Rethinking from first principles
The effects of the credit crunch, and stalling income growth from the deterioration of market conditions, are increasingly forcing financial services organisations to reconsider their cost positions. Whilst most senior executives recognise that there is scope for cost savings within their organisations, it is often harder to visualise how these savings can be realised.
In many organisations, past attempts at cost reduction have failed along one or more dimensions: an insufficient part of the cost base was addressed, identified savings were not implemented, benefits proved hard to track or there were negative commercial implications in parts of the business.
Such programmes are generally characterised by a piecemeal approach to cutting budgets in the near term, with limited consideration of how to embed sustainable savings, and a general disconnect with the overall view of the business, its operations and the key commercial processes that create value for the firm – in other words, key elements of strategy.
Historically speaking, cost reduction in the financial services sector has been highly cyclical, generally coming in response to stock market slumps and economic downturns. Yet when the markets recovered and rose again, so did costs. In recent times, the staff numbers of major financial institutions have often returned to previous levels following recovery, with little sign of improved productivity so that the benefits of cost reduction were largely lost.
The key challenge is how to take a strategic approach and create a low cost and effective operating model that will deliver sizeable and sustainable benefits and enable the delivery of corporate strategy
Analysts have long been warning that the high cost-income ratios of many banks and the combined underwriting ratios of major insurers are not competitive enough to grow shareholder value. Many financial institutions still have substantial structural issues to tackle before they can move beyond the status quo. The current downturn is forcing management to confront these challenges. Furthermore, this pressure to take action to reduce costs is augmented by three key effects of the credit crunch, which will continue to test financial institutions over the next two-to-five years:
- top-line growth will be difficult, emphasising the value of cost control as a means to stabilise performance and provide shareholder value;
- continued overcapacity in financial services should precipitate further consolidation; and
- the new regulatory landscape and Government intervention will increase overall costs for the financial services industry.
The first line of defence?
Top-line growth will be difficult – emphasising the value of cost control as a means to stabilise performance and provide shareholder value
Perhaps the single biggest reason why much more effective cost management should be a key objective in today's financial services industry is that it is likely to offer the best chance of recovery in returns and profits, at least in the short-to-medium term.
Revenues growth is at risk from declining consumer confidence, tightening credit markets, intensified competition and the growing commoditisation of products. Therefore, costs will need to be reduced significantly to maintain margins or at least limit the damage. In addition, UK retail banks are subject to further, specific domestic forces, such as: the conflicting public and media reaction against both transaction charges and their alternative, fee-based current accounts; closer regulatory scrutiny of products deemed have been sold inappropriately, such as payment protection insurance; as well as riskier borrower profiles coupled to declining values in loan collateral, all of this at a time when banks need to rebuild their balance sheets. Accordingly, the industry will find it hard to keep loan volumes up, maintain levels of key cross-sell and complementary products, and sustain sufficient revenues to off-set the costs of operating the current offering.
The insurance industry will also be affected. In life insurance, where UK players are struggling for new business profitability, sales of protection policies are suffering from a downturn in the housing and mortgage markets. In general insurance, companies are bracing themselves for professional liability claims stemming from the credit crisis.
Just the beginning?
Continued overcapacity in financial services should precipitate further consolidation
Well before the credit crunch, both Europe and North America were considered to be over-supplied for retail financial services. In the UK, the long-standing case for further consolidation finally appears to have been triggered by the credit crunch and the consequent sharp drop in valuations and its impact on new business at some banks. More cross-border deals are likely. Elsewhere, the credit crisis has highlighted some weaknesses in financial services business models, leading to a surge in bail-outs, divestments to raise capital and mobility of talent between organisations. This consolidation represents a shift in focus away from mega-deals associated with the previously buoyant market towards paying attention to the core business and driving improved efficiency through simplification of operational activities. Private equity houses and sovereign wealth funds have made it clear that they see opportunities for participating in the restructuring of the financial services sector as it begins to recover. Much of the logic for such consolidation will centre on strategic cost reduction and efficiency improvements. As a result, even those firms not immediately in the firing line should embrace the opportunity to address their cost base, before they end up on someone's shopping list.
Indispensable and inevitable
The new regulatory landscape and Government intervention will increase overall costs for the financial services industry
Following on from massive government intervention in many countries, it is increasingly likely that regulation and legislation will be changed in an attempt to address some of the structural issues that led to the credit crunch. Some of these changes will be appropriate and beneficial, in particular around the application, interpretation and enforcement of regulation, but they may nevertheless involve higher costs in the shorter term. And given there is a risk of an over reaction, bringing with it further costs.
