It's Time for Banks & Credit Unions to Embrace Change

As I travel across the country, visiting financial institutions in the midst of their annual planning cycle, it is like a trip down memory lane. While the technology and distribution channels have changed, banks and credit unions are still faced with the many of the same strategic challenges we talked about 20 years ago.

As a long time banker and friend, Michael Bencic said, "Improving the customer experience, embracing change, deriving value from data, building strategic partnerships, leveraging technology, ensuring privacy and security, cutting costs and generating fees is like deja vu all over again."

I agree. While the details behind these goals have changed, why have the overarching themes stayed the same? Is it because the planning process usually begins with broad financial requirements and many involved in the process simple dust off last year's plan and hit the restart button? Or is it because, despite a lot of talk around embracing change, the industry (and the regulators) frown upon the potential risk associated with innovation and doing things differently?

In a new report just published by KPMG entitled, Reshaping Banking in a Dynamic Business and Regulatory Climate, the author emphasizes the importance of getting out of 'survival mode' and embracing change, creating new strategies, crafting new infrastructures and focusing on the customer. While there is no denying the importance of each of these issues, this report is not much different than similar reports I read in the 1990's. The primary difference is that the risk of ignoring these issues has far greater implications.

Dusting off last year's planning document and making small alterations is not enough. It will take more than simply finding ways to 'do more with less', cost-cutting and operational improvement. According to Brian Stephens, national leader of KPMG's banking and capital markets practice and author of the report, "There must be acceptance among the entire leadership team that the rapid, unpredictable, and profound change we are witnessing is structural -- not cyclical." He continues, "The debate in not about the need for change, but what changes should be made."

As in the past, the issues that must be addressed are many. The difference is that today, while the issues may look similar to the past, the issues are more interconnected than ever before and the environment where these changes need to be made is evolving at breakneck speed.

The KPMG report provides a perspective into the following critical areas as banks and credit unions plan for 2014 and beyond:

• Culture of embracing change – In today's environment, change is constant, so banks must be nimble and innovative. "Banking leaders must choose to adapt and evolve, or risk irrelevance," says KPMG. "In the future, when banks look back on this time of change, an organization's resilience will not be measured by how much adversity it endured throughout the financial crisis and this period of recovery; rather, it will be measured by how well it adapted to it." The challenge is a tradition of rigid internal resistance to change and a consequent inability to execute. The change in culture must come from the top, starting with the board and senior leadership. And it must me more than just words.
   
• Focus on customers, not products – To increase revenue, banks must determine the appropriate customers to target and how best to package the products and services for which they are willing to pay. The challenge, related to the first issue above, is that banks have a legacy of talking to the masses and giving services away for free. Without better segmentation and an understanding of what customers will pay for, the impression of any revenue initiative will be negative. Alternatively, bundling services such as mobile bill pay, alerts, ID protection, payment services, etc. using a customer-centric perspective can results in a win-win.
   
• Deriving value from data – Banks and credit unions that can extract more value from all available data sources to develop a better understanding of customer needs can serve customers more effectively and profitably, while developing a competitive advantage and staving off threats posed by new market entrants. The challenge is that all internal product-centric data silos (retail deposit, credit card, small business, mortgage, commercial, etc.) must be integrated to provide a single customer view. Once data is integrated, the customer insights need to be leveraged for better product development, new cross-sell and revenue opportunities and reduced risk.
   
• M&A/Alliances – Despite many predictions around increased M&A activity in the past that have not come to fruition, the environment today is prime for consolidation due desires for geographic expansion, product enhancement and cost reduction. The immediate issue is that organizations need to strategically evaluate whether they are a buyer, a seller, or neither, while also examining the possibility of developing alliances where strategic fit warrants.
   
• Technology – At a time when costs are being cut, the appetite for investment in technology is usually tainted by the memories of previous IT upgrades that never met expectations. Nonetheless, the ability to effectively support the integration of new delivery channels and a customer-centric view leaves most banks no choice but to upgrade aging infrastructure. "The promise of harnessing technology advances can help banks streamline operations to reduce operating costs, connect future and existing customers across a multitude of new and emerging channels, tap new revenue streams, enhance customer loyalty, and build better defenses against cybercrime and denial-of-service attacks," says KPMG. In the end, ignoring or putting off the inevitable is a risky strategy, especially with the risk of noncompliance, losing market share or not being able to support an ever more important mobile strategy.
   
• Cybersecurity – The increasing scope, frequency, and sophistication of cyberattacks on banks means institutions need to be better prepared to address a risk with implications that both enormous and unknown. With the public's trust in banks finally recovering from the impact of the financial crisis, this trust can be shattered if life savings (or even access to funds) are at risk. In addition, there are some who believe that we are at the tipping point in the acceptance of mobile banking (and mobile payments) without greater ID protection and mobile security in place. 2014 will be a year when most of these issues need to be addressed (if not sooner).
   
