In challenging industry circumstances, winning banks will define the next phase in their growth strategies and lay out individual paths to sustainable profitability.
Bank executive management teams face a pressing challenge to simultaneously improve financial performance and transform the business model for digital competitiveness. While leaders have clung to hope for a return to hospitable market conditions that would ease pressures and transitions, unforgiving realities are forcing aggressive action.
The fundamental issue is that industry profitability has not fully recovered following the recession. Compared with a 13.4% average return on equity over the decade preceding the ’07/’08 downturn, the ROE for FDIC-insured depository institutions has averaged only 9.1% over the last three years (Figure 1: Disappointing Recovery in Industry Profitability).
Our research reveals that more than a third of the top 100 publicly-traded banking companies are not generating returns commensurate with their cost of capital. Probing more deeply at the branch level, Novantas research indicates that 30% of U.S. branches — 27,000 in all — currently are not generating sufficient sales returns and should be evaluated for consolidation.
A huge revenue revival is unlikely given spread pressures and fee limitations, plus the eventual need to replenish loan-loss reserves, which continue to hover at historically low levels. This leaves the chief financial officer to primarily consider cost reduction to restore profitability. But to recapture the 10-year average pre-crisis return on equity of 13.4% in the current flat climate for net interest margins, dramatic action will be needed.
Industry-wide, annual expenses would have to be slashed by more than 25%, or more than $100 billion (holding other factors constant), just to pull even with prior profitability norms. Even with a semi-miraculous return to a pre-crisis net interest margin of 350 basis points (fully 42 bp higher than today), the industry still would need to lop off more than a tenth of its expense base (Figure 2: Challenging Options to Regain Full Altitude).
The branch network is an obvious candidate for cost reduction. But with preservation of core customers and deposits more important than ever, aggressive consolidation poses a substantial risk of harming the current customer base and limiting future core growth. Meanwhile, ongoing investment required for digital transformation presents a further complication. Over the next five years, up to a third of the core base could be put in play as more high-value shopping and purchase activity shifts online.
The situation is daunting but this is no time for paralysis, as senior management has a series of priorities to master over the next several years:
- Map the next round of the game plan. Along with near-term precision management of revenue levers and expense controls, this is a time for multi-year vision. Plans should set the end goals for customer acquisition and bank profitability; map the core elements of digital and cost transformation; and specify timing and resources. Mergers, acquisitions and divestitures should be on the table for discussion.
- Focus the bank on core deposits. Rising funding needs and tightening liquidity regulation have elevated core deposit expansion to a corporate priority. Implications include the need for revised metrics and funds transfer pricing, along with a shift in growth planning to the funding (versus asset) side of the balance sheet.
- Redefine the value proposition. The branch must now be fitted into a larger formula for creating distinctive value for consumer, small business and commercial segments. Winners will find their own unique combinations of product and channel innovation, sales and service experience, brand, and core message — all critical in answering the customer question: “Why should you be my primary bank?”
- Reconfigure networks market-by-market. This is not simply about branch closures; rather, progressive banks will use robust multi-factor analyses to close and consolidate some, resize, reformat, relocate and reopen others, and use other local levers to sustain and grow balances and sales in each major locale.
- Accelerate the change process. Time is of the essence, with many large banks already restructuring and direct banks continuing to make inroads. Surviving institutions must give serious consideration to more aggressive restructuring actions and be willing to take on larger charges that will permit aggressive network consolidation and repositioning, divestitures, market exits, etc.
Clearly these will be difficult steps. But the good news is that winning banks will be defining their next phase in growth strategy, laying out their individual paths to sustainable profitability, and boosting their odds of becoming acquirers in the next wave of merger consolidation.
Elephant in the Room
To see how well various institutions and strategies are holding up in the current challenging environment, we evaluated the larger publicly-traded banks on two strict measures: 1) sustained profitability; and 2) sustained growth. What we found was that the more profitable, higher-growth banks comprised 18% of the study group but accounted for 45% of the industry’s total assets and an estimated 60% of market capitalization.
While the outsized asset representation among top performers does speak to scale advantage, it does not spell mega-bank domination. Larger regional and superregional banks had a solid representation within the top tiers, as well as niche players with laser focus on categories such as small business or wealth management. Importantly, high performers also include some mid-size regionals and even smaller institutions. The winning combination includes management discipline, defensible markets and deeper customer relationships — providing better profitability and room to run.
Which is not to say there is time to waste. Along with repositioning for sustained organic growth, banks are pressured by tighter competition and regulation, pushing most surviving players to look carefully at M&A, now and in the coming years.
