UK: No Stone Unturned - Transformational Cost Reduction In An Era Of Market Volatility

New challenges need a radical response

Five years after the crisis erupted, financial institutions remain under huge strain. An unprecedented range of economic, regulatory and competitive forces is putting pressure on operating margins, investment budgets and investor returns.

There is no end in sight to this pressure, and institutions therefore need to assume that change is here to stay. Cost reduction will play a big part in their response to this new era of persistent volatility and uncertainty.

Historically, financial institutions have embarked on a range of organisational restructuring and cost reduction programmes with mixed long-term results.

The crisis has prompted a sharper response, with more strategic change, bolder cost saving initiatives and quicker decision making to counter pressure on performance and profitability.

However, these historically extensive actions have not gone far enough to protect operating margins in the current climate. The pressing challenge for major financial institutions is where to go next.

Firms must take a broader view of the organisation to put aside internal barriers and restrictions and take a hard look at how it can be transformed to weather the current storm and the continuing uncertainties that lie ahead. No stone can be left unturned.

Radical redrawing of established business models - for that is what is required in many cases - is painful and fraught with challenges. Such action requires careful analysis and expert implementation to succeed.

No cyclical salvation

Cost reduction in the financial sector has traditionally been cyclical in response to stock market slumps and economic slowdowns. In many cases when conditions eased, costs rose and employee numbers crept back up with insufficient underlying productivity and efficiency.

In the years before the crisis, booming markets, cheap capital, abundant liquidity, and the emergence of profitable derivative products obscured a lack of cost discipline and an overcapacity in UK financial services. In response to the crisis, financial organisations have carried out IT and operational outsourcing and offshoring, shared services, process re-engineering and consolidation inter alia. They have also been quick to implement more tactical measures by freezing recruitment, reducing head count, culling budgets, cutting capital investment and controlling spend.

Since we highlighted the limited scope of past cost reduction and the need to carry out meaningful change (Focused on the fundamentals: A sustainable approach to cost reduction - February 2009), a cyclical upturn has proved elusive. Organisations now need to focus continuously on cost management to maintain margins and satisfy their investors.

The world has changed

After a lull in the aftermath of the crisis peak of late 2008, financial institutions have operated in an environment of prolonged volatility. The world has changed. There are five major interacting elements to this long-term state of unpredictability.

1. The outlook for the domestic and global economies has worsened sharply. After emerging from a deep recession in 2009, the UK economy slowed to little or no growth before slipping back into recession. Some commentators predict a decade of stagnation or worse.

2. The Eurozone crisis and gloomy economic outlook have triggered a further period of extreme market volatility. Investors are responding by avoiding risk and sitting on capital that could be used by financial companies to drive economic growth and income.

3. Top line growth is under severe pressure. Margins are squeezed by record low interest rates and high funding costs, consumers are reluctant to spend and are wary of financial products, the housing market is moribund and corporate activity is weak.

4. Competition for business is intense. Firms are battling for whatever corporate activity exists, retail customers in banking and insurance have more choice and the war for deposits is set to intensify.

5. Institutions face an increasing demand for regulation which is designed to discourage excessive risk taking, prevent future taxpayer bailouts and protect consumers. Implementation costs and the increased expense of doing business are huge and unpredictable, not to mention on-going and long-term costs that organisations must manage.

It's getting tougher

The operating environment for all financial institutions continues to grow more challenging. In each sector, different radical responses are required:

Investment banks' established business models are unsustainable because of higher capital costs and regulatory restrictions on proprietary trading operations. Revenues are shrinking and firms are competing fiercely amid a slump in corporate activity.

These institutions have traditionally run complex, high-cost businesses that were a barrier to entry for new competition. However, given market conditions, radical action is needed for investment banks to rebuild their businesses and generate adequate shareholder returns.

Firms must find the right balance of management to achieve cost efficiencies while meeting all regulatory demands. In some cases, this will mean replacing the model of powerful individual business units overseen by a thin layer of management with centralised functions supporting new customer-facing businesses. Silos that house support functions such as finance and research may also be merged, while activities kept in-house such as consulting, technology and real estate management could be transferred to external providers or joint ventures.

For retail and commercial banks, the uncertain economy will continue to suppress business volumes as both lenders and customers remain cautious.

