Salomon Brothers recently interviewed more than 50 leading banks in 11 major markets to evaluate the industry's success in controlling costs and to determine how performance might be improved.

The survey concluded:

"Cost management has become a dominant strategic theme throughout the banking world. ... The major lesson from the handful of successful low-cost producers is that a cultural commitment to cost management, invariably driven forcefully throughout the organization by the chief executive, is the single most important success factor. ... If this culture is in place, the techniques of successful cost management are proven ... (and) are summarized under the heading 'business process reengineering.'"

I would add that true reengineering looks at both sides of the income statement; repricing of services based on the "perceived" value banks supply to customers is comparable in importance to successful future competition.

Bankers must therefore acknowledge an imperative to reengineer.

This may seem a surprising assertion, given the industry's record earnings of the last three years. Yet complex and outdated cost structures, unsophisticated pricing models, and the convergence of competition with nonbank suppliers are collectively leading to an earnings crunch for banks that the industry must meet head-on.

Senior and middle-ranking bank managers face an enormous cost challenge. By its nature, the banking business involves an inherently more complex structure of process, functional, physical plant, and systems costs that are common to multiple customers, products, and geographies.

Costs are not unique to a particular product - as in a dedicated factory production line - but are shared among multiple products and customers, as are back-office data centers or branch networks. The expense of entering new geographic and product markets, and new forms of investment, have then been overlaid on this already complex structure, creating an intertwined "spaghetti" bowl of process costs.

In response to niche marketing by product specialists, banks have introduced a flurry of "new" products and services. Although some of these efforts have helped retain a departing customer base, many have a "flavor of the month" quality.

This latter characteristic creates a threefold effect: first, the dilemma of whether to create a specialist product sales force and infrastructure; second, the need for increased cross-selling by marketers and even tellers; and third, the further burdening of systems and operations to serve the increasing number of products and services.

If costs were complex for the core bank, further complication has arisen from the industry's continuing consolidation.

More than 2,600 private acquisitions of banks have occurred since 1979, at a total price of more than $140 billion. Bankers hoped that geographic expansion would give them access to more customers, thereby leveraging their product mix and allowing them to achieve economies of scale on the cost side.

Bank mergers, however, have added the challenge of managing geographically remote affiliates. And recent academic research suggests that many acquirers have neither managed this successfully nor realized significant cost savings.

In a valiant effort to cope with their complex cost structures, banks have since 1980 invested a cumulative total of more than $100 billion in technology, and such spending is accelerating.

This investment may be warranted by the needs to upgrade to meet capacity constraints, make improvements required for customer ease of access and speed of turnaround, and avert competitive obsolescence vis-a- vis peers.

Yet it is far from clear that these investments have achieved the projected cost displacements that were their justification. And the increased value of service to customers through such upgradings has not been reflected in increased prices.

All of this has led to a burden on the management structure of banks through matrix management (in reality, even if not reflected in organizational boxes), narrow reporting spans, and successive layers of process "controls" that have made banks incredibly inward-focused.

The results of a general lack of pricing sophistication are evident across all product lines within the banking industry. Most pricing models used today are based upon cost-plus or competitor-matching approaches, both of which focus inwardly rather than reach out toward the customer.

The limitations of traditional pricing approaches should be contrasted with value-based pricing, which is rooted in customer behavior and, only then, factors in cost and competitive factors. Such a model focuses explicitly on customer price elasticity - that is, the percent change in demand for every 1% increase in price - at the transaction level.

The failure to manage process costs and prices effectively is more significant because of the fierce competitive challenges banks now face. Increased competition from nonbank product specialists and increased commoditization of bank products is creating an environment in which high- cost producers will be driven from the market.

This is true on both the retail and wholesale sides of the bank.

In retail banking, on the liability side, banks have lost a significant source of low-cost funds, as consumers have shifted their deposit balances to mutual funds.

From 1983 to 1993, banks' share of the combined U.S. total of consumer deposits and mutual fund assets (including bond and equity funds) fell from 84% to about 50%.

Though deposit disintermediation has raised the cost to banks of doing business, nonbank product specialists have also "cherry-picked" the most profitable retail credit niches.

From 1987 to 1993, for example, commercial banks' market share among the top 25 credit card issuers fell from 89% to 70%. Nonbanks now comprise 13 of the top 50 credit card issuers.

In wholesale banking, the increasing sophistication of markets and corporations has prompted development of cheaper alternatives to traditional bank financing.

The maturing, and consequent liquidity, of the commercial paper market turned short-term financing into a commodity-type product, based solely upon the issuer's credit rating. This has given prominent corporations a cost advantage over commercial banks, whose credit ratings have deteriorated as a result of deregulation and credit problems.

To illustrate, from 1980 to 1993, corporate commercial paper borrowings grew from $124 billion to $554 billion.

Even the weakest credits have been able to obtain nonbank sources of long-term financing - primarily through the high-yield (or junk bond) market. In 1993 alone, issues totaled $55 billion more than the total of junk bonds outstanding in 1980.

As a result, commercial banks' role as a provider of funds to corporations has changed dramatically. They have lost their virtual monopoly and become essentially short-term providers of credit for riskier corporations.

Although these loans have yielded more than their alternatives, the increased margins have not compensated for the additional risk incurred. The result: writeoffs of almost $110 billion from 1990 to 1992.

In today's world, it barely seems relevant whether a player is a bank or not. Product specialists, national competitors, and increasingly sophisticated customers are creating a competitive environment in which only efficient producers and sophisticated pricers - banks or nonbanks - will survive.

The margin of error for underperformance is continually narrowing. Yet bank costs are almost always too high and their prices too low. The average efficiency ratio for publicly traded banks (cents of cost required to generate each dollar of revenue) has remained at about 65% since the mid- 1980s, after adjusting for the last three years' supernormal spreads.

However, top quartile performers are operating with efficiency ratios of 50% to 55%.

In the past, regulation and limited competition prevented the development of a discipline that would inspire bankers consistently to challenge arcane, redundant, or duplicative processes - and at an enormous cost.

Pricing has, at best, been on a cost-plus or competitor-matching basis. Industrywide, the earnings left on the table from this imbalance of costs and pricing are of the order of $30 billion a year, before taxes.

And hungry, fierce competitors are waiting at the door to capitalize on banks' economic vulnerabilities.

The second and concluding article in this series will be published Aug. 16.

Mr. Allen is chairman of Aston Limited Partners, a New York-based bank investment and reengineering firm. He wrote "Reengineering the Bank: A Blueprint for Survival and Success" (Irwin Publishing).

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