The problem facing SA banks

[By Francois Beyleveld]

The economic crisis brought to light hidden challenges facing the global banking industry. Now a significant trend among local banks has emerged: high cost-to-income ratios.

In light of this, they have taken an aggressive stance on reducing overheads and are looking at retrenching staff in an attempt to make an immediate impact on the bottom line in a bid to contain spiralling costs.

Let’s take a look at Bank A, whose cost-to-income ratio has increased to 56,2% while its operating expenses grew by only 15%. These figures include a 19% increase in IT costs from the previous year and a 16% increase in staff costs.

At Bank B, the cost-to-income ratio climbed from 52,4% during the recessionary period of 2008 and 2009 to a worrying 61,7% in the year to end 2010. There are many reasons why this was happening, not least of which are demands placed on banks by the National Credit Act, sustained lower interest rates and continued weak demand for financial services.

Bank C is in a similar position. Its staff costs grew 13% in the past year, even though its headcount shrank. This, in turn, has resulted in deterioration in its cost-to-income ratio from to 52,5% to 55,3%.

But with every scenario there is an exception, and from our analysis this appears to be Bank D. This bank has managed to contain its costs through a number of activities that are now showing positively on its bottom line. Though this bank also went through the process of reducing its staff, it managed to slash operating expenses by 13% over the past year, an achievement that few of its peers have managed to emulate.

Why cost-to-income?
There seems to be a lot of confusion as to the importance of the cost-to-income ratio and why it is a critical for a bank to contain it. The bottom line is that the ratio shows what percentage of a bank’s income is spent on operating expenditure. This is particularly relevant at a time when opex is being crunched in light of the need for capital expenditure.

If one analyses the figures from the banks, it’s clear that since the beginning of 2009 costs have been climbing at a quicker rate than actual income — a worrying scenario for any business. That said, a factor to consider is that, on average, the cost of people on the income statement of a financial services organisation accounts for about 60% of total expenses.

The current spate of staff cuts shows the banks are analysing each line of expenditure. But by cutting back on staff they are merely applying Band-Aids to the symptoms and aren’t really addressing the problems at hand. From what we can see from working with the big banks, the real issue is that the cumbersome and unwieldy processes they are using are eating away at their expenditure. Also, many of them don’t have a true understanding of the “real” costs of the processes associated with their products.

Banks need to go back to the drawing board and put a critical eye on the processes they are deploying and ring-fence inefficiencies with the view of finding ways in which to improve them.

The real costs
It is in light of this that banks need to ask themselves whether they truly understand the costs associated with their products. They understand the interest income and noninterest income per product better than anyone else, but do they have an effective means by which to allocate the exact or accurate actual costs of each line item to the right products, services or channels?

This is where we are starting to see a disconnect between actual cost and cost allocation, and then, inadvertently, the expenditure they are experiencing as a result. Hacking away at staff quotas hardly seems to be the right approach if the products themselves are where the expenditure isn’t being accounted for.

A major contributor is the cost of IT and systems. Many banks find it difficult to allocate the correct IT charges to specific business units and this has a knock-on effect up to product level. The reason is that that they have not always understood the cost drivers of IT.

Looking back, we can see that in the period between the early 1990s and the early 2000s the banks had an excellent handle on costs per process and were able to reuse this information when making pricing policy decisions, particularly when developing new and innovative products, and when replacing old systems.

Though some banks still invest in teams whose sole purpose is to focus on calculating the true cost of processes and ultimately the “real” cost of products, the decisions reached or findings made seldom if ever make it to the boardroom table. In fact, the information isn’t even used to make decisions when developing pricing models. The reality is that most banks do not know the true costs of each product and service, but develop pricing models based on assumptions.

Steps to profitability
The time of blaming the recession or local and global regulatory policies is over. These are not the only reasons there have been big increases in the banks’ cost-to-income ratios and the resulting staff cuts, which are done to see instant results but which should only be used as a very last resort.

The facts is financial services companies’ year-on-year revenues are growing at a snail’s pace while expenses are increasing by an average 13% based on current market trends.

What the banks need to do is to drill deep down into the information at hand. They need to pinpoint which products and services are making money or costing money. Once this information has been gathered, only then can decisions be made on how to better deliver these products and services through the automation of processes or delivery channels.

It is all about good business decisions. If a product isn’t profitable then banks must look at how to make it profitable or cut their losses. Yes, staff numbers can be a problem. But they are more a symptom of the problem than the problem itself. Not launching a product doomed for failure means avoiding hiring more staff to babysit a product that will fail.

Conversely, banks must also look at their fee structures when trying to find ways in which to support pricing models or decisions. They must make sure the fees they are charging for each service pay for the service. If they don’t, or become unrealistic, then is it even worth their while launching these services?

The reality
No business will succeed if it looks at revenues and costs in isolation. Every line item needs to be viewed as a part of the overall balance sheet and then acted on in accordance with this.

The traditional model — and the figures here differ only very slightly from bank to bank — is that staff expenses within financial services make up about 60% of the overall operating costs of a typical bank. The other 40% is the portion that affects the viability or worthiness of the product on the balance sheet, which is nearly impossible to identify should banks not have the right systems and processes in place to quantify the viability of individual products.

There is no point in banks trying to be innovative if this very innovation is the reason cost-to-income ratios continue to spiral out of control.

• Francois Beyleveld is principal consultant at SAS Institute

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