The Culture of Transformation, or Transformation of the Culture?

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The debate is slowly bubbling to the service and the realisation finally growing across investment banking that banks will not survive in rapidly changing capital markets unless they transform to meet the new regulatory landscape and accompanying business and market challenges. That might not be new in itself, but what is different now is the growing recognition that this can only be achieved by a change of culture within the banks, which will only succeed if it is driven across the organisation by strong leadership. And that leadership will have to embrace a technology transformation that drives costs down through the automation and simplification of creaky, complex and archaic IT systems, while also adding in the more sophisticated data management and analytic capabilities demanded by today’s circumstances.

The Culture of Transformation, or Transformation of the Culture?

But while there is plenty of talk, there is little sign of action. Deutsche Bank CEO John Cryan said last month at a press conference: “We want to see ourselves increasingly as a technology company. Our work is not just about pursuing restructuring, we must also change how we work in the future.”6 It might be too little too late, but at least it’s a start.

But the task is being made more difficult by an absence of sufficient IT knowledge to provide the authority and leadership required to affect the necessary change. Recent research from Accenture showed that only 6% of board members on the biggest banks have professional technology experience and only 3% of bank CEO’s possess that sort of entry on their CV. Like in so many other areas a lack of understanding of a subject is prone to breed a fear of embracing it.

So the first step is that if banks want to be considered technology businesses they need to have IT specialists at their helm, or at least close to the epicentre of decision making. A question was posed recently that asked bankers “If you were told Google was taking over your bank would you be scared or excited?”. The question was rhetorical and no answers were provided, but the assumed conclusion worked the previous data in reverse in that the fear of the unknown would see the majority more concerned than excited. The truth is that bankers mostly still want to preserve the status quo, or at least just refine the way they are currently doing business. Putting it another way, if John Cryan was to swap jobs with Google’s Larry Page who do you think would make a better fist of the new challenge of running the others’ business? Many will conclude that banks could benefit from a fresh outside influence.

Taking a slightly different approach JP Morgan Chase two years ago deliberately appointed a CIO from outside the banking industry. Dana Deasy joined the bank from British Petroleum and prior to that had been CIO at General Motors, bringing with him first-hand experience of industries already disrupted by technology and digital innovation. The signs are there already that those experiences are shaping significant change at JPM. Other banks are also reaching outside of their comfort zones, with ANZ hiring the head of Google Australia to lead its digital banking.

In an interesting recent article UBS Investment Bank President Andrea Orcel wrote at length on the subject for Finextra1 and in some remarkably candid observations said, “Rather than solely relying on further tightening and ever more stringent generalised regulation, the focus needs to increasingly shift towards establishing strong leadership and developing the right culture and structure for each individual investment bank”. He said that the onus was on the industry to show that “when structured and run properly, with appropriate regulation, banks can be socially essential – not just socially useful”. And in order to do this it would “require reviewing the DNA and model of these institutions, how they are run and understanding the role they can play in society”.

This ties in closely with some even starker warnings from the latest assessment of the Capital Markets by consulting group McKinsey, which implied banks are in a last chance saloon if they continue to avoid adopting a transformation strategy; “the inescapable reality is that the industry’s restructuring efforts to date have failed to produce sustainable performance. A more fundamental change is required, based on the realization that for most banks, the traditional model of global capital markets and investment banking is no longer an option”2. More specifically, it said “High costs continue to undermine performance. New technologies remain underutilized, and many banks are struggling to make fundamental changes in their operating models and embrace the potential benefits of digitization”.

The challenges could not be clearer. In early October financial shares accounted for 74 (or almost a third) of the 240 equities in MSCI’s Europe Value Index. This is not a compliment. It represents those shares that are bargains, oversold or underperforming relative to their peers. This state of affairs was supported by the fact that in early October the average price to book ratio of European banks (what the market says a company is worth compared to how it values itself) was 0.8, versus an average more than double that of 1.7 for wider non-financial equities. The PE cash flow ratio of MSCI’s wider Europe index was 6.2, while for banks it languished at 2.3.

None of this should come as a surprise, given the pressures we know banks face, including complex and costly infrastructures, increasingly onerous regulations and new competition from changing market dynamics. Of course it is also compounded by prevailing low and even negative interest rates, as well as sluggish or zero growth in large parts of the global economy. All this weighs heavily on banks’ ability to grow and generate profits that rely on wider economic drivers to grow. Nevertheless, if this is just a cyclical situation with a rebound on the horizon, then bank shares are probably a bargain. But if it’s not they could be in deep trouble. It’s therefore probably better to start preparing for continued difficult conditions.

