New Business Models in Finance – Out of the Doldrums, into the Breeze
By Johan Kestens (Partner, ATKearney)
Boosted for two decades by an environment of deregulation, falling interest rates, growth in the world economy, and a “Master of the Universe” attitude, the financial industry now finds itself cornered in the doghouse of the economy since 4 years.
There is inertia in the unraveling of excessive practices, with Wall Street being hit in 2007 with the forced sale of Bear Stearns, the bankruptcy of Lehman, and flashing over to the United Kingdom and Ireland. Various other parts of the developed world experience similar crises unfolding a t a later stage, as in essence overextended lending led to excessive credit and the need for structural adjustments. Spain is the latest market going through the pain of experiencing this in depth.
Now the financial industry is facing tightening regulation, rock bottom interest rates, a sputtering global economy, and a significant loss of respect and even basic trust. The situation is of course different for banks, insurers, pension funds and asset managers , but all are facing tremendous pressure on existing revenue models, and struggle in a variety of degrees with loss of reputation, and with a blurring of their historical lines demarcating their business.
However, the world is evolving in fundamental ways beyond the impact of probably one of the biggest crises. There are fundamental forces at work that fundamentally underpin demand for financial services, to build, protect and preserve wealth of individuals and business alike.
These forces will confirm the need for credit, savings, payment transactions, investment services, and insurances of all kind. But there is more to provide, depending on the skills, entrepreneurship and ability to execute of institutions. These forces have to do with demographics, technology, to some degree globalization. Supplementing these forces is the role of regulation and increasingly also activism, which will also drive opportunities and limitations of each institution in its respective field. These are the real shapers of the path to financial institutions to get out of the doldrums they have been finding themselves in, and provide the steady healthy breeze to sail back into a prosperous future.
To capture the changes and opportunities associated with these trends, financial institutions need to gather around the essence of their business model. It will require a deeper focus on customer centricity, a specialization on core activity and skills, and a new covenant with their customers, society and also employees to confirm the place as key intermediary in financial estate building and managing.
Life in the dire straits
It is obvious that most if not all parts of the financial industry are or have been going through a very difficult time. Some have been kept alive by government intervention, some have been saved by competitors, and others are still struggling. Timing and impact varies as is obvious to all. The different causes by country or sector, complex dynamic and subtle contagion by subsector can be looked at in great detail but a few fundamental forces are clear.
Historically low level of interest rates, leading to significant profit pressure in almost all institutions. In banks, this reducing interest margins, also because loss of trust combined with a fight for liquidity makes them offer above market rate compensation for retail deposits. In life insurance, continuing low interest rates could create failure to meet long term obligations, concluded in a period of much higher rates. In property and casualty insurance, low interest rates decrease the return on reserves, increasing the need for more efficient claims handling and settlement or for premium increases, as observed in the UK motor insurance market. In asset management, low prices for many securities reduce fee levels.
A sputtering global economy reduces market confidence and fees earned on products sensitive to market confidence such as equities. Stock exchanges in smaller countries are losing attraction, both by investors and by companies abandoning their listing. While in essence savings remain largely intact in many economies, the combination of low interest rates and depressed equity markets lead to a lower fee generating base. The particular dynamics of the Euro sovereign crisis results in a bipolar world, with some sovereign paper nobody wants as indicating by mounting spreads, and other sovereign paper which commands negative yields from desperate investors. Clearly, this either is a huge arbitrage opportunity for the European Union, or the beginning of a fundamental break up. Recent announcements by the European central Bank and rulings by the German Constitutional Court seem to suggest the latter may be more likely than is commonly assumed. The alternative is a scenario of capital destruction, either in a slow way by financing credible sovereigns issuing at negative yields, or in an abrupt way by holding debt of countries facing default.
Regulation will affect the industry in different ways: it will increase the capital level needed per industry, putting pressure on the required level of profitability to achieve acceptable returns. Basel IIi and Solvency II are well commented frameworks. Limitations will define scope of activity, amongst others the thinking around narrow banking embedded in the Volcker rule and the ring-fencing ideas of the Vickers Commission. It also changes demand such as through introducing Banksparen in the Netherlands, which substituted the majority of classical life insurance. In addition, because of excessive commissioning, regulators increasingly favor transparent fees, possibly paid by the customers. There is pressure on the concept of interchange fees in payments in Europe, and on the commission rewards of mortgages, long term investment products or their combination through brokers in the Netherlands. Finally, and maybe less publicized, local regulators may also think about the size of the financial industry they can still host. It becomes increasingly difficult for small or mid-sized sovereign to rescue an oversized financial sector. Not only sheer size is an issue, but also the morality of saving an internationally active institution with tax payer’s money. Iceland is possibly the best example of this trend, but Belgium, Switzerland and Austria are in the same case.
