Strategic Cost Management Is Key to Efficiency and Profitability

Tom McGrath FIS Consulting Services White Paper

Strategic Cost Management Is Key to Efficiency and Profitability

Unabated Pressure on Revenues

Two data points do not a trend make. Nevertheless, the 10-year comparison of revenue as a percent of industry assets fairly reflects the continued overall decline in the industrys ability to generate top line income. Using FDIC year-end Call Report data as a reference, a look at revenues finds top line revenues comprised of net interest income and non-interest income declined by 58 basis points compared to 2000 results. The 58 basis point decline is 10.3 percent of year 2000 revenues. Myriad factors that unfavorably impact revenue have been discussed extensively and there is little to add to the ever-lengthening list of negative factors that have been impacting top-line income production. While the industry is working diligently to seek out new sources of revenue, there seems little doubt that overall revenue momentum is negative and it is likely to stay that way, continuing the downward slide seen over the past 10 years. The fundamental questions become: are the improvements that have been made adequate to offset future revenue pressure and, if not, what else can be done to improve efficiency?

10 Years of Revenue and Expense Change

If the past 10 years have proven anything besides how imperative sound credit policies and procedures are, it is the value of continuing to focus on cost control as a means of offsetting ongoing pressure on revenue. Were it not for reducing operating costs at a rate that outpaced revenue declines, profitability would have deteriorated even further than it did due to credit quality issues. From a profit perspective, 2010 was another difficult year with industry return on assets (ROA) at just .66 percent. Had the industry not reduced operating costs at a pace nearly 20 percent greater than the decline in revenues, the year would have been even more difficult. Had expenses not declined by 42 basis points over the 10-year span, the industrys already depressed 2010 return on assets would have been cut by two-thirds.

Strategic Cost Management Is Key to Efficiency and Profitability

Efficiency Ratio
The cost/income ratios for the two periods are seen in the following chart which shows a modest overall improvement in efficiency as operating costs shrank from $58.40 per $100.00 of revenue to $57.22.

Cost Inputs to the Efficiency Ratio

Where was the improvement? High level data available from FDIC Call Reports break out a limited number of expense categories. While limited, these data are informative and suggest where the industry has made progress and where opportunities may deserve further attention as depicted in the following graphic.

The largest percentage reductions from the year 2000 spending base, ranked in descending order, were: Category Premises & Equipment Additional NIE Amortization & Impairment Compensation 22.7% 12.9% 12.5% 8.6% Reduction

Strategic Cost Management Is Key to Efficiency and Profitability

Drivers of Efficiency
Scale economies and utilization efficiency play a substantial role in overall industry productivity ratios. The following segmentation of banks by asset size illustrates this point. The larger the bank, the better the cost/income ratio becomes. Investments are leveraged across a larger business base and fixed components of operating costs are absorbed across higher volumes.

This high-level illustration holds true across the full spectrum of banking operations. As a case in point, data from client costing studies and profitability analysis conducted by FIS over the past 10 years reflect the impact of scale on efficiency in branch networks. The above graphic reflects direct operating costs relative to deposit balances for branch offices of varying sizes. Finally, the impact of scale is evident in top-line revenue across various asset size bank segments. The larger the bank, the more revenue was produced per FTE employee. No doubt the nature of the business mix influences this result, but it is also true that the larger the bank, the larger the client relationship tends to be that is supported by a single banker.

This fundamental question then emerges: How does an organization that lacks the size of a $10 billion bank capture the benefits of scale economies and utilization efficiency?

Strategic Cost Management Is Key to Efficiency and Profitability

Proven Approaches to Operating an Efficient and Scalable Organization

The balance of this paper addresses options to assist mid-tier banks and regional organizations in realizing benefits from greater scale and improve utilization of resources that are already owned by the bank.

Strategic Outsourcing
One obvious solution to achieving a degree of scalability that captures economies and utilization efficiency is the outsourcing of functions that can be performed by another entity more cost-effectively due to the outsourcers scale economies and utilization efficiencies. A wide-array of services is available to banks on a sliding scale tied to volumes. Perhaps the best example of such services for bankers today is check processing. As overall check volumes decline, individual banks find it makes more economic sense to outsource this back-office function. This can reduce expenses as volumes decline rather than burden them with high fixed internal costs. Selecting a strategic partner for a full range of business processes and IT outsourcing is critical. Key considerations when selecting a partner include:
The reputation for regulatory compliance, service quality and financial soundness of the service

provider can be determined with proper due diligence

The willingness of the partner to enter volume-sensitive/scalable pricing arrangements that reflect

decreases as well as increases in volume which generate reduced unit pricing as volumes increase

Clear, unambiguous service-level agreements for all key business outcomes critical to the banks

customers and the banks internal operations, as well as clear processes for escalating problems for prompt remediation alter customer activity patterns if savings are not extracted from legacy distribution channels such as branch networks and ATM systems. The keys to sound decision-making in this sensitive arena are:
Household trends Understanding the

