios well in excess of regulatory minimums in Q2 2017 (ranging between 11-16%), significantly higher than five years previously.
Now that banks have pushed through the hard yards of compliance with Basel IIIs capital regime, other regulatory deadlines are fewer and further between. Alas, the end of an existential crisis does not herald the resumption of business as usual. Recent financial performance is still well below historical norms, and other sectors. Having inched up steadily in recent quarters, the US banking sector finally achieved return on equity (ROE) above 10% in Q2 2017, albeit with wide differences between laggards (5-6%) and outperformers (12-15%). In Europe, the picture is worse. The European Banking Federation puts European banks collective 2016 ROE at 3.5%, down from 2015s 4.3%. With a 9% average cost of capital, the sector is barely breaking even.
Indeed, few banks were looking forward to the Q3 2017 reporting season with much confidence, some warning investors to expect 15-20% falls in trading revenues, with a lack of volatility having weighing on Q2 figures. Once the dust settles on the Q3 numbers, fundamental realities are likely to depress earnings outlooks and book values. The rising costs of meeting steeper compliance obligations and evolving customer expectations will continue to far outstrip revenues, regardless of changes in interest-rate policy or termination of quantitative easing.
We are entering a new era. The era of high leverage, low wholesale funding costs and high margins is over. Pledges on both sides of the Atlantic to review post-crisis reforms to support economic growth may ease transition to the new normal, but will not bring back the good old days. Pressure on banks to continue to cut costs through operational efficiencies will only intensify.
Cutting operational costs is, of course, no easy matter. Compromising on quality of service delivered by the back office is not an option in times of low yields. Indeed, errors, delays and breaks are tolerated less when there is less profit to go around. How then to reduce their stubbornly high cost and frequency, thereby reducing the back-offices burden on balance sheets, without further damaging customer trust and confidence?
Banks have often tried to drive costs down and efficiency up by shifting responsibility for the back office. But the outcome of banks attempts to outsource or offshore has been mixed at best. You wont necessarily find the evidence in banks financial statements or on their balance sheets, but quality and control have tended to suffer, even when costs have been reduced, which is far from guaranteed. According to a recent DTCC survey, almost 50% of firms still experience moderate to very high costs fixing trade exceptions. Several credible service providers are attempting to build business process outsourcing (BPO) franchises, but the complexities of taking over and managing highly customised processes from a diverse range of banks remain difficult to overcome in a way that achieves both cost savings and productivity improvements for users, and revenues for providers.
This is because years of under-investment have left back-office processes too manual, fragmented and inefficient to be shipped offshore, migrated to a BPO provider or overhauled by enterprise-wide transformation on todays budgets. Typically, the systems on which processes run are deeply embedded into the fabric of the bank, their origins obscured by the passage of time, causing many to fear the consequences of tinkering with the unknown. While some have succeeded in retiring platforms, back-office systems easily run into the thousands at most global banks, while back-office headcount can be triple that level. Despite escalating regulatory pressures, the risks and costs of wholesale back-office reengineering are too large to contemplate, but the same could be said equally of continued reliance!
Hitherto, banks individual efforts do not address the key problems that thwart efficiency, i.e. the lack of standardisation and effective data and process sharing across counterparties. As an industry, we have a collective blindspot that prevents us from recognising the obvious: were all in this together.
Mutualisation of back-office costs and risks is very hard to pull off, but not impossible. I have two reasons for optimism. First, whilst banking may lag other industries on collaboration, there are still many examples where sustained multilateral efforts to standardise processes and drive efficiencies through multi-year commitment to harmonisation have achieved results. From industry-owned cooperatives such as SWIFT, to industry association working groups, to the development initiatives of client-owned market infrastructure operators, it is clear banks can collaborate effectively to tackle common problems.
Second, advances in technology are making it easier to improve back-office productivity and efficiency, without undertaking the Herculean task of ripping out existing systems. If not by reducing the number of breaks and exceptions caused by the balkanised back-office landscape, technology innovation can nevertheless accelerate and automate – and, importantly, mutualise – the processes deployed to resolve them.
Utility solutions based on common platforms and processes can help back-office staff to track and resolve errors and breaks more effectively, partly by identifying authorised contacts at counterparty institutions, but also by creating a dedicated environment for resolving problems, disputes and errors. New technologies are helping banks to exchange information on errors more effectively and more securely, an important consideration in the context of know your customer checks and other financial crime compliance requirements. Also important, a dedicated framework for problem resolution not only encourages collaboration across counterparties, but also fosters best practice in back-office processing, e.g. by enabling benchmarking and peer group analysis.
Many further challenges lie ahead for operations staff, but it is clear banks will have to mutualise risks and costs to really get a handle on back-office operational efficiencies. Its time to mobilise the power of the crowd.
John OHara is Chief Executive Officer and co-founder of Taskize.