Cost Cutting An Axe or a Scalpel?

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1 Cost Cutting An Axe or a Scalpel? By Michael Burke, Head of GAUGE, McLagan September 23, 2008, Unit 9 As we move into the second half of the year, the inevitable questions around pay and performance are coming to the fore. Firms are facing a more challenging and complex pay equation than they have probably ever seen, as people begin to believe that the impact of the credit crunch is here to stay. In this, the second of a series of McLagan Alerts on pay pressures, we will review the feasibility of firms cost-cutting their way out of the current crisis. While not an exhaustive list, we identify seven key areas where firms can reduce costs. RISING COST BASE Over the last 3-5 years we have seen a steady increase in the cost base of the large financial institutions and in particular, the banks. Much has been written about the ever increasing levels of compensation, however, cost : income ratios have remained fairly static (with 2007 as an obvious exception). If we dig below the surface what this hides is an increasing level of, what now appears to be, high risk or non-recurring revenue and increasing costs. Most of the firms have had pockets of exceptional revenue and growth. On the back of this increased revenue we have seen a steep trajectory of increasing costs in producer compensation, support area costs and non-compensation expenses. This increased capacity to spend has meant that many front office and support areas with lower growth rates or lesser revenues have risen with the tide. Now that the revenue in many of these businesses is faltering or threatening to do so, firms are being forced to review and reverse this trend. Support Costs vs. Front Office Headcount Firm-Wide Direct Non-Comp Costs 1 16 % 17 % 16% 14% 12% 11% 10 % 10% 10 % 6% 4% 2% 0% Trend 04 to 05 Trend 05 to 06 Trend 06 to 07 Support Comp Costs Front Office Heads 1 16% 14% 12% 10% 6% 4% 2% 0% 17 % 14 % 13 % Trend 04 to 05 Trend 05 to 06 Trend 06 to 07 Firmwide Direct Non-Comp 1

2 PERFORMANCE REVIEW AND IMPROVEMENT Historically, in a downturn, there have been several key target areas which have received focus. We thought it would be interesting to consider the various alternatives in terms of both the level of difficulty in realizing any saving and the quantum of savings available before exploring the main components:, Unit 9 Market Data Professional-Legal Marketing Professional-Consultancy Office Administration Recruitment Training Travel & Entertainment Technology & Communications Non-Compensation Costs Revenue / Business Driven, 22% Variable, 50% Fixed, 29% Professional-Audit (External) Premises Overhead (Direct) NON-COMPENSATION COSTS Probably the most obvious and first signal that we are in a decline is the mandate that we now fly at the back of the plane and there is a freeze on non-essential business travel. This is often scoffed at as being insignificant, but from our work on benchmarking we can see that for some firms non-compensation changes can have a material impact on cost : income ratios. The range between the upper and lower quartiles in non-comp costs per head can be approximately 35%, and at a large firm, as much as one half-billion dollars. There are several interpretations of non-compensation, but here we are referring to the direct non-staff related costs incurred by all groups within an organization (other definitions sweep in all support costs, brokerage and clearing costs, alternative sourcing costs). In order to look at non-comp costs and identify savings opportunities, we would suggest breaking them into categories and reviewing, once scaled by drivers: 2

3 3. Reduce businessdriven non-comp FASTER RESULTS, LOWER RISK / INVESTMENT, Unit 9 MODEST COST SAVINGS 6. Reduce comp by location strategy 1. Reduce fixed noncomp costs 7. Reduce title inflation 2. Reduce variable non-comp costs 5. Reduce support areas headcount SLOWER RESULTS, HIGHER RISK / INVESTMENT 4. Reduce front office headcount HIGH COST SAVINGS 1. REDUCE FIXED NON-COMP COSTS (25-30% OF TOTAL NON-COMP) Audit, Premises, Overhead It may take a long time to adjust these costs, and internal adjustments will often merely push the costs around the firm, but not out of the door. A less frequent and centralized review of these costs is likely to be as effective as a widespread, detailed, regular review. 2. REDUCE VARIABLE NON-COMP COSTS (45-55% OF TOTAL NON-COMP) Consultancy, Administration, Recruitment, Training, T&E, Technology & Comms These costs are user-driven and have a greater discretionary element to them. These costs should be reviewed regularly by the consumers to assess the rate of consumption, and across the firm to ensure per unit costs are achieving the best value. The challenge in reducing these costs is identifying the appropriate targets, for example, which costs are better centrally managed, and what are the implications of cuts, both culturally and tangibly. 3. REDUCE BUSINESS DRIVEN NON-COMP COSTS (20-25% OF TOTAL NON-COMP) Market data, Legal, Marketing, Training To review these, one must scale them by the revenue generated, as there is a chickenand-egg argument that cutting client facing T&E will potentially hurt revenue and the scale of any such reduction may far outweigh any cost benefit released. Often the biggest challenge is actually executing change, as opposed to identifying an overage. Objective benchmarks are essential in analyzing this. It is essential to take a holistic view when considering some expense lines that are effectively managed on a shared basis. The mix between external legal fees and internal staff and centrally managed costs can lead to a deliberate skew to one or the other and firms need to review, which is the most effective model for them. 4. REDUCE FRONT OFFICE HEADCOUNT In a downturn, we consistently see firms look at the support groups as one of the first targets for headcount and cost reductions, however, here we will also consider the producer groups. Although it is more difficult, culturally, to reduce staff in this area, it will have a more marked impact on the cost base. Many of the announced RIFs during 2008 have been firm wide reductions across all businesses and levels. There is a conflict here between the message the firm wishes to 3

