Top Five Imperatives for Banks in 2004

2003 has been a tumultuous year for the corporate world, particularly for the financial services industry. Corporate frauds, financial reporting opacity, fund scandals and resulting SEC probes have undermined investor confidence and raised serious questions on the way banks and corporations are managing and running their businesses. They have also brought in their wake new regulatory oversights. At the same time, steadily declining interest rates have enabled banks to widen their spreads, improve profits, be it from treasury or corporate or retail banking. Consolidation and competition still characterize the industry landscape, even as some of the larger global banks continue in their quest to become financial services powerhouses. The year also saw a host of regulatory initiatives (Check 21, Sarbannes Oxley, FASB and IAS 30 & Patriot Act,) leading banks and financial institutions to assess closely their position on the compliance scorecard. Banks are now placed in a position where they can reexamine their businesses and operational efficiencies without being unduly worried about bottomline pressures, thanks to some good profits last year.

Going forward, as in every new year, banks will be faced with multiple challenges or imperatives for 2004, some old and some new. We believe that in order to maintain focus banks should identify a manageable number of thrust areas and prioritize them.

We present below what we believe are the 5 most important imperatives that banks need to focus on this year. While these are broad areas in themselves, we have tried to define specific issues in each area that need to be tackled. The approach a bank chooses would emanate from its own growth strategy and experience. Yet there are certain broad facets that will need to be kept in mind. And in discussing each issue, we have tried to provide pointers that can help individual banks draw up their plans.

These 5 imperatives are:

1. Process & Technology Rationalization

Traditionally business focus, growth (organic or inorganic) and technology spends have been done in a loosely integrated manner that has resulted in sub-optimal situations. Consequently there exist multiple processes and / or systems that support similar functions. For example, a bank may have the same class of customers utilizing multiple products – a retail customer having a savings account, credit cards, mortgages, loans etc – wherein the account opening process and customer data may be duplicated in a variety of these product systems. At the other end of the spectrum, a single product may be utilized by different customer segments; for instance payment services (at a basic level) – account to account transfers over the web, being utilized by both retail and corporate clients, again giving rise to duplication of processes and systems capabilities.

Continuing with such proliferation of processes and systems does not offer any economic rationale. While banks have taken some steps towards rationalizing both, what is required is a bold initiative that goes beyond the enterprise to the next level and addresses the group as a whole. The key drivers for rationalization are:

• Costs – Cost reduction is surely a prime driver. By focusing on removing the redundancy in applications, banks can save substantial amounts on maintenance and license costs.
• Risks – Multiple applications and processes handling similar functions may increase the overall operational risk of the organization. This may be mitigated by standardizing processes, eliminating redundancies and rationalizing the applications.
• Reference Architecture – Standardization of processes and technology will allow banks to evolve well defined and flexible system architecture models that are amenable to robust scaling, and can support new product introductions or customizations in a smooth manner. This is particularly important in view of the increasing reliance on transaction based fee generating services where growth will be volume driven.
• Mergers & Acquisitions – M&A activities often run into problems especially when it comes to integrating technology or assimilating and propagating best practices / processes. With reference architecture and standardized processes, banks will be better placed to decide what to retain, and may also discover a simpler method to evaluate the costs associated with technology / process assimilation in acquisitions.

2. Driving Customer Relationship Value

Pricing pressures, competition from traditional and non traditional players, increased commoditization, a maturing marketplace and the emergence of sophisticated customers demanding personalized services have, over the years, reduced the room for maneuverability in the retail banking space. Customer retention is a key priority, especially since the cost of customer acquisition is many times higher and is constantly on the rise.

Banks have spent billions of dollars on CRM systems over the years. However, it is clear that this alone will not suffice in ensuring that they target the right customer by offering the right service at the right price over a sustained period. Banks need data and information from customer behavior which will enable them to convert a transaction into a relationship at a lower cost and in a profitable manner. Investments in CRM need to be closely coupled with spending on other tools such as data warehousing and data mining. The other key drivers are:

• Know Your Customer (KYC) – Whilst the regulatory aspects of KYC certainly add to the cost of customer acquisition, banks can leverage their spending on improved KYC procedures by designing processes that also focus on minimizing incidents of fraud / illegal transactions and the potential for monetary and / or reputation risk, losses.
• Customer Behaviour Profiling – Understanding the customer – whether s/he is a short-term relationship or a long-term one; profitable or non-profitable; single-product or multiple-product user; self-service oriented or otherwise are some of the factors that can help determine the appropriateness of the product or service, the pricing and the timing of the offerings made.
• Product Design – The ability to accurately understand and forecast the demand for various products and services from different customer segments will enable newer and better product design and also help banks in constantly assessing their strategies towards mass customization versus standardization.
• Personalization – The increased demand for personalization in service offerings has led to the reemergence of the branch as an important channel of delivery. Banks must focus on training the personnel in relationship management and cross selling skills, in addition to product knowledge, as that will enable them to maximize the value from each customer visit to the branch.