• Capital & Compliance – Banks will continue to need to prepare for stress testing, while also monitoring various capital adequacy and liquidity requirements and associated staffing and compliance costs. For many banks, the issue of capital adequacy may be secondary to the ongoing costs and internal 'friction' that is associated with the added staffing associated with meeting regulations
   
• Accounting for Credit Losses – Banks will need to understand revisions to accounting for credit losses on financial assets and other rules. These changes could not only have a significant impact on an institution's reported earnings, but also on its capital ratios due to the need to carry larger loan loss reserves.

While the list of issues may not be new to any banker who has been in the business more than 6 months or more than 20 years, the risk of not proactively addressing these issues has never been greater. So, if you are in the midst of planning for 2014, make sure your team is just not listing these in a SWOT analysis without building strategies to address the risks and opportunities. If you are 'done' with the formal strategic planning process, it may make sense to review the strategies and tactics planned for 2014 to make sure some version of 'status quo' is not your plan.

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Are Some Banks Too Small to Survive?

With increasing regulatory capital requirements, declining interest margins, a greater need for investment in innovation and new competition, there are many in the industry who believe that smaller banks may have limited opportunity for growth in the future. 

These pressures may lead to an acceleration of consolidation in the banking industry that impacts both small and mid-tier banks and results in a significantly reduced number of institutions in the future.

While attending both the BAI Payments Connect and CBA Live conferences in Phoenix last month, discussions often revolved around the heavy financial and organizational impact of new capital requirements and of regulatory compliance being faced by institutions of all sizes. It was also clear that the investment in advanced technology and the pace of innovation was creating a distinction between the 'haves' and the 'have nots'. While there were some exceptions, this line of demarcation appeared to be defined by the size of organization.

The question I asked several industry thought leaders over the past couple weeks is whether smaller banks are in a position to survive given the massive industry changes on the horizon. While their responses varied regarding the chances of survival for today's community bank (and smaller credit union), there was unanimity in their belief that smaller institutions must quickly adjust to the 'new reality' of increased capital requirements and regulatory pressures, a greater focus on revenue, and a need to innovate for an enhanced customer experience.

"The thing that keeps me up at night is that we will likely see an industry contraction in the next decade like we never experienced", states Bradley Leimer, vice president of the $3.2 billion asset Mechanics Bank in California. We are moving from over 14,000 financial institutions today to less than 5,000 in the next 10 years (maybe sooner). This is due to the changing nature of consumer behavior with the introduction of mobile and social and technological innovation, but also due to systematic changes to the banking model itself."

Also supporting my informal findings, Emily McCormick, director of research and writer for Bank Director, interviewed the risk officer of an $8 billion bank holding company for Bank Director's 2013 Risk Practices Survey. He told her that, while he found a lot of positives in the regulations coming out of Washington, this could be a challenge for smaller banks that lack the resources and staffing to keep up.

McCormick also believes there's a technology challenge, "Internally, smaller banks need the right resources to do things like manage risk, but they also need the resources to compete. While smaller banks have the significant benefit of connections within their local business communities - giving these banks a potential advantage in business lending - customer expectations for services like mobile and online banking will continue to rise."

Increased Capital Pressures

According to an Invictus Consulting Group report entitled, Buyers and Bleeders, more than half of today's institutions will need to participate in some type of M&A activity based on new capital requirements alone. This includes as many as 2,000 banks that should sell due a lack of financial return and/or a lack of capital. In addition, the report believes that as many as 3,500 institutions have enough capital, yet lack loan demand and therefore need to deploy their capital to acquire banks that will grow their business. Unfortunately, even some of these firms with capital may not have enough to spend to grow to the level to be competitive.

An interview of Adam Mustafa, managing director of Invictus, was done by Bank Director Magazine to discuss the research report findings. 

Impact of Increased Compliance

According to an October 2011 research report developed by Aite Group entitled, Reducing Banks' Compliance Toll, the annual cost of compliance for banks well exceeds $1B. Unfortunately, many of these costs (personnel, software, etc.) are 'fixed' infrastructure costs which place a heavier relative burden on smaller organizations who still must comply with many of the same regulations.

According to the Aite report, however, many institutions have failed to take advantage of technology and process improvement steps that could reduce redundancy and paper intensive processes that are a major contributor to these costs. Aite (and many other consultancies noted in the report), believe that the end game is an 'electronified' organization that can eliminate paper and enable real time information management.

Unfortunately, this automation of processes requires a substantial investment that may bring long term benefits, but is not affordable to many smaller institutions today given other priorities.

The Innovation and Distribution Imperative

While we could discuss for days whether or not the improvement of branch-based, web, online and mobile interactions should be considered 'innovation', there is no disputing the fact that the typical banking customer is expecting more services, delivered through more channels than ever before. As I experienced in person at the two conferences in Phoenix, the investment in innovation is both required and substantial.

