2011 Financial Services Industry Perspective

Transcription

1 2011 Financial Services Industry Perspective The worst of the financial crisis may be behind us, but if 2010 has taught us anything, it s that we are still very far from business as usual. Many economies, particularly those in the U.S. and Europe, remain deeply troubled. Their economic growth is weak, joblessness is high, capital markets are volatile, and the overall macroeconomic picture is uncertain (as evidenced by inflation and deflation fears that seem to alternate monthly). To make matters worse, public sentiment regarding the sector remains strongly negative, thanks to the bailout, excessive banker compensation, and the continuing weakness in the mortgage market; meanwhile, investors in financial firms gripe about their poor returns. Add to this challenging business environment much stricter regulations. Banks and financial firms face new legislation and regulations in four key areas: capital requirements (they will be higher across the board); liquidity management (sources of funding are being scrutinized); consumer protection (credit card and overdraft fees have been curtailed as a new Consumer Financial Protection Bureau starts its work); and trading (proprietary trading is being separated from traditional banking, and OTC derivatives must increasingly clear through central counterparties). It s no wonder the financial services industry isn t celebrating the end of the Great Recession. A New Normal Instead, we are seeing a growing realization within the industry that we may never return to business as usual at least not business as it was pre-crisis. Many of the changes wrought by the financial tumult on the regulatory and business environment will be enduring. They have created deep shifts in the markets in which financial firms compete, which will force management teams across the industry to scramble to rethink their strategies even as they strive to finish working out bad credits and cleaning up their balance sheets. For large, diversified financial services firms, there are four shifts of particular importance. First, higher capital requirements and other regulations will permanently boost the cost of doing business and reduce profitability even after the current credit problems abate, which will take another year or two at least. For instance, prior to the crisis, regional banks often enjoyed comfortable double-digit returns on earnings. We expect those returns to decline 3 to 6 percentage points. In the process, the industry will become a cost-of-capital business, more like a utility.

2 Page 2 of 5 This has serious implications for how firms allocate resources: Whereas nearly all new sources of top-line growth increased shareholder value in the past, now firms will need to distinguish between good growth (accretive to shareholder value) and bad growth (dilutive to shareholder value). A second hallmark of this new business environment will be the fierce competition for low-capital, fee-income services such as payments, transaction services, and wealth management that can help firms compensate for the increased capital costs necessary to generate net-interest income. Ironically, the competition for these services will drive their margins lower as well. Third, financial firms can no longer rely solely on the capital markets to fund their balance sheets. Investors are demanding that these firms diversify their funding sources to avoid a repeat of the recent crisis. As a result, financial firms will compete intensely for liquidity-rich clients, including affluent individuals and commercial accounts, which can provide stable sources of funding with dependable deposits or insurance premiums. Fourth, risk is being repriced across the board by providers and buyers of financial services alike. In the consumer markets, for instance, the risk-adjusted profitability of subprime credits has declined. In the commercial markets, the cost of providing long-term credit has increased relative to short-term loan products. Meanwhile, in the capital markets, the cost of market risk associated with proprietary trading and securitization has increased. Financial institutions are not the only ones repricing risk. Investors in financial firms have a much deeper appreciation for the risk associated with both debt and equity. And employees themselves, who once gladly accepted stock and other forms of deferred compensation, now prefer cash to reduce their exposure to their employers fortunes. Four Strategic Agendas Given the profound and enduring changes in the business and regulatory environment and after two years of working out poor credits and other balance sheet exposures, shoring up capital positions, and reducing operating costs many executive teams are starting to chart new long-term strategic courses. To do so, they are thinking in terms of distinct but related agendas, which enable them to identify, assess, and prioritize issues critical to their company s financial and market performance. As they work through these agendas, a new strategic direction emerges and is executed. The specific agendas that companies adopt vary by market and institution, but they typically include risk and capital, growth, capabilities, and operating model agendas. The first of these, risk and capital, is mainly about surviving in a new regulatory environment and better managing the risks that can debilitate a

