Canadian banks remain healthy but face challenges from a wobbly economy, digital disruption and restrictive regulation — all pointing to restructuring ahead.
Canadian bankers have acknowledged the dual challenge of cost control and digital transformation. In recent investor relations calls at several institutions, executives have emphasized the need to free up resources to invest in digital technology and improve mobile and online offers.
The question is how to accelerate the process in stressed profit conditions — with minimum further strain on shareholders. Although profitability at the six largest Canadian banks remains head and shoulders above large banks in the U.S. and other countries, Canadian returns on equity and price-to-book multiples have slipped from prior peaks. Competitors want to put a floor beneath that trend and then reverse it.
In simpler circumstances, blunt cost-cutting would be the obvious coping mechanism. Setting aside structural issues and looking strictly at current market headwinds — flat interest rates and margins; credit worries for the energy and consumer sectors; contracting GDP and slower revenue growth — the traditional response is to hunker down and put a choke on risk and expenses.
But locking down is of limited help if the business model is slipping out of sync with a changing market. Pure cyclical coping tactics are losing effectiveness, not only in Canada but globally, as two major structural transitions envelope the banking industry:
Digital disruption. Dense physical branch networks are facing accelerating obsolescence as customers relocate transaction, shopping and purchase activity online. The world-class branch networks constructed over decades by Canadian banks now must be carefully — but ultimately heavily — thinned to reflect the realities of declining usage. Meanwhile digital value propositions must be strengthened to meet the onslaught of disruptive niche players.
Constrictive regulation. Balance sheet flexibility and corporate profitability have already been affected by the constraints and implementation costs imposed by stricter international banking standards. And there is more to come — the Basel III Net Stable Funding Ratio (NSFR) is a potential game-changer, which will further pressure spreads and require strategic reassessments of assets, funding and certain lines of business.
Putting all of this together for 2017, the essential strategic questions revolve around the transformation agenda, including:
- Network realignment — Pare the branch network without harming core customer relationships and deposit acquisition; free up resources for reinvestment.
- Digital value proposition — Shift the marketing stance from local branches and pricing to product functionality and brand.
- Relationship expansion and profitability — Anchor and expand core customer relationships to stabilize channel transitions and grow profitable market share.
- Funding and balance sheet management — Build/revise metrics and analytics needed for NSFR; identify strategies and tradeoffs; incorporate into governance.
In each area, success will depend on analytically-guided strategies. Canadian banks are navigating this transitional period from a position of strength, not having gone through the recession-driven turmoil seen in the U.S. and elsewhere. But they do have a lot at stake, requiring coordinated initiatives that will advance the transformation agenda while upholding performance in stressed conditions.
Profitability and trading multiples have retreated over the past two years, and 2017 will not likely offer much relief. At 16.3%, the average return on equity for the six largest Canadian banks during the third quarter of 2016 was down 200 basis points from two years ago, when ROE reached a stellar 18.3%. During the same 24-month time period, the median price-to-book multiple fell by 20%, to 1.6x from 2.0x (Figure 1: Return and Valuation Trends in Canadian Banking).
While assets and revenues have continued to grow, so too has expense — both interest expense (rate environment; digital competition for deposits) and operating expense (expansion; restructuring; regulatory compliance). Provisions for credit losses (PCL) have also jumped as plummeting prices rocked the energy sector. Meanwhile new regulations ratcheted up capital formation, increasing strength but reducing financial leverage and earnings per dollar of equity.
Looking ahead, the overall growth outlook for the Canadian economy remains tepid and hopes for an export-led recovery, supported by a weak Canadian dollar, have yet to materialize. Energy prices will not remain at basement levels, but are not expected to recapture former peaks anytime soon, posing a further drag on GDP and employment in an economy still highly dependent on energy and commodity sectors.
Turning to the rate environment, Brexit-exacerbated market uncertainty has prompted the Bank of Canada to freshly consider monetary easing — even the prospect of negative rates is back on the table. This is an important change in posture by the central bank, which had been expected to remain on the sidelines until well into next year.