Branch Rationalization and Delivery Channel Optimization

As noted earlier, larger offices are more costeffective to operate. With the volume of branchbased transaction activity in ongoing decline, and the use of alternative sales and service channels continuing to expand, the second obvious candidate for improving scale is to evaluate branch consolidations and outright existing of low potential markets. The number of domestic deposit domiciling branches declined in absolute numbers (1,443) for the first time during 2010 to reach a level below year-end 2008. No doubt part of this is the result of roughly 300 bank failures in the same period, but there is at least anecdotal evidence that bankers are starting to reconsider the viability of a larger number of offices. Said another way, there is no advantage to be gained from investing in new technologies that

demographics of a banks households is critical. The propensity for acquisition of financial services in each customer segment as a determinant of the market potential surrounding branches needs to be understood, as well as the anticipated household growth within a specific trade area. market share in relationship to investment in branches in any given market and evaluating the potential to alter results is also key. A simple metric worth considering is fair share. Fair share assumes that a bank should capture a percentage of deposits equal to its percentage share of branches in a market.

Competitive environment Evaluating

Strategic Cost Management Is Key to Efficiency and Profitability

Profit contribution/funding effectiveness

results Assessing the branchs ability to generate deposits as a low-cost funding source at a target profit contribution level is also important. A bank should evaluate the potential to improve through increased revenue generation or cost management.

Process Re-engineering with Enabling Technologies

Charter Consolidation

Incurring the cost of redundant regulatory examinations and quarterly filings, public accounting audits, director and officers insurance premiums to cover multiple boards of directors are illustrations of the inefficiencies associated with smaller scale and the impact of maintaining separate charters. The number of bank holding companies operating multiple charters has decreased by approximately 18 percent in the last two years (from 445 to 366). This suggests some movement to capture cost savings where available by improving cost leverage in consolidated operations. Any banking organization can continue to maintain a decentralized decision-making framework to empower local managers if this is critical to the organizations operating philosophy and culture. It can do so without the overhead of maintaining separate charters.

Substituting technology for manual inputs has always been a key to improving productivity. The application of emerging technologies (and expansion and adaption of even older IT platforms such as document imaging solutions where usage has been sub-optimized and under-leveraged by many banks) remains a key to improving productivity and further reducing overall costs. Critical elements for encouraging positive performance and improved business processes include:
Eliminating unnecessary work that consumes

time without adding perceived value in the eyes of the customer to produce quality service, achieve sales objectives and manage risk effectively

Simplifying tasks that must be completed

Utilizing available technologies more

effectively and implementing new systems to improve processing throughput and ensure quality outcomes support both revised and enhanced workflows and achieve reasonable management spans of control across the company

Streamlining organizational structures to

Strategic Cost Management Is Key to Efficiency and Profitability

Realigning responsibilities and tasks to ensure

that personnel with appropriate skills are assigned to complete required work

Utilizing a well-conceived and consistently

Restructuring employee compensation,

including variable incentives, to more closely align with all sales and service objectives in all units of the bank the strategic objectives and metrics by which the banks performance is assessed micro-market sales potential, with all other elements of sales management activities, including goal-setting and performancecoaching

applied approach to determining capacity over time. This is essential to realize long-term benefits from more effective staff allocation and avoid single, quick-fix staff cuts that never produce lasting results

Aligning goals and measurement plans with

Conclusion

Integrating a complete understanding of

The industrys limited improvements seen in a few productivity metrics have been offset in totality by an inability to maintain revenue levels. Revenues will not likely make a strong recovery banks best opportunity in that arena is to slow a decline achieved by some combination of new products and service offerings and reinvigorated attention to pricing disciplines. It is imperative that banks focus more attention and investment on reducing operating costs commensurate with declining revenue to avoid further erosion of profitability. The approaches discussed above have proven to be effective in achieving this objective.

Sales and Service Quality Driven Staff Capacity Management

The number of full-time equivalent employees in FDIC-insured institutions was approximately 6 percent below its 2007 peak at year-end 2010 (though up from its 2009 low point by approximately 1 percent). Systematically and consistently allocating human resources with the support of staffing and scheduling tools to satisfy strategic objectives and achieve business goals is critical to efficiency. Key points of staff capacity forecasting include:
Establishing targets and supporting staffing

Contact Us
For more information on strategies to improve efficiencies and overall financial performance, contact FIS Consulting Services at 800.822.6758 or visit www.fisglobal.com.

levels to achieve them, driven by market business development potential (as opposed to using business as usual as the sole determinant of new sales goals) using criteria driven by service expectations consistent with the banks desired image in the marketplace and commitment to the communities it serves compliant controls and statistically justified assessments of actual risk time for training and education, coaching and counseling, and general oversight of all frontline and back-office units

Staffing both branch and support functions

Allocating time consistent with prudent,

Allocating staff to incorporate sufficient

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