3 Page 3 of 5 financial company. By comparison, the remaining agendas growth, capabilities, and operating model are about thriving in this new environment characterized by increased competition and, in some markets, pressure to consolidate. The risk and capital agenda comprises the firm s short- and long-term priorities for managing its risk exposures and provisioning capital against those exposures. Since the financial crisis started, most banks and financial firms have had little choice but to focus their energies on addressing the most urgent issues on this agenda. Now they need to turn their attention to longer-term issues as well. The items on a risk and capital agenda typically include the following: Completely work out credit issues. Many banks and financial firms have made good progress on this front since the beginning of the crisis and are starting to see the light at the end of the tunnel. Stabilize long-term funding. This requires both tactical- and strategic-level actions. Tactically, a company may need to raise more common equity and defend its base of client deposits. Strategically, the company may need to rebalance its portfolio of asset- and liability-rich businesses, as well as pursue more client-centric strategies at the business unit level to grow both client assets and liabilities in a more balanced way. Decide long-term risk tolerance and financial leverage levels. Regulators may push firms to lower risk so substantially that it becomes difficult to generate the returns that shareholders expect. Settling on leverage levels that balance the demands of regulators and investors is likely to take some negotiation. Upgrade risk and capital management frameworks. The crisis revealed that many firms did not adequately understand, quantify, and provision for certain sources of credit and market risk. Regulators are demanding that firms do better. For instance, the Basel III international regulatory framework has new guidelines regarding counterparty risk and liquidity risk. Improve business risk management. All financial services firms face business risk, yet few have a rigorous process for systematically identifying and quantifying the sources of competitive, client, and regulatory risk and developing strategies to manage that risk. Broaden accountability for risk and capital management processes. Risk and capital management processes have too often been siloed, undermining both. Not only should these two processes be aligned with capital as the currency of risk, they also should be integrated into the strategic management process. Accountability for risk and capital management can

4 Page 4 of 5 then be shared more broadly across the organization, and resources can be better aligned with long-term drivers of value creation. Upgrade risk and capital infrastructure. Firms need to collect quality data and process it into meaningful information to enhance frameworks and make it possible for risk managers to act. Most companies will need to combine short-term fixes to their systems with longer-term and more costly improvements. While risk and capital agendas may be similar among financial companies, the growth, capabilities, and operating model agendas tend to be quite specific to markets, businesses, and individual companies. In this new business and regulatory environment, most firms will find profitable growth harder to attain. They will use a growth agenda to set realistic, yet ambitious growth targets; to create more organizational and investment focus in order to pursue the most attractive growth opportunities in specific product and client markets; and to enhance their organic growth and M&A capabilities if necessary. This growth agenda will need to be informed by a clear view of how profit pools have shifted and where they will be located in the coming years. The capabilities agenda should be aimed at identifying and developing a carefully selected system of mutually reinforcing and differentiating capabilities that support the firm s growth agenda. This system should be the foundation for the firm s competitive position going forward. Capabilities may take the form of superior knowledge of a particular client segment (e.g., premium clients) or client need (e.g., payments); the management of a particular asset (e.g., a payments network); or organizational abilities (e.g., innovation, talent management). Our research suggests that a capabilities system s value stems as much from the organizational coherence it engenders as from the outcomes that the individual capabilities within it enable. For those interested in more information about capabilities, Booz & Company has just published The Essential Advantage: How to Win with a Capabilities-Driven Strategy (Harvard Business Review Press). The operating model agenda should support the firm s risk and capital, growth, and capabilities agendas. Its purpose is to align the company s cost structure with the drivers of growth and value creation in this new regulatory and business environment. For instance, some firms might reorganize to better focus on new markets and leverage their capabilities system while also shedding costs. Other financial firms and banks will undertake and invest in multiyear transformation programs designed to implement leading-edge technology solutions. Still others will use lean methodologies to drive efficiencies throughout the organization.

5 Page 5 of 5 * * * These are challenging times for the industry, and there are no easy answers. But by recognizing the profound and enduring changes the industry faces and crafting a new strategic direction by working through key management agendas particularly risk and capital, growth, capabilities, and operating model agendas we believe that executive teams can position their companies to weather today s storms and capture tomorrow s opportunities. We hope you find these thoughts helpful as you consider your strategy for the future. We would be pleased to discuss how these ideas may apply to your organization or to answer any questions you may have. Paul Hyde paul.hyde@booz.com John Rolander john.rolander@booz.com Gauthier Vincent gauthier.vincent@booz.com Roman Regelman roman.regelman@booz.com