4 send culturally, and the competitive landscape. What firms need to do is be less democratic or political about the reductions and review realistically the economics of each business. We have seen many instances where businesses show clear benefits of scale in markets (or indeed regions) and firms need to consider seriously if they have the appetite to invest and achieve scale (will be a tough call in this market) or to retrench or withdraw from those businesses rather than remain in some middle ground., Unit 9 The firms that have been chasing the main growth areas, particularly in capital markets in the last few years, have been investing heavily into a competitive market (at a high cost) with the promise of future profits which may now be delayed or never achieved. Firms need to act quickly and decisively on these investments. The costs of reducing heads late in the year, where most costs, including potentially bonus, are sunk, versus the cost of rebuilding a business after recovery makes a compelling story for trying to hold out as long as possible. This compounds the importance of making the right long-term decisions about businesses. 5. REDUCE SUPPORT AREAS HEADCOUNT While revenue may have dipped materially in 2007 and into 2008, the volumes and complexity of products continues to rise and these opposing forces make it increasingly difficult to get the support model right. In our work, and as can be seen from the many published reports, there is no correlation between the amount of money spent on support and control functions such as risk and the outcome. The key is ensuring spend is directed in the optimum way (for example, spend on data gathering and collection in risk arguably adds far less value than senior and timely analysis of the resulting data). The other common argument is around automation (technology spend) versus manual workarounds and the economic implications of each. In our experience, this can be one of the most costly decisions a support group makes in the long term, so firms need to be clear where they want to be on the spectrum of automation and be sure they have the cultural and financial backing to see that strategy through (flexing this when you find it is not where you expect it to be can be hugely expensive). Many firms have moved to a shared services model to leverage economies of scale, where multiple front office areas leverage a consolidated support group, and many have reaped significant savings, however, we would caution against the assumption that these benefits can be attained in all functions at all firms. 6. REDUCE COMP BY LOCATION STRATEGY With firms increasingly looking at reductions in force, one extremely important element is how quickly and effectively firms can flex (and in particular roll off) costs after a restructure. Often with volumes constantly increasing, the temptation is to use low cost locations to cover capacity and hence never rolling off the onshore staff. Support groups have been moving towards alternative sourcing (contractors, temps and outsourcing) and so beware of quotes of reducing headcount this may not always be the whole story. We have seen a huge increase in captive or low-cost near shore alternatives to staffing. All of these measures make any per capita or scaled analysis from published data or within an organization increasingly difficult, so often several key drivers need to be 4

5 considered to get the real message. It will be interesting to see, in this market, which of the firms have the capacity and appetite to start / see through a long-term location strategy that will inevitably hurt short-term costs, as the set up is costly and the savings are realized over time., Unit 9 7. REDUCE TITLE INFLATION Firms often become top heavy in their staffing profile, with an expensive, highly senior headcount producing modest revenues. As firms look to reduce staff, this is an ideal time to remove excessive senior headcount. The strategy and implications around this will be the topic of a future McLagan Alert. COST ALLOCATIONS In times such as these, with increased pressure on support groups and reducing headcount, firms should focus on what activities they want to encourage by any cost allocations and adjust accordingly. All too often, firms in their quest for 100% theoretically accurate allocations end up either a) spending too much on the allocation process or b) having the wrong people focusing on costs they cannot directly control or even influence. In a large organization, either of these factors can have a material impact on costs and culture. METRICS AND PERFORMANCE Given the scale of the compensation component of the overall cost base for many banks, it is essential that the strategy, finance and human resources teams all work together, however, this is too often not the case. These groups would benefit from all working from a consistent, agreed set of key metrics that permeate throughout the organization and are clearly understood and communicated (with local and divisional additions and tailoring) CLOSING In summary, we have seen stellar performance in pockets of businesses, within capital markets firms in particular, that has partly allowed for the cost base to rise with the tide to unsustainable levels at many firms. With revenue dropping in all businesses and in some cases drying up completely, the urgency to address these overages is clear for all to see. There are several stark warnings from history for firms to take on board, where over zealous cost cutting has resulted in long-term harm to shareholders, however, given the extent of the losses, we believe some firms will have no choice but to try to aggressively cost-cut their way out of the current compensation shortfall. In most cases, both revenue generation and cost-cutting will be required, and the mix will depend greatly on the extent of the losses incurred. While other sectors within financial services may have fared better through 07-08, they would do well to learn from the issues faced by capital markets firms. We will be working with our clients throughout the year, combining all our expertise on compensation, non-comp costs, and performance, to help them achieve their goals. Michael Burke, Head of GAUGE, is responsible for financial productivity benchmarking (GAUGE) and the London office of McLagan. Michael s prior experience is drawn from a range of business and support roles within Global Bulge Bracket Capital Markets organizations. Michael is a Chartered Management Accountant. 5