Perhaps this is only natural following the scale of the recent discontinuity. Consequently, as the industry goes through its current downturn, the costs of regulatory compliance are more likely to rise than fall in line with overall market volume. Regulatory scrutiny is likely to increase across the financial services sector. Since 2000, more than 20 new pieces of major legislation and regulation have been introduced – and there are plenty more in the pipeline with the introduction of Basel II in the US and Solvency II in the European Union. Regulatory compliance will become more sophisticated and more complex and company attitudes to risk management are likely to reflect a defensive "better safe than sorry" outlook. In the US, compliance costs have already risen by 159% since 2000 and a further surge is expected.
Raising your game
Firms need to become smarter at implementing cost reduction strategies
As a group, banks and insurers need to learn from past mistakes and earlier efforts. They need to address enterprise cost reduction at a strategic level and become better at implementation and follow-through, so that they can become more efficient throughout the economic cycle.
Some leading organisations are already taking a more thoughtful approach to cost reduction by investing in the creation of low cost operating models. These firms are carrying out large scale transformational initiatives by carefully examining and thoroughly implementing in a number of key areas. Typically this involves:
- organisational consolidation;
- process simplification;
- creation of operational centres of excellence;
- replacement of core systems and processing platforms; and
- selective outsourcing.
Setting the tone
Cost reduction demands strategic choices which must be agreed and driven from the very top of the organisation
The shape of a cost reduction programme and the initiatives identified and selected should be informed by and aligned to the organisation's vision and strategic direction. Delivery of these objectives must be supported by visible and active sponsorship from the CEO and the senior team to ensure the right level of prioritisation and focus is signalled across the organisation.
Achieving a coherent set of cost reduction objectives is only possible by involving and engaging key business leaders and heads of functions, and by making choices about the future shape and design of the business. These choices will involve clear decisions about the business model, organisational structure and operational activities. For example:
- Choices related to the business model – clarity about where and where not to participate; which customers and clients to target; which products to offer; which channels to prioritise; which geographic markets to select; what level of service to provide.
- Choices related to deploying key assets and capabilities – what capabilities to invest in; how to differentiate operations; which brands to use and where; how to attract, retain and develop the right talent; what kind of culture to encourage.
- Choices related to organisational structure – how to structure the organisation to enable delivery of the business model; what relative emphasis of product, geography and line of business dimensions; what role for the corporate centre: steward, shaper or shared services provider.
- Choices related to operations – how to simplify key operational activities; how to prioritise critical processes and objectives; which technology platforms; how to handle information flows; where to locate functions and business units.
Once these choices have been confronted and made, the decisions that emerge will form a clear set of principles for deciding the most appropriate cost savings initiatives.
Savings initiatives are best delivered by the key lines of business and functional units with clear accountability for the results embedded in team and individual performance objectives. Delivery of change must be supported through strong governance, role modelling of behaviours and clear consequences for delivery.
Finally, sustaining the savings and creating a platform for growth requires a culture of accountability and continuous improvement.
In conclusion
A case for continuous improvement
Effective cost reduction is reliant on an organisation's ability to realise and verify the required savings while embedding cost management disciplines and a culture of continuous improvement to ensure the cost savings remain.
The effort requires consistency and commitment from the highest level in order to break down organisational barriers and existing norms. Furthermore, it requires astute monitoring of costs to reduce uncontrolled spending creeping back into the organisation; this cannot be done without regular measurement using agreed and established metrics. Finally, it is necessary to challenge the status quo and traditional ways of operating – pragmatism and a clear focus on execution should rule over perfection and endless analysis of detail.
Cost reduction initiatives can be made to stick by embedding them explicitly in the organisation's strategy and executive agenda – and then driving them from the top of the organisation down to embed a culture of ongoing cost management and accountability.
Ten out of ten
Our work in structuring and implementing cost reduction programmes with clients across the financial services industry, has led us to identify ten key conditions which, when taken together, significantly raise the probability of delivering a successful, sustainable cost reduction programme:
- Drive cost reduction from the top through senior executive sponsorship and ongoing day-to-day focus.
- Engage the senior leadership team from across the business to realise savings.
- Set a clear financial baseline as the starting point against which to measure and demonstrate progress.
- Apply a 'Zero Based' approach to reviewing and challenging all functions and activities.
- Recognise the need for structural and operating model driven change as the means to create significant savings.
- Savings initiatives must be factored into budgets and verified down to a cost centre level.
- Create an environment of transparency across the organisation by setting clear targets and accountability for the delivery of savings with progress measured weekly.
- Ensure a dedicated programme infrastructure is in place with the sole focus on driving out costs.
- Secure the confidence of the market by communicating progress regularly.
- Embed a culture of continuous improvement and cost management as a means to sustain the savings achieved.
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.