A loss of reputation or trust also leads to a lower rating. Regardless of the role of rating agencies over the last years, ratings are still massively relied upon. This means that a large group of corporate customers now enjoys a better rating than the banks they used to lend from, and this will over time likely transform the European credit market, where banks still dominate, into a more diversified credit market with a larger role for corporate paper of all kind. Any widening of the EURIBOR scandal can only deepen the distrust, and may lead to further disintermediation, regardless of fines imposed for unprofessional behavior or market fixing. Retail customers are also self-organizing, and most banks and insurers realize that monitoring social media is a must. The story of Molly Catchpole, a 22 year old unemployed college graduate who started to complain about a new fee levied by Bank of America is well known. She got massive support on social media, and when classic media picked it up, Bank of America quickly withdrew this fee.
Banks are under pressure: margins are going down and capital needs go up, and they are losing some of their historical franchise, credit to large corporates. Insurers face the need for more capital, and see demand for the long term savings product going down. In property and casualty, internet distribution is finally taking off. Pension funds see the value of reserves insufficient to meet long term commitments. Asset managers see revenues go down because the value of assets under management shrinks.
Facing all this, the industry has to regain its momentum, as a properly functioning financial system is essential for our economy and society. However, it seems to be that it has had difficulty coping over the long term with the freedom of deregulation, started in the second half of the eighties, and it clearly could not digest unprecedented growth in almost all segments. With some form of tightening regulation inevitable, the issue is what various industry segments should do, given changes happening.
Going down to the waterline
Although the recovery from the current debt crisis is likely to take a long time, the fundamental needs of customers are to even increase over the long term. These developments are actually an opportunity.
First, the industry has taken significant measures to cope with the new environment. Most banks have strengthened their capital bases, through portfolio restructuring, retaining earnings or raising capital. In addition, they have reduced the cost base in retail banking, but also they are reducing the size of their market operations and investment banking activities. Insurers have equally trying to adapt their business model, through pruning lines of business, or redefining the relationship with distribution channels. Asset managers have been investing in exchange traded funds as these offer new possibilities for clients.
These programs have demanded significant effort and energy, given the difficult market circumstances. And these efforts will have to be continued. But there is a good logic to look at some sources of long term demand and trying to position now to capture those. These fundamental forces are:
Demographics and behavior changes are well known. As people live longer, their needs and wishes may become more complex. The aging society requires new services to tend to people over 80, the fastest growing part of the population. These people are sensitive to good service and may require a personal butler service for personal affairs. Also, estate planning and transfer of wealth becomes more and more a lifecycle issue rather than an inheritance item. International mobility is rapidly on the rise, creating a need for financial services in a country where one may have no history or be present only in a temporary way. Finally, career patterns are changing with lifelong employment rapidly diminishing. People increasingly mix multiple employers and periods of self-employment over a career, and therefore face a much more complex need for old age provision. There is a crying need for better advice and guidance emerging, affecting banks, insurers and pension funds alike.
Oddly, despite the loss of wealth as a consequence of the crisis, there has never been so much wealth with individuals and households. Reasons are the absence of global conflict in many countries, allowing for continued preservation of savings, and smaller households concentrating wealth through inheritance. In addition, corporate cash has been building up, driven by prudent management, continuing demand in stable sectors of the economy, and careful investment attitudes. Finally, increasing prices of energy and commodities produced wealth for countries rich in raw materials, either capturing this through a sovereign wealth fund or other investment vehicles. Even in the current difficult state of the European and global economy, there has never been so much money to manage and protect.
Technology remains a shaper. With the smartphone taking over the importance as the primary personal companion, boundaries of the financial system are blurring. Where is your bank account residing? With your mobile services operator? With the provider of the device? Or in a cloud, where part of the banking world has taken refuge? In addition, rapid and sophisticated analysis of large amount of data is becomes embedded and allows for effective micro-segmentation, better behavior prediction in terms of credit scoring and assessing longevity risk. Other technologies, based on location services and advanced intelligence, provide new comfort and prevention services in property and casualty insurance and in the real estate market.
Becoming Sultans of Swing
So, how to move out of the crisis and into this new world of opportunity? The financial industry has been fairly integrated for a long time. Banks have offered taken a universal approach, insurers took a broad line of lines to carry; asset managers offered a wide array of products. But as capital is scarce, and also contagion risk between lines of business is getting too big, there is a strong call on focus.
What are the drivers of this focus? Simply put, most financial institutions have operated very integrated operations in distribution, product offering and transaction processing. And the current crisis is putting pressure to keep this model together.
First, in distribution, the industry faces since 20 years an increasing number of channels. While a bank branch or insurance agent was the sole sales and service channel 20 years ago, these have been supplemented by ATMs, call centers, websites, and now downloadable applications. The real challenge is to manage the cost of distribution, as no channel disappears. Even the generation of mobile Facebook aficionado’s wants to meet an adviser when getting a mortgage. But this leads to increasing cost pressure to maintain a presence in all channels. And specialized channel operators, such as ING Direct, have created a period of rapid growth, but the jury is still out on the long term sustainability of the model. It is an open question whether it is a structural force, or whether direct distribution just increases the amplitude of the tide, where focused savings banks attract smart but volatile funds or insurance policies, but fail to broaden the relationships through cross selling.