Overcapacity is the elephant in the room that applies incessant pressure on industry profitability. Despite a more than 60% reduction in charter count during the 30+ years since the removal of interstate banking restrictions, there are still 6,000 banks competing for core customers and deposits.
While regulation protects the deposit fortress, the lending side has been steadily picked apart. Seasoned bankers are familiar with national market competition in credit cards, large corporate lending, capital markets, and indirect auto lending — all putting long-term structural pressure on spreads and traditional intermediation. Local erosion does not stop there: a good chunk of residential mortgage origination has been seized by online players, and small business lending looks to be next.
Small wonder, then, that net interest margins are on a trend of secular decline. Industry NIM has steadily declined over the economic cycles of the last 25 years, measured both peak-to-peak and trough-to-trough. And while a near-term bounce still could materialize depending on the Fed, longer term the trend of NIM decline likely will continue, forcing a fundamental rethinking of the bank profitability model.
New regulation further complicates the picture. Without dwelling on the gory details, important fee revenue streams — card interchange, checking overdraft service — have been crimped. Fewer assets can be held against each dollar of capital, dampening returns on equity. Funding flexibility has been reduced, with more restrictions looming under the Net Stable Funding Ratio (NSFR). Compliance costs have soared. A further pressure on the horizon is the pending implementation of FASB’s Current Expected Credit Loss (CECL) model, which seems bound to fuel rising loan-loss provisions.
Given these headwinds, the logical conclusion is that to improve profitability, banks must continue to reduce costs and look to leverage scale. And when the chief financial officer looks across the enterprise for possibilities, the first thing in the line of sight is the branch network. To state the case as plainly as possible, significant branch consolidation is inevitable.
Not a Mechanical Exercise
Two other considerations complicate the picture for network consolidation. The first is the mandate for core deposits; the second is digital disruption.
Core deposits. Seasoned bankers have long known about the importance of primary relationships and associated core deposit preservation. During prior M&A waves that led to superregional and national franchises, valuable customer and staff defections reached crisis proportions in several instances, sending a stern message about service and relationship continuity.
Now the stakes are even higher. New regulations are exerting heavy pressure for core funding. More banks are bumping up against funding limitations as the lending cycle has progressed. And preserving and leveraging the core checking/cash management relationship has become essential in building profitable share in an overall slower growth market. A further consideration is sustaining marketing and sales momentum on a visibly reduced branch count.
Digital disruption. The growing challenge going forward is winning share of digitally-centered customer relationships and accelerating online account origination. Fundamental changes in customer preferences and behavior are hastening the replacement of the branch in favor of digital. This includes how consumers want to do their banking, where they go when a problem arises, and how they shop for bank accounts and open them.
Novantas research shows that rapidly-growing segments include “thin-branch ready,” or those who turn first to digital and just want some degree of branch presence as a backstop (at 37%, now the dominant channel segment of the retail customer base), and “digital only,” or those who neither use nor feel the need for branches (about 6% of the base). As the pace of change accelerates, these segments will pose significant transition challenges for branch based incumbents.
Meanwhile online shopping for banking providers and products has become prevalent, following the general trend in U.S. commerce. Among recent U.S. checking purchasers surveyed by Novantas, the majority said they had visited bank web sites and conducted other online/mobile research in preparation for their purchase. And online competition is ratcheting up, as reflected in digital rate-shopping for deposits and, increasingly, consumer and small business digital lending.
As these trends progress they raise increasingly serious questions about: 1) how to accelerate the further migration of service transactions to lower-cost channels; 2) how to revise the marketing and sales model; 3) the shape and scope of digital investments; and 4) required local network density and configuration going forward.
Structural and market headwinds will make navigating the future ever more difficult, especially given the rapidly waning relevance of locality. Most banks need to improve profitability — not only to achieve the minimum required return on invested capital, but ideally to fund organic as well as profitable M&A growth.
At the same time, simply to remain competitive, banks will need to invest in the shift from physical networks to digital channels and offerings. And while branch reductions can be a primary source of cost savings, they can also provoke customer defection rather than growth — with direct impact on core deposit formation.
The bottom line is that successful banks will have to simultaneously raise profitability while making the necessary reinvestments to move from branches to digital. We see a number of critical stepping stones for this journey, starting with basic changes at the top and working down to the branch (Figure 3: Stepping Stones to Network Transformation).