In fact, during a panel discussion at the recent 3-day meeting of the Institute of International Finance in Washington DC, where 1,600 of the world’s top bankers congregated, Goldman Sachs President Gary Cohn said, “I don’t see this changing. We keep saying we are getting closer to the end, but I don’t think we are getting any closer”3 according to Bloomberg reports of the event. Allianz AG chief economic adviser Mohammed El-Erian had an even blunter assessment: “As we look to the next 5 years I think the world of low growth starts to destroy itself”4.

New regulations and capital requirements have certainly turned the banking landscape on its head in recent years, with some justification given the abject failure of self-regulation pre 2008. But is the pendulum in danger of swinging too far the other way? These regulations broadly fall into two categories, those designed to create greater transparency that offers more protection to customers and investors and those aimed at bolstering bank capital bases to provide a bigger cushion against trading losses and prevent future systemic risk in the industry.

But there are unintended consequences of these initiatives, particularly the latter in the current flat interest rate environment. JP Morgan Asset Management head Mary Callahan Erdos demonstrated the growing gallows humour when she asked after the IIF meeting, which Bloomberg reported, “How can you have capitalism without any cost of capital”5.

There is no doubt that the more stringent capital requirements, and those yet to come such as FRTB, have made both banks and the system much more robust. But they are having a massive impact on profitability. What will be the point of having industry that is too safe to fail, but still eventually succumbs to the slow erosion of investor equity that is inevitably caused by returns that are persistently below the cost of capital.

JPM’s CEO Jamie Dimon was even more forthright - “Monetary authorities are trying to figure out what to do, but the system lacks co-ordination and is just enacting more onerous regulation”. It is a growing theme and it does appear that the industry that has quite rightly worn sackcloth and ashes for nearly a decade since the debacles of 2008 is now shaking off its apologetic mantle and beginning the fightback. Nevertheless, they need to demonstrate that they are also playing their part to deal with the new business realities and higher standards expected of banks in terms of risk management, performance and customer service. In order to get there, significant transformation will be required for most. Some are already articulating this reality; Societe Generale CEO Frederic Oudea said after the IIF meeting, “We are clearly aware of the need to adjust our business models”6. UBS’s Orcel went even further in his article - “Restructuring is becoming an event more obvious and necessary for investment banks. The move from universal banking to more specialist offerings is becoming more prevalent. Over the longer term, banks will need to focus on what they are good at, and, in our increasingly competitive market where the fight for market share is ever more intense, compete only in those areas where they can lead”. He went on to say, “By finding a structure that limits the need for capital, it is far simpler for regulators to understand, for shareholders to understand, and even for bankers internally to understand. It also helps to create a culture defined by integrity, quality, ownership and determination”. He accepts that this will not suit every bank and each must find its own path to a new approach, “Everyone will tackle the issue in their own way. But what is clear is that they need to tackle it. There is no longer the option to wait and see, or to rely just on corporate history as justification for current strategy and structure”.

So, there is a growing awareness that the status quo is no longer an option. But there remains a sense of inertia brought on by the daunting challenge of having to not only turn a business on its head, but tackle a potentially disruptive and costly exercise that might take five years to complete when your shareholders are looking for much more immediate remedies and improvements in profitability. It is an understandable dilemma.

But back to McKinsey, which starts to offer some specific suggestions - “Hard decisions must be made, particularly with regard to costs and banks’ commitment to the CMIB business. Amid increased price competition, banks must differentiate themselves based on value propositions that meet segmented client needs. Part of the solution is to make better use of data and analytics, along with financial technology and electronic execution and
distribution”
.

The combination of new technologies and business practises are now available for banks to tackle this in more cost-effective and secure exercises. However, any absolute savings achieved from IT rationalisation and transformation that are allowed to simply flow through to the bottom-line for short-term gain will be false benefits. There must be a wider commitment to redeploy these budgets to where they make a difference in supporting a parallel revenue growth strategy, which will be the only way banks succeed in the future. Any plan based solely around cutting costs or maximising capital will be doomed to failure. We can already see some banks who have the commitment to embrace this. Those that don’t will become footnotes in the next wave of industry consolidation.

 

References:

  1. http://www.efinancialnews.com/story/2016-09-26/fn-future-of-
    finance-investment-banking-andrea-orcel
  2. http://www.reuters.com/article/us-banks-mckinsey-idUSKCN11K1G6
  3. http://www.bloomberg.com/news/articles/2016-10-07/global-economy-shows-f...
  4. https://www.ft.com/content/c06bba4e-83cd-11e6-a29c-6e7d9515ad15
  5. http://www.bloomberg.com/news/articles/2016-10-10/titans-of-
    finance-gather-and-sulk-over-low-rates-deutsche-bank
  6. http://uk.businessinsider.com/deutsche-bank-ceo-john-cryan-memo-to-staff...

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