Opportunities for Action in Financial Services Refocusing on Costs
Refocusing on Costs Thanks to rapid economic expansion and widespread industry consolidation, banks have grown dramatically during the past decade. So far, however, they have largely failed to use their new scale advantages to reduce costs. Some of the reasons are clearly beyond any bank s control. They include the extra costs of dealing with challenges such as Y2K, increasingly onerous consumer-protection legislation, the introduction of the euro, and the advent of e-commerce. Nonetheless, many banks have yet to tackle the cost factors that are within their control. Focused intensely on the pursuit of growth, these banks have neglected important cost-cutting opportunities. But as economies around the world continue to slow, most of these institutions will come under increasing pressure to improve profits through tighter cost management. To refocus on costs, senior managers should ask themselves three sets of questions: How well placed are we to begin addressing costs? What is our track record? Why and where have our previous efforts stalled? What are the right targets and how should we set them? Are we looking for marginal improvements or radical solutions? What is the right approach? Top down or bottom up? Broad-brush or narrowly focused? Is there a standard methodology or do we need to tailor solutions for each division?
Leaders and Laggards Some banks have answered those questions and have far outstripped most of their competitors in addressing costs. They have driven down their cost-to-income ratios to 50 percent or less from levels of 65 percent or more. Some now aim to bring their ratios down to the low forties. Institutions such as the ANZ Banking Group, Hang Seng Bank, and Lloyds TSB have cut their ratios by more than ten percentage points in the past several years and are planning further reductions. However, analysis conducted by The Boston Consulting Group of the costs of 15 global banks shows that many lag far behind the industry leaders. The scale advantages that should have followed the recent period of growth and industry consolidation have simply not materialized. (See Exhibit 1.) Exhibit 1. A Missed Opportunity for Many Banks Average Asset Growth Versus Cost-to-Income Ratio for a Sample of 15 Global Banks Index 190 180 170 160 150 140 130 120 Asset growth 110 Cost-toincome 100 ratio 90 Opportunity for cost reduction Scale 80 ratio 1995 1996 1997 1998 1999 2000 SOURCE: BCG analysis.
The failure to produce scale advantages will prove particularly painful now that the economy has softened. An economic slowdown can quickly transform a bank s balance sheet. For example, a 15 percent reduction in volume and price would cut profits in half, and that s before taking bad debts into account. (See Exhibit 2.) But a slowdown does more than increase the need to focus on profitability: it also creates the conditions for successful cost reduction. Investors expect more cost cutting in this tough environment, and organizations have a greater appetite for change. Implementing tough initiatives becomes easier. With cost-cutting needs and expectations in alignment, an institution must take the right first step. Cost-cutting programs are nothing new in financial Exhibit 2. A Downturn Can Quickly Sink Profits How Declines in Volume and Price Combine to Upset the Bottom Line Index 100 Actual 70 80 83 10% Volume 65 56 50 15% 58 10% Price 75 Actual 15% SOURCE: BCG analysis.
services, of course. But the road to better controls has been littered with failures, not only in implementation but also in sustaining the efficiencies achieved. Before embarking on a program, senior managers should consider the most common reasons for failure. They include an inability to deal with competing priorities, the lack of a clear rationale, a fear that cuts will reduce profits, insufficient resources, and a failure to complete the program. In addition, banks often view cost-reduction initiatives as largely analytical endeavors. They therefore fail to devote enough attention to employees behaviors and emotions softer issues that can substantially affect the bottom line if not managed properly. (See Exhibit 3.) How can a bank avoid such pitfalls? First, senior managers must determine if the organization is ready, will- Exhibit 3. Addressing the Main Reasons for Failure Top Reasons Too many competing priorities No clear rationale for reductions Concern that cuts will reduce profits Insufficient resources No follow-through Lack of attention to behaviors and emotions Typical Comments We have too many initiatives under way. Why $1 billion in cuts? Why now? Cutting costs may hurt our performance. We can barely manage now. We don t need to take more action. It s about costs, not people. Levers Required Clear leadership and strategy External targets, high-level benchmarks Thorough, rigorous analysis Resource allocation, additional support Initiative tracking, incentives Thoughtful, sensitive management SOURCE: BCG analysis.