3. Compliance With Regulations

The introduction of a series of new regulations over the past couple of years has posed a new challenge to banks. Prominent amongst these are AML (Anti Money Laundering), SOX (Sarbannes-Oxley Act), IAS 30 and FASB (accounting standards with particular emphasis on accounting for derivatives). Some of these have implications on how profits are determined, while others pose technological challenges in implementation and compliance. Since they are mandatory, theoretically there is no need for any other driver. However, on account of the following factors, banks will need to adopt a holistic approach in their effort to ensure that they are compliant with regulatory requirements:

• National / Regional Regulations – Some of the activities that large banks undertake, such as centralization of processing, will mean a heightened need to ensure compliance with both host and parent country’s regulatory requirements.
• Proactive versus Reactive – Banks have the option of viewing compliance as another cost of doing business, or they could treat this as an opportunity to move beyond compliance in a proactive fashion and address a combination of several other issues such as reputation, culture and customer orientation.
• Multiple Regulators – A universal bank or a diversified financial group, with interests in multiple areas such as banking, securities and insurance, is subjected to multiple regulators with different, and sometimes conflicting, objectives. The challenge is to manage these different regulators and their objectives by adopting a perspective that goes beyond compliance, and yet does not lose sight of the business objectives
• Technology – While the use of technology can make the task of compliance easier in many instances, it can also be an expensive proposition and hence choice of applications / technology has to be judiciously evaluated.

4. Basel 2 and Beyond: Enterprise Risk Management

While Basel 2 appears to be a part of the regulatory compliance imperative, it merits a separate mention on account of its sharp focus on operational risk which is added as a new risk area for minimum capital requirement calculations . While there is no change in how capital for market risk is calculated, a greater degree of sophistication has been introduced in the calculation for credit risk. Banks have been relatively quick in responding to the revised credit risk guidelines, primarily on account of their long experience in managing credit risk.

Operational risk is still at an evolutionary stage and while banks may have been dealing with operational risk events in their businesses, it was probably not in a systematic and comprehensive manner. The current need is to set up an Operational Risk Management (ORM) system that will help banks measure and monitor operational risk events and calculate capital requirement. Implementing the ORM will have a huge impact on the way banks look at their operations. For the ORM, banks will need to determine not only the approach they want to adopt, but also design a new model, define the data requirements and finally put in place mechanisms to collect the data.

The major drivers here are:

• Regulatory Requirement – Though there is as yet no complete agreement from either banking authorities or the affected banks on the final shape or deadline for implementation, the Accord is here to stay and has to be implemented.
• Capital Savings – The objective of the banks is to reduce the amount of risk capital they need to keep on their balance sheets. Basel 2 now gives banks the tools to translate better risk management into lower capital.
• Operational Efficiency – The ability to measure and analyse operational risk coupled with the incentive of possible capital reduction gives banks the opportunity to critically re-examine their existing systems and processes. Wherever possible, banks can improve their current operations, not only to mitigate operational risks but also to reduce costs and improve efficiency.

The focus on risk management resulting from Basel 2 should eventually lead to the next step: Enterprise Risk Management (ERM). ERM is an integrated approach to risk management. It focuses on all uncertainties / risks facing the organization as a whole. ERM studies the correlation between various risks and attempts to present a single risk indicator for the organization. It will help in managing earnings volatility by examining all factors that have an earnings impact as well as non-traditional risks (e.g. legal / reputation). This will create a common understanding of risk across functions and business units.

The direction set by the Basel Committee through Basel 2 is towards a more comprehensive approach to risk management. Banks need to identify this early and put in place a strategy to implement ERM.

5. Strategic Outsourcing

Outsourcing, whether it be of technology or of process, is not new to the financial services industry. The first steps were taken with near-shore outsourcing. This was followed by offshore outsourcing (offshoring) driven primarily by wage arbitrage considerations.

Today, offshoring to countries such as India, the Philippines, South America or Eastern Europe is not just an option anymore. It is a business imperative. Estimates of potential savings are wide and varied depending on the type and value-adding nature of the tasks being outsourced. Other drivers for offshoring are:

• Competition – While offshoring is not yet a competitive differentiator the benefits some banks have obtained from this have helped them better stave off competition.
• Talent – The availability of a large talent pool facilitates process outsourcing while availability of strong technical expertise coupled with project management techniques does the same for technology outsourcing.
• Efficiency – With vendors of services moving up the value-chain and focusing on process improvements, the emerging mantra will be getting work done ‘most efficiently at the best price’ rather than merely at ‘the cheapest price’.

CEOs will increasingly have to contend with socio economic concerns and the potential for backlash whether inspired by regulation or otherwise. This is particularly true if issues pertaining to service quality and privacy arise. Banks will have to closely partner with high quality vendors who can demonstrate value, and devise a strategic approach that ensures that processes and service quality are not impacted as a first step and improved as a second.

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