Value Based Cost Reduction: Strategy for revenue growth
Challenge 05
Introduction
Despite significant transformation e fforts over the past eight years, investment banks have seen only modest improvements in their cost-income ratios.
For many firms, this metric remains near 70 percent. How could this be the case when banks have reduced costs by billions of dollars in recent years?
At least half of the answer lies in the challenge of driving income in markets that have been drastically altered by regulation and capital charges. A decline in the denominator of the cost-income calculation has caused the entire ratio to suffer.
This paper addresses the other half of the equation: cost reduction. We have written extensively about significant cost reduction actions by major investment banks over the past eight years, yet new cost reduction targets continue to be announced. Many of these new targets are directly related to decisions to exit or scale back selected lines of business. While these actions can produce—and have produced—significant savings for individual firms, they seem to have been insufficient to return the industry to reasonable profitability.
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ESTIMATED AVERAGE
COST-TO-INCOME RATIO IN
INVESTMENT BANKING IN 2015
FIVE “HOT TOPICS” IN
COST REDUCTION
TAKE ACTION
LEGACY OF PAST EFFORTS
Our research and discussions with industry leaders indicate that, assuming current investment banking income remains somewhat static, the largest investment banks will collectively need to further reduce costs by up to $20 billion if they intend to significantly improve the average return on equity. More specifically:
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All firms have increased their compliance activities. Some large firms have added several thousand full-time equivalents (FTEs) to their compliance functions, largely offsetting other cost-reduction activities. According to data from TheCityUK, reported in the Financial Times in October 2015, investment banking jobs in London hit a record high of 730,000, with the bulk of recent growth in compliance and legal.1
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Cost reduction has largely taken place within the four walls of banks. Firms have optimized the processes they can control, including parts of the securities settlement cycle and reference data management. That still leaves significant reconciliation and other “hands-off” activities involved in connecting to clients, trading partners, depositories and custodians.
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Improved virtualization and cheaper computing power have helped to reduce IT costs. Many firms have also worked hard to retire legacy systems, but there are still opportunities (see Challenge 2: Investment Banking Technology: Jettisoning Legacy Architectures).
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Firms have largely focused on reducing “unit costs.” These improvements in the cost per labor hour have typically been achieved through offshoring, outsourcing and process improvements. As one investment banking executive recently said in a client meeting, “I think we have squeezed this lemon dry. There is no way to continue with historical cost-reduction activities and expect more savings or any sustainable cost advantage. We need to solve this differently—with industry-wide cooperation and with different techniques within our institutions.”
BROKER-DEALER EXPENSE STRUCTURE
Cost benchmarking and bank-to-bank comparisons are notoriously difficult due to allocation methods, nomenclature and structure, but Figure 1 gives a sense of typical ratios at a large investment bank.
FIGURE 1: TYPICAL NON-INTEREST EXPENSE STRUCTURE FOR A LARGE BROKER-DEALER
Notes: Figures are based on the average cost structure at large broker-dealers over the past three years. Not all cost categories are consumed by all business lines. Certain categories may be larger for broker-dealers that receive an overhead cost share from a parent banking group. Some banks include certain brokerage activities as contra-revenue items. Figures exclude bonuses, operational losses and taxes.
Source: Accenture Research
WHAT’S HOT IN COST REDUCTION?
There are five “hot topics” or recurrent themes in cost reduction that we believe are worth noting.
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Broker use is increasing as a result of remediated broker policy and controls, and a shift in the role of inter-dealer brokers in the over-the-counter (OTC) market.
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Market data use is increasingly driven by proactive enforcement of usage agreements by data vendors.
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Sales and trading workforces are being resized to accommodate ongoing electronification across asset classes and changing market conditions.
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Control workforces, particularly compliance and risk departments, are growing as a result of new rules regarding conduct and supervision.
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Technology is being simplified, driven by increased consumption of change, IT infrastructure and third-party application services.
WHAT ELSE IS THERE?
Although cost-cutting alone is not the answer, more can be done to achieve a sustainable cost structure. In the next wave of cost reduction, banks should:
Shift their focus from process optimization to outcomes.
Adopt a factory approach to legacy application retirement.
Embrace utilities.
Implement technologies like robotic process automation for routine tasks, such as reconciliations.
Adopt techniques that have been used successfully in other industries, including zero-based budgeting.
Accenture believes this last idea, in particular, is of growing interest to the investment banking industry. Therefore, let’s take a closer look at it.
STARTING AT ZERO
Zero-based budgeting and spending has started to make waves across different industries and has the potential to radically alter the investment banking industry. Introduced by the US government more than 50 years ago, zero-based budgeting involves justifying the need for each budget item, while respecting strict policies and top-down targets set by cost category owners. Today, it has the potential to play a pivotal role in helping banks make effective, value-adding investments to continually refuel for growth.
Investment banks must first complete a one-off “greenfield” cost-resizing exercise before transitioning to an ongoing spend- and performance-management technique, such as closed-loop or zero-based budgeting. While many banks have begun to examine cost-resizing, the latter requires further exploration. Accenture believes this fundamental shift is paramount for growth. Starting from zero helps to ensure that the past does not dictate the future, and weaves accountability for the numerator (costs) and denominator (income) into decision making at all levels of the bank.
Accenture research shows that
regulatory change alone can reduce a
tier-one investment bank’s return on
equity by approximately 500 basis
points.
A NEW WAY OF MANAGING COSTS
Banks can take the following steps to help increase cost-base
transparency, determine how to reallocate capital and optimize return on
investment:
Take an outside-in view to create visibility and insight into costs. In other words, wherever possible, compare how much it would cost to house a specific function outside the bank with how much it costs to maintain it internally. Increasing transparency and using it to identify cost drivers and develop key metrics, including fully loaded cost-to-serve by business line, will be critical in this regard. A “product” view of revenue and a “functional” view of costs do not support the kind of insights required for change.
Build an end-to-end governance model that drives accountability to the rightful owners. To complement increased transparency related to cost drivers and their impact, a governance model that establishes dual expense ownership and rewards shifts from unproductive to productive spend can help establish accountability across the entire organization. The governance model, along with its related financial controls and performance incentives, plays a key role in ultimately shifting the mindset to allow sustainable change for the bank.
Use cost savings to fuel growth. The true effect of cost reduction and zero-based budgeting can only be measured if savings are reinvested to drive growth, innovation, talent and productivity. To achieve a profitable end state, investment banks need to design transformation programs based on sustainable operating models that promote efficiency and cost savings. Simultaneously, they must scrutinize their business models to design growth strategies that focus attention where they can and want to be profitable and successful. Cost savings from those areas deemed unnecessary or unprofitable should be viewed as fuel for growth initiatives.
CONCLUSION
Investment banks may feel as though they face diminishing rates of return when it comes to cost reduction, but there remain opportunities to improve return on equity and use savings for growth initiatives. By taking a holistic view of business line costs—comparing internal ownership and outsourcing options, and evaluating the profit potential of each—banks can gain fresh perspective on optimization. Zero-based budgeting is one approach that can help optimize cost reduction beyond the initial cost-cutting phase. The main objective for further cost take-out should be aimed at looking at the challenge through a different lens at all levels of cost ownership within the organization rather than the “functional” (cost) versus “product” (revenue) methods employed to date.
Cost-cutting measures that emphasize near-term financial performance can produce benefits that are fleeting, forcing banks to start the cycle all over again—usually with mixed results. Investment banks need to begin closing the loop. Once identified, cost-saving opportunities should be converted to long-term investments in new products, services and financial technology (FinTech) initiatives.
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