Inevitably, some institutions will focus on a few customer segments, and combine their offering with new services to increase their relevance to these customers. In general a more complex society will explode in multiple segments which much more differentiated needs. For example, Canadian banks have set up branches in Florida, to follow the increasing group of tens of thousands of Snowbirds, people living in Canada during summer but seeking refuge in Florida during winter. In retail banking and even insurance, reverse mortgages may become interesting as a supplement in old age income provision. These will create new needs in terms of managing the real estate acquired. In corporate banking, processing accounts receivable and payable may be the next step beyond working capital financing. In pension build up, coverage for additional risks such as incapacity to work or financial planning could be natural extensions. In insurance, prevention and repair services could assist in better controlling claims and even offer assistance in vehicle management. In short, the financial industry will have to get closer to its customer and increase its level of service. Like a Michelin star restaurant, it will have to provide a worthwhile experience, each time over.
Second, other institutions will focus on unique products. They may be reputed for corporate advice in management and acquisitions, or be the owner of stellar investment products. Bank of New York Mellon in securities services or Blackrock in asset management come to mind. They may offer the best cash management globally, or be the absolute specialist in connecting to various market infrastructures for securities trading. They may be an absolute specialist in health care for handicapped people, because they understand the needs and particularities of this segment better than anybody. They are to their customers what Hilti is for the professional construction worker: the best product around.
A third way is to become really excellent in processing. Our European cards and payments survey found still a factor 4 to 5 in cost differences between various institutions. In life insurance, many insurers still operate multiple legacy systems, which are increasingly expensive to operate but need to work until the last customer standing has disappeared. Only the UK seems to embrace the movement of portfolios to large standardized product factories. In securities processing specialist such as Bank of New York Mellon have been able to reduce costs and offer an unparalleled level of service because they have about 15 % of all the world’s securities in custody. But the financial industry has not yet reached the level of industrialization attained by other industries, where specialists provide services to almost all participants.
The good news is that technology is now mature enough to allow this type of focus. Growth in the availability and quality of both software packages and industry service providers such as Equens in payment services and Slater in mortgage processing allows for better and easier outsourcing opportunities. Through cloud operations and increasingly more compatible software, it is easier to go for a best of breed solution in the required technology support, without a need to control the platform. The best example is perhaps the app, which can be downloaded and is immediately operational. Regulation now makes it easier to focus and source other elements of the portfolio. The Single Euro Payment Market, although slow in complex in its creation, now offers the opportunity for cross border processing of domestic payments, much more difficult before. Further standardization in the European passport of funds facilitates their cross border marketing and sales. But there is still significant ground to cover, for example in pension build up for internationally mobile professionals and households.
Oddly, the current crisis may stop the embedded greed in the financial services model of the past, and valuations of financial firms may perhaps never again reach their historical heights. But the purified model should be much more robust, more customer centric, more specialized, and more innovative in terms of customer value. In this respect the crisis could be the catharsis for the industry to achieve a more stable structure, and earn a more solid place in the economy, which it deserves.
So, management of financial firms need to decide on what they really want to focus on: serve selected customers in a truly excellent and innovative way, focus on a product niche and dominate it with unseen skill, or become a ruthless efficient factory with a true international scope.
Management is facing tough choices, but as usual, those who dare to choose radically, will enjoy the biggest benefits. Historical experience shows how painful a process this can be. This industry transformation may take many years. It could create a new wave of mergers and acquisitions, but of a different nature. Rather than piling up assets, as was exemplified in the creation of Citigroup with the merger with Travelers, there could be a rebalancing of asset portfolios towards a more focused model. The case in point is Bank of New York Mellon, which is now custodian for almost 20 % of the world’s securities. So, rather than a concentration wave as seen over the last 20 years, we could have a reshuffling wave over the next 10 years. Oddly, the forced restructuring imposed by the European Commission to those receiving state aid could be the trigger for a broader wave of activity in this field.
But there is more, management needs to instill a new sense of orientation in their staff, and to inspire them with a new sense of mission and pride. To work for a more focused institution means to acquire new skills, to leave behind old beliefs, and to learn how to deal with new insecurities. This will require a transformation for most people, a process which can be tough and uneasy. But there are institutions that have proven that it can be done. Through a systematic engagement of their workforce, a deep digging for true process improvements, and a careful communication and support, they have achieved this transformation.
All this is also needed to restore a sense of pride and motivation for the many people delivering daily services in the financial industry. Imagine being a bank teller at Bancia. It is hard to believe that the current situation is not affecting how people feel about their job, and how they relate in terms of their professional reputation with friends and acquaintances. Yet, their cause is a noble one, to help people build and protect their assets. Ultimately, this restoration is vital, as the reputation of the industry as an employer of choice will be the true engine to attract talent. And this has a broader meaning than attracting top talent to work in market operations, it has to do with the people you meet when you are seeking advice or service about your personal or company’s needs. Ultimately, these are the people that, through caring about their customers and excelling in meeting their needs, will have to restore the reputation with the public.
So, the long term future of the financial industry could look bright. The path to capture it will require tough strategic choices by management, but the way to succeed depends probably just as much on the degree of mobilization of the talent of employees, to make the new models truly come alive.