08 Nov 2017
Bank investors – and regulators and policymakers (to say nothing of the industry itself) – are acutely focused on the challenge of from where profitability in the sector is coming.
It’s not coming from revenue. Across the world, and particularly in this region, improving economic fundamentals are not translating into significantly higher revenue. (Although that is changing as global – but not Australian – interest rates rise and economic growth picks up.)
"Increasingly underpinning all [bank] efforts is a major shift which is easy to forget because it is so pervasive: simplification.”
In mature, still lower growth, markets the focus is on costs rather than revenue. Who can become more efficient, more quickly? Meanwhile, revenue threats continue to grow, particularly from new competitors from outside traditional banking, and higher regulatory and compliance costs.
These are clear and present challenges for financial institutions. In response they are becoming digital to improve efficiency and deliver innovative products. They’re becoming more customer focussed. They’re addressing reputation and operating risks.
Increasingly underpinning all these efforts is a major shift which is easy to forget because it is so pervasive: simplification.
For decades, particularly in the 90s and early 00s, many large banks tried to become more ‘universal’, adding businesses like insurance, wealth management, broking and a vast array of cottage industries to become the equivalent of financial services supermarkets.
It didn’t work. Customers proved reluctant to shop at such a supermarket meanwhile the added complexity created its own problems. Reputational risk rose without an offsetting improvement in returns.
Moreover, since the financial crisis, regulation has played a clear role. Those banks hit hardest in the crisis and supported by taxpayers (and in some cases accepting state ownership) have been broken up and cut back to more simple structures.
New capital requirements meanwhile, designed to make banking safer, have in the process made some businesses far less profitable – so banks have sold or closed them.
Complexity itself is not just a collateral challenge, it is a corrosive force in its own right. Consulting firm BCG pinned the recent slowdown in productivity across advanced economies as reflecting growing business complexity or “complicatedness” as they describe it.
“We define complicatedness as the increase in organisational structures, processes, procedures, decision rights, metrics, scorecards, and committees that companies impose to manage the escalating complexity of their external business environment,” BCG argue.
The drive to simplification is evident in a new EY report How can divesting fuel your future growth?
“A record number (87 per cent) of companies are planning to divest in the next two years — strikingly higher than the 43 per cent reported in our 2017 study,” the report says.
“Companies are facing intense pressure to evolve their business models using rapidly advancing technology. And they continue to navigate ongoing macroeconomic and geopolitical issues like the recent US tax reform and Brexit.”
“All of these pressures are placing divestments at the core of their growth and transformation strategy.”
This bank, ANZ, has been very active in simplifying its business model, including with a slate of divestments. At the last annual result ANZ’s chief executive Shayne Elliott emphasised “our simplification is real”.
“We have closed more than 200 products across the organisation, decommissioned around 100 systems and removed 70 tonnes of hardware (since Elliott took over just under two years ago),” he said at the time.
“In just two years we've announced the sale of 14 businesses. This has simplified our portfolio, reduced our operating risk, freed up investments and strengthened our capital position by around 100 basis points.”
This month ANZ announced it would explore options including a share market listing for its asset finance business in New Zealand with ANZ NZ chief executive David Hisco saying “we have been looking at strategic options for UDC’s future for some time as part of ANZ’s strategy to simplify the bank and improve capital efficiency”.
Obviously ANZ is far from alone in this process.
As the business environment becomes more complex, complexity actually becomes more expensive. Complexity has multiple costs. Not only does it require more resources, it dilutes management focus and leads to much higher operational risk.
Former Reserve Bank governor Glenn Stevens emphasised this risk in his 2010 Shann Memorial Lecture.
"The finance industry, certainly at the level of the very large internationally active institutions, needs to seek to be less exciting, less ambitious for growth, less complex, more conscious of risk and more responsible about where those risks end up than we saw for the past decade or two," he said.
They need to be simpler.
In the academic literature, complexity has three broad categories of cost – the resources expended are not rewarded by the market; the dilution of focus on growth opportunities; the misallocation of resources to lower growth (or even value destroying) areas.
Without simplification, even large scale automation or the adoption of ground breaking artificial intelligence won’t deliver cost savings or revenue in the long term.
Yet behind this crucial debate is a deeper question: why have these institutions become so big? The obvious answer is the classic one of economies of scale.
However, there is a limit. At a certain point economies become diseconomies – value is destroyed.
In the banking context, the financial crisis of a decade ago graphically demonstrated some institutions had become too big to fail – their collapse would wreck real economies.
There were advantages to being TBTF: providers of funding make it available more cheaply because they believe governments will not let the institutions fail. The ratings agency have made this explicit, noting any lowering of the implicit guarantee governments offer would result in lower credit ratings.
But with this becomes the issue of “too big to manage” – and this is really what pushing organisations to simplify. HSBC chief executive Stuart Gulliver has asked “can I know what every one of 257,000 people is doing — clearly I can’t. If you want to ask the question could it ever happen again — that is not reasonable.”
This issue of ‘too big to manage’ started to come to the attention of markets before the crisis.
Institutional complexity grew in synergy with ever more complex financial and shadow banking systems in the run-up to the crisis. For example, Citigroup, before it became a ward of the state during the crisis, was increasingly suffering from what many believed was unmanageable complexity.
It was fined for ramping bond markets in Europe, banned from some businesses in Japan, and pilloried for its analysts flogging stocks they considered dogs in the US.
Then chief executive Chuck Prince acknowledged his biggest challenge was to institute a common, effective culture and maintain proper controls across the sprawling global empire.
Since then the downside of size and complexity has become all too clear – and costly for banks. And
Citibank notably has been one of the most aggressive divesters of businesses in recent years.
Interestingly, BCG believes complexity is a management and leadership challenge rather than a strategic one.
“Every organisation’s top leaders have a substantial impact on its degree of complicatedness,” he said. “Yet as a rule, they fail to perceive just how much their company’s complicated activities, processes, and interactions reduce employee productivity.”
“They are not regularly in the trenches, so they rarely feel the painful effects of complicatedness.”
There’s a Mahogany Row challenge – often akin to Franz Kafka’s Great Wall of China – where the leaders fail to appreciate the real world implications at the far ends of a company.
“Moreover, they typically don’t need to live by the many rules and procedures they create and instead can work outside the systems that apply to their workers,” BCG argues.
In the financial services, the BIS found in its report Structural changes in banking after the crisis institutions hit by the crisis responded by making their businesses more simple.
“Many banks directly affected by the crisis have shifted their businesses away from complex and trading activities and have become more selective in their international activities,” the report said.
“In contrast, banks less affected by the crisis, including those in many emerging markets, have expanded internationally.”
As it is too the need for real cost reduction and more disciplined capital allocation. The trend is unlikely to disappear soon. Particularly given the shift to digital in itself throws up huge new cost management challenges.
Andrew Cornell is managing editor at bluenotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
08 Nov 2017
27 Jan 2016