According to Leimer, "If community based institutions are going to relevant going forward, they need to be much more agile and much more focused on partnerships with technology providers and other similar shaped financial institutions. We must work together to partner and innovate to deliver community based services in a hybrid model - centralizing resources, sharing innovations, riding on non-traditonal service frameworks - the type of cooperation these institutions haven't historically embraced." 

In addition, as consumers embrace the smartphone and do more of their banking online and through mobile devices, additional negative dynamics occur. According to Sherief Meleis, partner at financial consultancy Novantas, the reduced importance of local branching means that banks are moving from being primarily local retailers (where the average community bank could simply out-local the big banks), to product/marketing organizations where there are indeed economies of scale. 

"In an environment where the branch importance is diminishing from a transaction perspective, it’s difficult for smaller banks to afford the required fixed cost (just like with regulation and compliance). Our analysis suggests that super-regionals and national banks have substantially higher returns to branch network position, due to their ability to invest in product innovation and brand marketing."

This position was shared in a recent American Banker article entitled, "Why Regional Banks Are The Right Size Right Now" where the case was made that regional banks benefit from the scale to absorb compliance and regulatory costs better than their smaller brethren, yet are nimble enough to develop new technologies that can improve service delivery and efficiencies. This was evident in their chart showing the ROE for different sized organizations.

Power of Shared Services

As shown above, critical mass is a "sine qua non" for success in today's highly competitive market place. One of the impediments to small size is that it gets difficult to embrace new technologies and improve your operating margin as investments in technology do not give the same payback as it would for the larger banks. Therefore small banks need to take advantage of some one else's strength and critical mass and deal with a service partners and business process outsourcers that are able to improve efficiency ratios.

According to Nicole Sturgill, research director for retail banking and cards for CEB TowerGroup, "Small banks have the opportunity to take advantage of single supplier discounts (i.e. using one solution for branch sales and service, online banking, mobile banking, etc.). In addition, there are a number of solutions that cater to the community bank and credit union markets, which offer lower pricing because they are selling to thousands of institutions (i.e. mobile RDC and PFM)." She adds, "While these solutions may not offer all of the wiz bang functionality of a large bank solution, the increased focus on personal service that a smaller bank provides may give them parity if not an edge on the larger banks."

While there are some very good banks of all sizes, the efficiency ratios get better as we have some critical mass, according to Sankar Krishnan, global banking engagement head for business process outsourcing leader, Sutherland Global. "Companies that provide operations and technology services to banks and are able to improve the operating metrics have a great role to work with the smaller institutions (Community, Regional etc). They can provide industry best-in-class knowledge and help support their efforts to get better on efficiency ratios and operating margins."

Some Small Banks May Survive . . . If They Have a Plan

There is very little doubt that, given the economic environment and the paucity of available capital for smaller banks, the number of banks will certainly decline over the next several years. This decline may simply be a continuation of recent history – or the consolidation of the banking industry could accelerate. While most of the advisors I contacted agreed that small banks must take an aggressive stance to increasing sales and reducing costs to survive, they also believed that some smaller institutions may be positioned to succeed in the future. 

Mary Beth Sullivan, managing partner of Capital Performance Group, thinks that earnings pressures for smaller banks will be even more significant in 2013 than in the past but states that many banks may not simply succumb to the pressures to consolidate. "Smaller banks are sometimes odd characters . . . many will continue to hold onto their independence as long as possible."

Serge Milman from Optirate warns that deploying technology and/or introducing products and services without the benefit of a comprehensive business strategy is an effort that is likely to disappoint.  "Just look at institutions that have deployed these tools and most will show little or no improvement in profitable customer growth, increased wallet-share and certainly, not higher ROE.  This approach is analogous to attempting a cross-country drive without a map (or GPS) --- no one would try this, yet Bankers do exactly this every day of the week!"

Milman continues by saying, "The journey to growth, profitability and customer loyalty must begin with a sound strategy that is supported with a measurable and implementable operational plan.  Community Banks can succeed, but to do this, they must embrace the reality that the world has changed and they must willing to adapt."

"There's only one strategy that makes sense for smaller banks: get more sophisticated about analyzing customer feedback and leverage the voice of the customer to prioritize which initiatives to pursue," stated Steven Ramirez, CEO of communications consulting firm Beyond the Arc in an email interview.

"Smaller banks have the potential to gather deeper insights about their customers, but few of them do. Since small banks can't invest in everything, they need to focus on what really matters in their local market."

Brad Leimer probably summed up the conundrum of smaller banks best when he said, "There is space for community minded institutions in the financial marketplace of the future - but they will look and act much differently than today - simply because the banking model has seen a significant shift."

Additional Resources

Buyers and Bleeders: Invictus Group (March 2013)

Bank Director 2013 Risk Practices Survey: Bank Director (March 2013)

Reducing Banks' Compliance Toll: Aite Group (October 2011)

Why Regional Banks Are The Right Size Right Now: American Banker (April 2013)

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