Financial institutions are certainly facing the toughest strategic challenges they ever encountered. New regulations constructed from the lessons drawn from the financial crisis have led to higher capital costs and stricter liquidity buffers resulting in higher cost of doing business. The banks’ own actions to deleverage their balance sheets put an additional pressure on their profitability. The contraction of their international ambitions and refocus on their home markets have led to over-crowded domestic markets. The digital generation requires banks to invest in new technologies while they are increasingly attacked in their service offerings by technology firms. And these Fintech startups are targeting very focussed segments of the transaction cycle where they are not subject to the tough regulations banks face.
The same is true for insurance companies coping also with increased regulations such as Solvency II , stricter consumer protection rules and the digitalisation wave, while having to survive within a very low interest rate environment coupled with lasting contractual and legal return requirements.
As an example, a sample of the 66 largest banks in Europe (Bankscope database, analysis Vlerick) shows a weighted average ROE of 3,4% in 2013 compared to 13% ten years ago in 2004. This severe drop is not surprising, knowing that banks in 2013 had a cost/income ratio of 67% compared to 63% in 2004, a leverage ratio of 20 compared to 27 and a capital ratio of 17% compared to 13%, and these figures don’t yet show the full impact of the lessons from the crisis. Yes, this is an average number and there are important variations. Based on subsamples with highest ROE in 2013, ROE averaged in 2013 8,8% in 2013 compared to 13,9% in 2004. When looking at a subsample with the lowest ROE in 2013, ROE was -3,1% in contrast to 2,9% in 2004. Important to note that whatever the sample, ROE has dropped by at least more than 5%.
You could say this is temporary and will improve once restructuring measures and efficiency improvements are showing their full positive impact. Nothing is further from the truth. A ROE of 5% could be, under current circumstances, quite a fair representation of the potential ROE for banks while the shareholders still live in the expectation of 10% ROE. It is crystal clear that substantial changes will be needed to bridge the gap between current reality and expectation.
Banks having spent (and still spending) time and effort in dealing with the fall out of the crisis will need to embark on a major change programme: reinventing their business model, moving from a product offering to a customer-centric service offering, making the right choices with the appropriate investments to create more added value and therefore more distinguished and more appreciated differentiation.
Banks will not only have to be prepared to change, they will have to embrace change and learn how to be self-critical, to evaluate their role and how to innovate. Except for product innovation, banks have always struggled with transforming ideas in sustainable services. Too often ideas were small-scale departmental initiatives, not impacting the entire the bank. Innovation was often an approach from within, quickly suffocated by internal procedures, premature risk assessments and not sufficiently looking at the outside world with the needs of the customer at the forefront.
We currently see encouraging signs showing that banks start to see the need for a truly different approach. Innovation centres are being set up away from the traditional functional organisation to give ideas a chance; important investments are made to better understand the needs of the clients and to define the target client base; and approaches to innovation start to change, tackling the opportunities from the outside, looking at what exists in terms of innovation and what can be leveraged through collaboration and partnerships.
Building on the “Enjoy Change” campaign of the Vlerick Business School, the White Paper (There’s no such thing as “small change” in the Financial Services Sector; ....) talks about the game changers and the articles from market practitioners are testimonials of why change is needed, concrete initiatives taken to embrace change, to make it part of the DNA and to enjoying it. Some articles talk about the game changers rightly pointing to the fact that not only technology and regulations are transforming the business, but that demographic changes also play an important role, questioning to what extent the latter is sufficiently addressed by the financial industry. Another article zooms into the interplay between regulation and innovation leading sometimes to misguided innovation. Another testimonial talks about how to integrate “embracing change” into the corporate behaviour through revision of the values of the company and through creating platforms and incentives to allow creativity to become a sustainable differentiation allowing to address the strategic challenges faced. One final article is zooming on a new category of regulated financial institution in Belgium: the independent financial planner.
I hope that the testimonials from several market practitioners and partners of the Vlerick Business School together with the White Paper is food for thought. As other sectors, like healthcare, have already shown, it is important to understand the game changers, embrace radical new ways to address innovation and adopt a new outside-in mindset if financial institutions want to make innovation a sustainable differentiator.
We would appreciate receiving feedback and views as well as new ideas you may have for other topics you may find interesting.
Have a pleasant reading,
Chairman Financial Services Centre Vlerick Business School