Utilities in the banking market

The trend will only accelerate

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You might have heard the buzz about utilities. Banks are still struggling with return on equity targets (RoE) because of historic conduct issues, expensive regulatory requirements, and the cost of maintaining legacy architecture. Traditional responses to lift RoE have become less effective as attractive opportunities for relocating staff away from central business locations diminish, particularly with the weaker £. Mergers are also unlikely to offer relief as any proposed merger of large banks is highly likely to be blocked by regulators (RBS taking over ABN AMRO is still raw in many minds). Consequently market utilities are now taking centre stage as the preferred way to reduce employee and IT costs. Here’s what you need to know about them.

What is a utility?

There are many variants of utilities in the market at the moment and as such, no standard definition. So I’ve created my own:

Utility’ refers to an entity that performs a common function for multiple clients where those clients have previously performed the function themselves at a greater cost, without deriving a competitive advantage.

What would an ideal banking utility look like?

Quite simply it would have to…

  • Serve multiple customers allowing a sharing of costs between participants
  • Perform a function that is not a source of competitive advantage for its potential clients
  • Use a single core technology infrastructure as opposed to a separate system per participant
  • Have a flexible resource pool to source talent outside of the major business centres
  • Be appropriately incentivised to continue driving quality and efficiency within a model that shares the benefits amongst the participants
  • Be appropriately capitalised

‘Necessity is the mother of all invention’

Since the global financial crisis many banks have struggled to meet RoE targets. Among the many explanations for this reduced profitability, two reasons stand out.

The first? New regulation is expensive to comply with and has impacted trading activity generally. The BBA notes 80 separate pieces of new legislation since 2007 impacting UK Banks. 60 more are in the pipeline, while in the US the Dodd Frank Act has proposed some 400 new rules.

The impact on banks has been a significant. There’s been a huge investment in people and technology to comply with new rules and regulations – just look to central clearing for over-the-counter (OTC) derivatives and Mandatory Collateralisation for an example. Increases in cost per trade (think Mandatory Collateralisation again), as well as increases in capital and liquidity provisions (such as global regulatory framework Basel III and EU legislative package CRD IV) are all leaving their mark. And there’s also been a decrease in proprietary activity thanks to the Volker rule. The result? Margins have been squeezed by higher running costs and volumes have dropped.

The second? Fines levied on the industry have been enormous. At the end of 2015 it was estimated that the top 20 banks paid fines worth £252 billion in the preceding five years.

Many banks are worth more dead than alive

The fundamental issue for many banks is that their current business models are now simply not profitable enough. The most stark evidence is that the share price of many banks trade below tangible book levels. Many banks are worth more dead than alive or, put another way, that if they continue in their current form they will destroy shareholder value.

So what can they do to return to consistent profitability? Its hard to grow the top line and so cost management continues to be the answer.  This means a laser focus on employee compensation and IT expenses given they make up the bulk of the cost base of any bank.

One approach to reducing costs has been near shoring and offshoring. Under these strategies the overall employee compensation costs are reduced by employing people in locations where the cost of living and wages are lower. While this has produced significant results, it is often seen as quick fix. And more importantly it does not tackle all IT costs, nor reduce the overall number of employees required. A utility however, if structured correctly, will deliver cost reductions across IT systems and across both price and quantity of employees.

How can a utility help?

Reduced run the bank costs

  • The ideal utility would run only one core processing platform. Each client would all benefit from paying for a fraction of one system instead of the whole of their proprietary system.
  • As separate institutions, each bank will require a certain number of support staff in both high cost and low cost locations. By combining a chunk of the industry’s staff into a single utility with high straight through processing rates, the number of staff (including managers and other high cost location staff) will be reduced, meaning savings for utility participants.

Higher compliance rates

  • Fines for non-compliance with rules and regulations are enormous. In theory an industry utility should be far less likely to suffer a critical failure in process leading to sanction. Why? Their very existence depends on performing a process to the highest possible standards and they benefit from adopting the best practices of participant banks.

Change the bank costs

  • The ideal utility has one core processing system. Making changes to the system (in response to a new regulatory requirement for example) requires just one system to be changed. That’s one project lead, one testing schedule and one IT build out as opposed to one of each per participant.

Competitive advantage

So much depends upon the size and scale of the processes transferred to the utility and the efficiencies gained. In theory, for larger process transfers, the following will be possible

  • A business line of marginal profitability can improve profitability to acceptable levels.
  • A loss making product that cannot be closed due to the risk of losing profitable customers of other business lines can become profitable in its own right.
  • Clients that were likely to have been off boarded can now be ‘kept on’ avoiding damaging conversations
  • In theory greater profitability will increase the ability of a business to attract new customers, for example   by offering better pricing.
  • There can be a first mover advantage. The first banks in the utility can enjoy increased profitability earlier, and can also influence the structure of the utility in their favour.

Conclusion

Hitting RoE targets continues to be a struggle for financial institutions. In other industries throughout history this would have been the time when mergers occurred. Two banks would have attempted to create a single entity with twice the revenue and something less than the twice the cost.  However, in this era of ‘too big to fail’, regulators find further industry consolidation difficult to accept; alternative cost reduction strategies, like utilities, have to be considered.

Utilities provide an opportunity to reduce costs, benefiting from economies of scale, best of breed processing and reduced change the bank costs. Given the pressures that many banks are under to increase RoE and the back drop of increased regulatory change, the benefits from market utilities mean the trend will only accelerate.