In common with the investment banks, retail banks are grappling with the scarcity and high cost of capital. This is in addition to cost pressures from regulatory interventions such as the Independent Commission on Banking (ICB) proposals for ring fencing retail and investment banking. Additional measures include preparing for Basel III and super-equivalent rules on capital and liquidity proposed by the Financial Services Authority (FSA).

Previously stated return-on-equity ambitions are in doubt and tougher liquidity requirements have increased competition for deposits and require banks to hold lower-return assets. Furthermore, new nontraditional competitors have added to pressure on margins and pushed up spending as established lenders seek to retain customers.

Banks with a proliferation of businesses are looking to consolidate functions geographically and operationally. However, the potential for cost reduction may be constrained by the ICB's proposed ring-fencing of retail from investment banking.

At the same time, retail banks must grow to survive. Recent financial results have been flattered by declining bad debts but this trend has largely run its course.

To generate income, banks have to become smarter at delivering products through innovative channels that customers want - for instance mobile phones or tablet computers. The drive for cost reduction is combined with the need to invest in a digital revolution of service delivery. This will mean building a capability to rapidly respond to customer and technology innovation.

Insurers in the low-growth UK market face higher capital requirements and implementation costs under Solvency II as well as the impact of the FSA's Retail Distribution Review. These pressures should act as a spur to deal with long-running inefficiencies and legacy systems, and to free funds for investment.

Life insurers are under pricing pressure from increased transparency and competition from cheaper alternative products. Old business models do not work for the mass market and companies must make difficult decisions about which markets they want to operate in. Solvency II has increased capital requirements and running costs while domestic regulation has increased pricing pressure and scrutiny of products. To meet these demands, business portfolios should be reduced to focus on core capabilities. Annuities and protection business may need to be jettisoned to focus on investment management. Outsourcing functions such as IT, transactions and elements of finance and risk to third parties will also reduce costs.

In general insurance, personal lines providers have been through various stages of cost reduction and are now looking for profitable growth. They are investing in data analytics to tailor products to customers on terms other than price. There is scope for cost reduction to release funds for growth, for instance by improving claims management and offshoring actuarial and modeling functions.

Non-life insurers damaged by their investment activities in the crisis need to refocus on their core capabilities. In a competitive market, catastrophe insurers are also seeking to manage costs.

While premium cycles are hardening, in the mass consumer market competition has never been stronger, new low-cost entrants are prolific and customer loyalty is difficult to achieve.

Composite insurers that have historically grown through acquisition have enacted a range of efficiency programmes but have never fully integrated their business, consolidated legacy systems or reaped the benefits of scale.

No quick fix - transformational cost reduction

Cost reduction in financial services has traditionally started with the existing business model and left a trimmed-down version ready for expansion when normal service resumed.

With these basic reductions already made and few signs of the good times returning, management needs to go further than before. Leaders at many institutions are asking: "How do we achieve more, and permanently?"

To enact what for some will no less than an 'industrial revolution', companies need to decide first on the end result and work back to identify the changes required. This approach is no quick fix. Transformational cost reduction needs careful consideration and management. But firms who execute it successfully will embed reductions which drive future shareholder value. No transformation takes place without disruption.

Meaningful change will require large, intrusive programmes that go to the heart of an institution's business and culture. Careful execution will be essential to minimise upheaval, and short-term costs will have to be borne to realise long-term goals. Every element of the business will need to be reviewed and challenged, leaving no stone unturned.

Cost reduction on the scale required should be combined with reviews of companies' wider business and geographical footprints. Low-profit, capital intensive or non-core operations may be divested or closed. Businesses and teams, particularly in investment banks, may be relocated to more appropriate regulatory jurisdictions, and institutions could consider moving their headquarters to more cost-efficient markets. Having the flexibility to do so through 'plug and play' capabilities will be important.

Cost reduction must interact with macroeconomic trends as institutions make choices between low growth Western markets and dynamic emerging economies, which may require investment in infrastructure or distribution offset by efficiencies elsewhere. Such decisions will raise tax issues as well as legal, operational and cultural challenges.

The current environment imposes conflicting pressures on financial institutions. The price of complying with regulation is a spur for cost reduction but cutting risk and compliance functions too deeply may expose institutions to greater regulatory risk. Reducing costs is a natural response to squeezed income and margins but firms also need to maintain income generation, invest to open up new and innovative service channels and tap profitable growth.

