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Renewing Core Banking

Banking’s core function — to intermediate funds between depositors and borrowers — is now much less profitable, possibly permanently so. What are the options?

As the U.S. banking industry lays plans for 2014, institutions are on generally solid footing and potentially will get a lift when the rate environment shifts. Yet concerns remain about post-crisis profitability and the prospects for loan growth, lagging factors that continue to weigh down investor confidence and stock trading multiples.

In the continuing quest to overcome these issues, it is important to isolate the problem and get a realistic sense of the possibilities. One way to do that is by stripping away ancillary lines of business, such as monoline mortgage, card and investment subsidiaries, to look at core bank intermediation – meat-and-potatoes deposit gathering and lending.

Viewed at this fundamental level, it is clear that the industry has yet to regain its former self. Our analysis indicates that core banking generated only an 8.4% annualized return on equity in the first half of 2013, down 20% from the profitability level of 2006 (based on Federal Deposit Insurance Corp. data for all banks and thrifts). Average loans rose by only 9% over this six-and-a-half-year time span.

By contrast, we estimate that ancillary business lines generated a 20% ROE in 2013’s first half, well over twice the profitability of core intermediation. Meanwhile average loans have risen by nearly 17% since yearend 2006 in the ancillary cohort, nearly twice the growth rate seen in core banking.

The situation points to a two-part challenge: significantly reduce the drag of the core bank, and find ways to capture more high-value ancillary growth. This probably will prove difficult on both counts, but still there are options for adept players.

With core intermediation, banks must reconfigure themselves for a “new normal” – with muted credit demand, restrictive regulation, customer migration from the branch to remote channels, and effective customer interaction as the key to growth. Ancillary banking is a different story, largely turning on the haves and have-nots in the industry. Mid-size traditional banks either need to harness this trend toward adding ancillary businesses, possibly through acquisitions, or learn to fight it far more successfully.

Less than Meets the Eye

To outward appearances the banking industry seems back on track, maybe doing better than ever in the eyes of the casual observer. After all, what is not to like about record net income of $42.5 billion in the second quarter of 2013, up 23% from a year ago?

Looking at the quality of earnings, however, a different picture emerges. For one thing, the lion’s share of growth in interest income has come from gigantic volumes of low-yielding securities investments, not a sustainable proposition and certainly inferior to robust loan growth. Second, profitability is sagging relative to the enormous capital base the industry now must carry. At 10.4% in the second quarter, the industry-wide return on equity compares with 15% returns from a decade ago.

To more precisely identify issues and opportunities going into next year, we used FDIC data to break out the trends in core intermediation. This also permitted an analysis of “ancillary businesses,” defined as businesses and products that typically are run in standalone business units or not required for classic bank intermediation (Figure 1).


In the ancillary bucket we included several business lines that are largely fee-based, including capital markets, asset management, retail brokerage and insurance. Also included were several fee- and loan-based businesses with a concentrated presence of standalone/monoline providers. These include credit card issuing and acquiring; mortgage origination and servicing; and indirect auto lending. For card, mortgage and indirect auto, we excluded from core intermediation only the estimated portion carried by standalone/monoline providers.

This split of into core vs. ancillary is revealing in terms of profitability. In 2013’s first half, FDIC depository institutions collectively earned a 1.15% return on assets – vastly improved from the depths of the recession. It is a different story looking at core intermediation alone, however. Without the benefit of ancillary businesses, industry profitability drops to an ROA of about 0.93% – clearly below hurdle levels that most of the larger banks would set for themselves.

Body Blows

The most glaring “hits” to the traditional banking business model have landed on retail deposit gathering. Here banks have suffered the triple whammy of: 1) lingering low interest rates, which have lasted long enough to depress the internal credits assigned to deposit funding; 2) regulatory limits on overdraft fees, with more to come; and 3) the Durbin Amendment’s limit on debit interchange fees by the larger banks.

These three pillars – low deposit rates, overdraft fees, and merchant POS fees – propped up the free checking model for retail deposits. Only the former will improve with economic recovery.

Then to compound the problem, branches are now clearly a declining channel. Huge infrastructure changes (and charges) will be required to take down branches and simultaneously improve the competitiveness of electronic channels.

Formerly a star in the firmament of retail banking, pure retail deposit-gathering has collapsed into zero or even negative earnings. Even including small business banking and/or some consumer lending (as most bank business lines do), profitability remains below hurdle. Rising rates will help but will not by itself return deposit gathering to historical earnings levels.

Now consider broader changes affecting all of classic bank intermediation, and not just deposit gathering. While bankers are concerned about the recent cyclical decline in net interest margins, the fact is that NIM is in secular decline as well, fitfully drifting down ever since a historical peak reached in 1992, more than two decades ago (Figure 2).


On the lending side, downward influences on NIM include price competition fueled by improved public information in lending markets. Also larger borrowers have gained progressively easier access to capital market alternatives. And recent times have seen lower demand and excess lending capacity. In particular, consumer lending demand will remain muted relative to pre-crisis levels for some time to come.

On the funding side, the deposits “marketplace” is broadening from local street corner rates to national direct online competition. When rates rise from today’s rock bottom, competition in the broader digital marketplace will exert upward pressure on deposit pricing more quickly than what was seen at equivalent inflection points in prior economic cycles.

Beyond issues with NIM, there are also regulatory and economic impacts on loan loss provisions, capital and expenses. As a consequence of destabilizing losses during the financial crisis, banks will be pressured to carry higher levels of loan loss reserves, entailing higher provisions. Equity capital levels also will remain permanently higher than pre-crisis levels. Regulation and litigation risk have increased the compliance expense side of the equation as well. All in all, too much has changed in traditional bank intermediation, and not just cyclically – and it has taken a toll on the bank economics.