Consumer leverage is a high-visibility issue, already above U.S. pre-crisis levels and still climbing. According to a recent report by the Office of the Parliamentary Budget Officer, Canada’s household debt-to-income ratio is the highest among G7 countries. The World Bank and the Organisation of Economic Cooperation and Development (OECD) have both expressed concerns about housing affordability for Canadians, given both high debt levels and high residential prices. Yet prices and debt continue to climb.
In the corporate sector, cash positions are high and corresponding borrowings are low. Credit has deteriorated, albeit primarily in the oil and gas sector. While portfolio performance has stabilized (at least temporarily), the outlook remains cautious and prospects for corporate loan growth are muted.
In the scheme of things, cutbacks and restructuring charges announced thus far have been modest and manageable relative to the size and strength of the institutions involved. More aggressive action appears likely going into 2017, tying into the structural challenges facing the industry.
Breaking the Mold
Going forward banks will have to operate differently. One driver, digital disruption, eventually will require profound changes, yet holds plenty of upside potential for adept players down the line. The other driver, constrictive regulation, is the result of an international movement sparked by the 2007-2008 U.S./European market crash.
Canada’s banks are not immune to the digital innovations that are disrupting conventional banking models, lowering barriers to entry and limiting the effectiveness of traditional competitive responses. While non-traditional competitors carve inroads in online lending and payments, fundamental changes in customer preferences and behavior are accelerating the replacement of the branch with digital channels.
As technology enables choice, changes in consumer channel preference have followed — including how consumers want to do their banking, where they go when a problem arises, and how they shop for bank accounts and open them. These changes have sparked a series of interrelated distribution issues:
- Former branch-centric customers are shifting more solidly to banking digitally. In particular, rapidly-growing segments include those who neither use nor feel the need for branches, and those who turn first to digital and just want some degree of branch presence as a backstop. As the pace of change accelerates, these segments will pose significant transition challenges for branch-based incumbents.
- Mirroring an international banking trend, branch transaction activity is declining in Canada, we estimate by 4% to 6% annually.
- Online shopping is now prevalent. Among recent Canadian chequing purchasers surveyed by Novantas, more than a third said they had visited bank web sites and conducted other online/mobile research in preparation for their purchase.
- Online competition is ratcheting up, as reflected in digital rate-shopping for deposits and, increasingly, consumer and small business digital lending.
- Online functionality and products are becoming more prominent influencers in customer acquisition and retention. Among recent chequing purchasers, one of every 10 Novantas survey respondents cited “leading online/mobile banking” as the single most important factor in selecting their primary bank.
As these trends progress, they raise increasingly serious questions about: the required network density going forward; how to thin networks with minimal customer impact and maximum future productivity; how to revise the sales model (particularly for small business); the shape and scope of digital investments; and how to revise the overall marketing stance.
Turning to regulation, Canadian banking regulators were early adopters of stricter international banking standards, which has led banks to raise capital and provision levels, shift their asset mix to more liquid instruments and lengthen funding duration. But the cumulative impact has also been to drag down ROEs. Going forward, banks will have less flexibility in balance sheet management, plus they will incur higher compliance expenses, given ongoing requirements for data compilation, analytics and reporting.
And there is more to come. On the horizon is the next round of liquidity regulation, focused on long-term funding. The Net Stable Funding Ratio (NSFR) requirement of Basel III will have wide-ranging impacts on balance sheet management and core earnings.
Canadian banks have a full plate to restore profitability lost to cyclical headwinds and structural disruptions. One course of action is to simply take a defensive posture and wait for a fuller economic recovery when interest rates, margins and credit quality eventually normalize. But to regain prior levels of profitability, growth and competitiveness, banks will need to tackle underlying structural issues as well.
While each Canadian bank has unique considerations relative to its specific market position, strategic priorities and performance goals, management teams face a common balancing act with efficiency vs. transformation. Short-term cost-cutting is a sensible response to tightening conditions, but teams also have to think about how to transform delivery channels, meet changing consumer preferences (or even lead the evolution), and leverage scale for more permanent cost reduction (Figure 2: Strategic Priorities for Canadian Banks).