Cost reduction priorities

Transformational cost reduction will require careful balancing of priorities while embedding significant change. Key elements will include:

Focusing on the core business: companies must be clear about where and where not to compete - which jurisdictions, clients and products are the most cost-effective, which operations they have the skills for and which business lines fit their core strategy.

Agility: the only thing that is certain in this economy is uncertainty. Leaner organisations need to adapt quickly to future changes in markets and regulation.

Centres of expertise: increasing and changing regulatory pressures require consolidation of core capabilities to build true centres of expertise to provide consistent guidance and advice on complex issues.

Organisational consolidation: companies should consider industrialisation of the corporate centre to combine fragmented functions across business lines. Inefficient silos with duplicate functions should be broken down, and multiple legal entities may be consolidated.

Outsourcing activities: non-core in-house operations should be transferred to specialists where possible. These functions may include legal services, internal consulting, transaction processing, elements of risk and finance, IT and property management.

Upgrading systems: multiple legacy systems should be rationalised to cut long-term costs, maximise data, reduce risk and enable innovative product development and distribution.

The importance of analytics: companies with strong data collection will have a competitive advantage in understanding their customers and their own businesses to manage costs efficiently and maximise profitability.

Investing to reduce costs and capture growth: long-term investment is necessary to provide the services and products customers want and to improve distribution. Investment in digital platforms will drive efficiencies in the long run.

Getting it done

Re-designing an organisational structure on paper is one thing; implementing change of this scale is another.

Successful restructuring demands strategic choices that are agreed and driven from the very top. Intrusive programmes on the scale required can disrupt organisations if they are not executed properly to maintain day-to-day trading and performance. A change of this nature will often be over two to three years. While some initiatives will take that long to implement, many companies will have to make shorter term efficiencies along the journey.

In delivering large-scale restructuring and cost-reduction programmes for many clients, we have identified a number of key factors common to successful programmes and likewise absent where measures have been unsuccessful. Many appear to be self-evident but they are often the most difficult to make happen on the ground. See our top ten 'make or breaks' on the next page.

The top ten 'make or breaks'

1. Drive it from the top: the CEO and senior executives need to be accountable for success, be visible and stay the distance. They are the only ones who can drive the 'horizontals' across functions, divisions and geographies.

2. Set clear objectives and outcomes: clearly defined and understood objectives and outcomes are paramount. There must be no ambiguity, with aims entrenched in the senior team's performance and reward packages.

3. Get an agreed financial baseline: ensure there is a clear and agreed starting point. This can be surprisingly difficult to deliver.

4. No sacred cows: a complete review of the organisation with strong challenge and all options on the table.

5. Tactical and strategic change: incremental changes will not be sufficient. Quick wins must be sought to 'self fund' but the strategic change will be the hard yards that are difficult to agree and implement.

6. Communication and engagement: engage people in the vision, the rationale for change and the solutions as they are forming. Be clear on roles, responsibilities and expectations. 'What will it mean for me?' - sensitivity to the impact of this on the individual is key. Over-invest in this area.

7. Strong governance: structured stakeholder management and reporting and informed decision making. Difficult decisions will need to be made (quickly) and at various levels in the organisation.

8. Dedicated programme infrastructure: have the right capabilities and skills to run the programme. Engage the business areas but drive it from the centre to ensure holistic management of risk and the correct pace of implementation with a single line of sight on progress. The finance function must be an integral part of the project team.

9. Bake savings into budget: embed the savings in the budget with disciplined benefits tracking. The finance function is the gatekeeper.

10. Embed continuous improvement: change management begins on day one. Make cost management and efficiency a way of life.

In conclusion

The financial crisis was not a violent, short-term shock. Its effects on economic growth, market sentiment and regulatory change have left an era of continuing upheaval. In response, financial institutions must go further than ever before to transform their business models and embed cost reduction.

Transformational cost reduction will require consistency and commitment at the highest level of the organisation to challenge organisational barriers and existing norms. Everything must be in scope to ensure that no stone is left unturned. Change will be painful in many cases, and a coordinated approach - from design to delivery - is required to ensure success. Those institutions that manage change effectively will emerge with a competitive advantage to meet the challenges of the transformed financial landscape.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.