ing, and able to proceed. Then they must identify the levers that can help position the organization for successful cost cutting. Setting the Right Targets For managers, the most challenging aspect of a costcutting program is setting clear and accepted targets. Such targets are crucial for avoiding failure and ensuring that there is follow-through. To champion change with employees, leaders must present a strong, logical argument for what needs to be accomplished. That means conducting rigorous analysis to support the new cost strategy and establishing a process to anticipate and manage the change effort from the start. The whole organization must see clear leadership that connects the cost-reduction program to the company s overall strategy. The executive team should show employees that it is united and fully involved in the effort. In our experience, managers and other employees quickly reject arbitrary targets. Only targets set externally with reference to the competitive environment can withstand the scrutiny of an internal cost review. In practice, external targets can be set in only two ways: by benchmarking competitors or by establishing a market-based value-creation target. Both measures provide the keys to setting cost-reduction targets and agendas. Of the two approaches, a target based on value creation is the more powerful, although it has more meaning for the organization as a whole than it does for individual divisions. Setting such a target, which is usually tied to a company s share price, provides managers with a compelling logic and focuses their
efforts. A strategic reassessment of costs requires a firm value-creation target. As a target-setting tool, benchmarking is often applied inappropriately. For example, it is misleading to compare the mortgage-processing costs of players in the United States and Europe because of the very different legislative frameworks and payment systems on both sides of the Atlantic. Nevertheless, benchmarking can be used strategically. Competitors, for example, achieve widely varying levels of efficiency in terms of their sales per employee. The level of efficiency is similarly varied when it comes to sales volume relative to sales, general, and administrative costs, or SG&A. (See Exhibit 4.) Benchmarking can clearly pinpoint cost issues and help with setting targets. Exhibit 4. Strategic Benchmarks Can Be Powerful Plotting a Range of Efficiency Levels in a Sample of Banks Low 150 100 Laggards SG&A/sales average Worst offenders Worst offenders 50 Sales per employee indexed to industry average (%) 0 50 100 High Big Leaders spenders Big 150 spenders 150 100 50 0 50 100 150 Low cost High cost SG&A/sales indexed to industry average (%) SOURCE: BCG analysis.
Selecting an Effective Approach Once managers have prepared the organization for change and established clear cost-reduction targets, they must decide on an approach. The challenge is to adopt an approach that is broad enough to have a decisive impact but not so diffuse that it becomes dysfunctional. In our experience, there are five dimensions to a successful approach: the level of ambition, the scope of the program, the amount and nature of intervention, the methodology to be used, and the direction from which the initiative is driven (bottom up or top down). Although each organization is unique and requires its own tailored approach, there are broad best practices that every bank should consider. (See Exhibit 5.) Exhibit 5. Best Practices for Cost Reduction Level of ambition Scope Intervention Methodology Drive Marginal improvement Single business unit Broad Single tool Bottom up Achievable stretch Radical solutions Most of the organization Entire organization Opportunity based Focused Specific tools for each opportunity Multiple tools Strong elements of both Top down SOURCE: BCG analysis.
Cost reduction is moving to the top of the banking agenda. Investors and markets will scrutinize costcutting efforts, judging them by their contributions to the bottom line and how they compare with the efforts of competitors. Organizing to execute well, setting the right targets, and selecting an effective approach are the three elements that will distinguish the leading players through the next economic cycle. Jon Nicholson Michael Krupp Chuck Callan Jon Nicholson is a vice president in the Sydney office of The Boston Consulting Group. Michael Krupp is a vice president in the firm s Frankfurt office. Chuck Callan is a vice president in BCG s New York office. You may contact the authors by e-mail at: nicholson.jon@bcg.com krupp.michael@bcg.com callan.chuck@bcg.com The Boston Consulting Group, Inc. 2001. All rights reserved.
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