Game plan. Each bank is at a different starting point and must undertake a candid individual assessment. What are the current sources of profitability? Will rising market rates be enough to regain lost profitability (it will not), and how much of the cost structure will have to come out over the next five years? Is the bank losing or gaining share of new customers (consumer, business, and commercial) and the more attractive tiers of deposits and loans — both at the franchise level and market-by-market?
The questions do not stop there: How much of our funding base truly comes from core deposits that are not as rate sensitive? How much of our new-to-bank acquisition and current customer cross-sell is dependent on best pricing/promotions vs. other forms of more sustainable advantage? How competitive are our digital offerings? How many branches must go to assure future profitability in each market?
Following this assessment are the tough conversations among executive leadership and the board of directors. Can the bank see a path to sustainable success? Where will it need to be in three to five years? What are the major initiatives, in which sequence and at what cost, and what measurable outcomes need to be achieved with each step? There will be a lot to do, so setting overall goals and priorities is essential.
Along with repositioning for sustained organic growth, most banks will have to consider M&A possibilities in coming years. In 2015, more than 300 banks (5%) exited, and that pace should continue. But even thriving survivors (except for national and specialty banks) will likely participate in ongoing industry consolidation. Better-performing banks will have the currency to acquire, and if deals are effectively chosen, priced and executed, M&A transactions will leverage scale and improve efficiency ratios.
Core deposits. Going forward, sustainable advantage in bank intermediation will largely go to those with sticky low-cost funding. To be sure, some banks have advantages in lending — e.g., monoline card players, wealth and small commercial specialists, and some branch banks with deep local business relationships where pricing is not the only winning strategy. But generally lending remains over-competed, and non-core deposits will be as well in the next rate rise — hence the differentiating value of core deposits. Liquidity regulation has both made this more apparent and further amplified the value of core deposits.
Maximizing core deposits at optimal cost should become a primary exercise of bank-wide balance sheet management. Measuring deposit stickiness — by customer and not simply by product or geography — will reveal where the value lies for banks. Appropriate bank policies and FTP changes will follow.
In turn, translating that knowledge to customer level offers — in consumer, small business and commercial treasury management businesses — will both protect deposits and attract incremental balances on profitable terms. Traditional deposit pricing promotions — especially with the next rising rate environment — will prove untenable.
Core deposits also will play a more prominent role in M&A. Deals can no longer be priced on the basis of acquired branches and their total deposits. Rather, they must be laser-focused on true core deposits — those that come from stable customer relationships that will not readily shift over time. Gauging which customers and deposits are worth paying up for — and which are not — is the new, less observable, M&A calculus.
Value proposition. Instead of “We’re the bank on the nearest corner,” the value proposition must become richer and better voiced. Components include: sufficient local presence for less frequent use; a near-leading-edge product set; a much stronger brand; and leading online/mobile banking, properly promoted.
And that is the easy part. True differentiation will take some doing, given that in general there is little unique about receiving deposits, processing payments and lending money. Exceptional service; cutting edge innovation; having the customer’s “back”; best rates; true personalization, top-notch advice, and other differentiated value — all are options, if in fact they are true, are valued by a meaningful group of customers, and are effectively communicated.
Network reconfiguration. This must be a local market-by-market effort — one size will not fit all. And it is not a branch closure effort, but rather a local strategic resource reconfiguration. Given current market share of local customers, deposits, loans, and other business (assets under management, etc.), what level of bank resources can profitably support those market shares three years from now, and how should those resources — marketing, staffing, ATMs, branches, etc. — be best deployed? How will incremental investment or cost reduction help or hurt customer acquisition and product shares, at what pricing impacts?
A broader holistic view will help guide a local game plan of branch and other resource changes and alternative investments. If it is built with some markets shrinking or closing, then resources can be re-deployed to priority markets.
Exit from low-performing or sub-scale markets needs to be on the table. Getting too far ahead of competitors in local branch closures heightens the risk of customer loss. But slack market rates have stunted customer switching propensity, and intensive customer engagement at affected branches can limit defections.
Decisive action. Major banks face the same set of distribution challenges across the industry, and the sooner an individual competitor bank steps up to the hard decisions, the sooner it can reap a benefit. This includes the elite players that are currently leading in profitability, which should not sit still but stay ahead of the rest.
Further cost reductions are tough, given how much belt-tightening banks have done in the last eight years and the explanations that shareholders will require in the event of restructuring charges. Regardless, all signs point to the need for transformative efficiency improvement.
Lee Kyriacou is a Vice President and Gordon Goetzmann is an Executive Vice President in the New York office of Novantas. They can be reached at firstname.lastname@example.org and email@example.com.