Restoring the Core

Sorting through the priorities for core banking, the more immediate solution is to reduce costs, in particular the cost of gathering deposits and fulfilling related transaction services. This further intensifies the need to restructure overgrown branch systems.

While high pre-crash estimations of deposit value have lingered, deposits likely will receive less credit in funds transfer pricing models in the unfolding market. This weakens a powerful financial justification that has been used to sustain branch networks.

Meanwhile retail customers have profoundly changed their shopping and service patterns, downplaying the branch in favor of web and mobile banking, automated teller machines and contact centers. This redoubles the pressure for branch cost reduction, in that one layer of cuts is needed just to free up resources needed to beef up other channels, and a second layer is needed to assure an absolute reduction in overall distribution expenses, given the constricted market in which banks must now operate.

In terms of capabilities, a major lever on both the deposit and lending sides of intermediation is improving the precision pricing. The precision pricing of loans – not undercharging slightly worse credit risks, differentiating rates by market and product feature, understanding customer elasticity so as to not leave money on the table – is now essential in winning profitable market share and bolstering risk-adjusted returns throughout the credit cycle.

Precision deposit pricing has already received a lot of attention from major banks but now poses some new challenges. In a rising rate environment, it will be critical to understand how each segment of the depositor base likely will react, and begin to craft finely gradated strategies that will preserve core funding on the most favorable terms.

The urgency is increased by competition from direct banks, which operate free of branch shackles and focus on raising deposit funding online. These low-cost players will have more leeway in rate competition, plus banking customers are now much more comfortable shopping for providers and products online. Hence in a rising rate environment direct banks will impose serious competitive pressure to raise deposit rates.

A third lever for banks is adapting product offers. While banks are revising the free checking model in response to low rates and increased regulation, there are no magic bullets with respect to rebuilding fee revenue generation. A more promising avenue is innovation with product bundles and incentivizing fee arrangements. The goal is to shift customer behavior over time, in terms of consolidating balances and payments, managing down branch usage and generating some fee revenue.

The more important area of product development centers on household cash management, which entails connecting consumer lending back to payments and deposits. For banks without major monoline business units, this means finding ways to recapture credit card or unsecured lending by leveraging bank knowledge of checking account customers and giving them greater control over borrowing and repayment choices. For all banks, it means responding to innovations by non-bank providers in ways that will preserve the centrality of banks to payments.

The fourth capability lever covers the broad topic of customer relationship effectiveness. This is a multi-dimensional issue, as it includes understanding which customers to target; how to find and attract them; how to build deeper relationships than other banks; and how to balance profit-taking against retention. In the end, banks that develop more comprehensive relationships with their core customers – payments, deposits and lending – will have the best chance to offset continuing competitive pressures that push down profitability in core intermediation.

Swing Factor

Our review included the significant portion of total revenue arising from ancillary businesses. As makes sense, there is a statistically significant relationship between higher ancillary revenue and large bank profitability. This is the case even though several ancillary bus’inesses (e.g., fixed income capital markets) are still lagging (Figure 3).


There are several approaches to ancillary businesses. U.S. Bancorp and Fifth Third Bancorp built payments processing units. BB&T Corp. is one of the largest insurance distributors in the country. Wells Fargo & Co. built up retail brokerage. A number of banks have invested in growing indirect auto lending, whether in their footprint or beyond. Then there are the standalone card and mortgage units at JPMorgan Chase & Co., Wells, Bank of America Corp., and Capital One Financial Corp.

Given the higher profitability for most ancillary businesses compared with core intermediation, the strategic consideration for banks is whether they can grow or create ancillary businesses. There are many reasons why this is easier said than done.

Ancillary businesses are not created equal – either in relative attractiveness, ease of entry, growth trajectory or strategic fit with various banks:

  • Capital markets activity will necessarily be limited to the larger regional banks, as these services are largely only provided to established commercial customers.
  • Most banks have trust businesses, so for many banks a modest and appropriate expansion into more components of asset management is a viable path, and not just limited to the largest banks. But it is not a quick path to growth.
  • For consumer lending – credit card, auto, mortgage – creating full-fledged independent business lines is not likely possible. Rather, most banks will have to improve the integration of these products or their equivalents into their core banking relationships.
  • Insurance distribution, at least as currently configured, will require acquisitions. Also insurance generally has not been a profitable play in banking, relative to other uses of capital.

Clearly, banks that already have sizeable, thriving ancillary businesses are at a distinct advantage. They have better overall profitability and are better positioned for growth – both directly from ancillary businesses and from synergies with core banking and overall retail distribution.

Many diversified players have gotten there through slow but steady expansion; others from small serial acquisitions; and a few from major acquisitions. Perhaps a few more banks will successfully join this group. For most small banks, however, expanding beyond core intermediation is not in the cards.

Bank profitability will keep improving as the U.S. economy continues to recover, leading to rising interest rates and a more upward-tilting yield curve. However, the constriction in core banking profitability is a long-term phenomenon. Institutions that can best adapt to this world of tighter spreads and heightened loan and deposit competition will come out on top. And the better-diversified banks, with both robust core bank intermediation and sustainable ancillary businesses, are best positioned going forward. For smaller traditional deposit-and-lending banks, exit pressures will only increase.

Lee Kyriacou is a Managing Director in the New York headquarters of Novantas Inc., a management consultancy. He can be reached at

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