Manage the digital transition. The industry is standing at the edge of a new transition phase that might be termed “definitive channel migration.” It is no longer strictly about providing a fully-configured multi-channel experience so that customers feel comfortable using all available options. Rather, it is increasingly about closing off underutilized physical capacity as more customers establish a digital center of gravity.
Canadian banks so far have been quite cautious about reducing branch count. But to keep up with changing customer transaction patterns, they are going to have to pick up the pace. Successful consolidation will require looking ahead, looking locally and looking at customers:
- Looking ahead entails foreseeing what digital banking will look like in the next five years and the likely pace at which consumers and businesses will migrate, then laying out a game plan to build/buy/partner for the necessary functionality, product bundles and digital marketing and sales expertise.
- Looking locally entails reviewing current distribution and marketing assets in each geographic market, and then laying out market-specific plans to restructure those assets — taking down branches but also reinvesting in digital marketing (search engine optimization, online messaging and advertising, social media, sponsorship of community web sites, etc.) and local assets (ATMs, kiosks, billboards, local advertising).
- Looking at customers entails developing an effective segmentation to understand which customers have already left the branch, which are ready to move, and how to serve them and acquire others like them.
There are multiple balancing acts here: knowing where the right investments are needed; when costs can come our versus shifting between markets or to other expense categories such as marketing; which savings need to be reinvested elsewhere versus hitting the bottom line; and how to migrate customers to other channels or branches depending on their preferences.
Deepen customer relationships. To offset lower spread revenue, Canadian banks will need to keep building stronger customer relationships — on both the consumer and commercial sides — that generate higher balances and fee revenue with each customer The theory of the case is that it should be easier and cheaper to sell more products and services to a current customer than to win a new one. The hard part is execution, with each bank at a different point in optimizing the relationship journey.
A core requirement is having the right systems, both to see the entire customer relationship across businesses and to manage contact efforts. A second is analyzing all available customer data — descriptive, product, transaction activity including payments — to develop segment insights that will inform offers and pricing.
From a management perspective, one ongoing priority is organizing operations and processes around the customer (as opposed to fragmented internal business silos). Another is staff sales performance optimization via training, goal-setting and incentives.
Balance Sheet Management, Capacity Realignment
Two additional items on the transformation agenda are balance sheet management and the all-important task of capacity realignment.
Rethink balance sheet management. The frequency and extent of regulatory changes affecting intermediation — capital, liquidity, interest rate risk and loss reserves — necessitate a hard look at the metrics, processes and assumptions underpinning the asset-liability management activities of the treasury units.
Is the right data being captured on assets and liabilities? How good are the models for determining duration, liquidity and total loss-absorbing capacity (TLAC)? How will NSFR be determined and integrated into various metrics and processes? And, given all the changes, have funds transfer pricing (FTP) methodologies kept up, and are they sending the right signals to the business units?
Addressing these and other questions will require strategic perspective — starting with an overall assessment that can guide the recalibration of bank-wide balance sheet activities as well as business line performance measurement.
Reengineer the infrastructure. Short-term cost reductions, such as tightening expense policies and third party spending, may buy time but will not alone correct the rising bank efficiency ratios that are hurting profitability.
On the agenda for the Canadian banks are process and systems re-tooling initiatives, both to reduce cost and to preserve competitiveness in changing market conditions. For example, with non-bank players offering rapid approval lending, the loan origination process at banks must keep up in terms of speed, digital reach and credit quality — and the realization of lowered operating cost after the initial investment.
Certainly, a large portion of cost reduction will come from branch network consolidation over the next decade. Meaningful and sustainable reduction of efficiency ratios is not possible without rightsizing the network. The companion priority is reinvestment in digital to fuel future growth, keep the innovative upstarts at bay and improve profitability. Striking the right balance is specific to each bank and will require rigorous monitoring and likely many course corrections along the journey.
Adel Mamhikoff is a Managing Director and Steven Luckie is a Director in the Toronto office of Novantas; Lee Kyriacou is a Vice President in the New York office. They can be reached at firstname.lastname@example.org, email@example.com and firstname.lastname@example.org.