U.S. banks are shedding plenty of costs these days, with little choice.
They’re responding to fallout from a housing crisis that is taking no prisoners and a credit crunch that has slammed economic growth. U.S. banks are currently on course to cut costs by an estimated $20 billion or more. No one knows for certain what lies ahead.
The danger of cost-cutting decisions taken in times like these is that the remedy tends to be short-term and limited in nature. Bankers risk ignoring a greater challenge, namely how to create a more efficient enterprise that achieves strong returns for shareholders in the longer-term. Near-term approaches often fall short, leaving organizations scrambling to make additional cuts just as options for doing so are less favorable.
In contrast, a sustained approach to cost management – one that seeks to build a culture of consistent efficiency improvement across the enterprise and led by top executives – is the real key to financial success.
You can’t cut your way to glory, as a colleague of ours is fond of saying.
It should be all about efficiency, outcome and approach. Successful organizations implement a system of consistent cost management that is part of “business as usual,” both in good times and bad. Sadly, U.S. banks have been slow to hardwire this mindset into their DNA. This makes them a target for foreign banks, some of whom are looking to capitalize on stronger efficiency ratios, balance sheets and the weak dollar.
More important, Wall Street recognizes effective cost management, reserving high ratings for institutions combining a focus on efficiency with overall revenue growth. This is the conclusion of a new study by the Deloitte Center for Banking Solutions that compared changes in efficiency ratios with share prices of 30 U.S. retail banks between 2000 to 2006.
The Center segmented banks into three groups based on the extent of efficiency improvement: those who do it well, those that are sensitized to efficiency and those that are inconsistent cost managers. Revenue growth occurred in each group. While the common market perception is that revenue growth is valued at all costs, we found that this is not necessarily the case. Even among institutions with deteriorating efficiency, revenue growth was evident, but share price growth was limited in comparative terms, and in some cases, negative.
We found the average share price growth for leaders with the greatest efficiency improvement to be twice as great as the average share price growth for those in the middle group. And the leaders’ performance was six times greater than the average share growth of inconsistent cost managers. While many in this third group increased revenue, it often came at the expense of a higher cost base. The data also found that growth in return on assets for those who were the most efficient was significantly greater than it was for the other two groups. This suggests that more efficient banks can generate greater revenue per dollar of assets than less efficient banks. What is most surprising is that this is not translating into consistent action for many banks today.
The conclusion: Growing revenues is not enough. To have a greater chance of achieving significant share price growth, banks must consistently strive to be in the group of the most efficient through sustained cost management.
Why is this important now?
Banks are coming off a relatively long period of industry consolidation. Economies of scale were once believed to be the primary driver to achieve greater efficiency, but that theorem, much like “all revenues are good revenues,” may not ring entirely true. More than ever, banks must now find other ways beyond market transactions and consolidation to pursue growth and profits.
While Federal Deposit Insurance Corporation data show that larger banks tend to have better efficiency ratios than smaller banks, the difference diminishes as institutions grow above $10 billion in assets. Diseconomies of scale also begin to appear, driven in part by integrations left incomplete and increased complexity from both scale and scope. Interestingly, we found that one of the smallest banks in our sample of 30 showed the greatest improvement in both efficiency and stock price.
In speaking with those that were effective cost managers, here were four secrets they shared:
- Refocus on Core Business: While there is obviously not a uniform strategy in this area, there was one thing we constantly heard: Business units that serve as hobbies must go.
- Drive from the Center Out: The C-suite needs to drive the program; this is a culture change more than anything. And, the change won’t be painless – some glass will be broken and knees scraped.
- Set Non-Negotiable Targets: Goals must be established for the longer-term at all levels of the firm, and a structure must be created that incentivizes performance and penalizes failures. There must be consequences if you don’t adapt.
- Benchmark Against the Best: Don’t just look in the mirror. Identify and benchmark your performance against best-in-class competitors. Sure, no one is exactly like you, but don’t use that alone as an excuse to be cost heavy.
And here is the biggest secret: You must understand the critical processes that impact your goal, as well as the supporting technologies and key people managing both. You have to make sure you have the right processes in place and the right people to fill them. Ultimately, a disconnect here means unnecessary cost.
For some time, we’ve believed cost management has been the silent catalyst in the realignment of the U.S. financial system. More efficient banks survive. Less efficient banks are absorbed. Even where less efficient larger banks acquire more efficient smaller banks, the management team of the more efficient smaller bank tends to come out on top. With the industrywide need for improved cost focus, it is an excellent time to begin pursuing a more fundamental, longer-term program for managing costs. Take advantage of this challenging market – it can be a catalyst for making sustained cost management a permanent part of your bank’s culture.
View the article below, which was published within American Banker on June 6, 2008.
Don Ogilvie – who served as president and chief executive officer of the American Bankers Association for two decades – is the independent chairman of the Deloitte Center for Banking Solutions, which provides insight and strategies to address the complex issues that affect the competitiveness of banks operating in the United States. Paul Legere is a principal in Deloitte Consulting LLP's financial services practice, leading the enterprise cost management service line.
