Experts' Verdict: Cost Is King in Banking Industry

Is cost king in the banking industry? American Banker editors recently put that question to a panel of top consultants.

Their response was no surprise: Because of ongoing consolidation and keen competition from nonbanks, the industry is in a transition period from which only the most cost-effective players will emerge.

In a wide-ranging question and answer session, panel members - identified on page 3A - touched on the role of technology in paring expenses, strategies in place at large and small banks, issues surrounding compensation and layoffs, successful suggestions from employees, and a list of the most common cost-cutting mistakes.

AB: What's the most important thing for banks to know about cutting costs? CLARK: Banks should know that there are two elements critical to cost reduction.

The first is the human factor. The second is to make sure that efficiency, as an operating philosophy, becomes ongoing - not just a one-time event.

Like most service businesses, banking is people-intensive. So it's no surprise that a typical bank has about half of its noninterest expenses tied up with compensation benefits and other people-support obligations.

In this area, competitive advantage comes from efficiency and a high-service-quality approach. That is best achieved through a participatory process involving employees.

For a bank to be successful at cost cutting, its employees have to buy into the changes.

AB: Any new wrinkles on the cost-cutting front? BIRD: There's been a shift among our clients toward reengineering, or working smarter, instead of just cutting 10% across the board.

Part of that involves technology. I'll give you an example.

Under the traditional way of booking loans, for example, a customer sees a bank employee and fills out an application. That application goes to the lending officer.

The lending officer reviews the application and sends that piece of paper to another person, who punches the data into a computer system.

By using platform systems, the lending officer of a small bank - with $200 million in assets - can now do the inputting. There is no piece of paper, and only one person inputs the application. At least two intermediate steps are eliminated.

Even a small bank, using technology, can do things in a more cost-effective way. McCORMICK: You have to look at expense control in terms of value impact.

Take the value of an expense dollar saved. If you can continue to move forward with the same level of revenue and the same level of equity - and you take out a dollar of expense - that dollar saved has an infinite return on equity.

For example, at a growth rate of 7%, the effective price/earnings on the after-tax dollar saved would be some 12 times. This is much higher than most people appreciate.

If you saved some $130 million pretax on a merger, you would create about a billion dollars in market cap.

Let's say you're a typical regional bank spending 350 basis points. If you were only 10% better on expense productivity, you could save 35 basis points pretax. After-tax - with typical tax and leverage - that would equal a four-point advantage in return on equity. And that would be worth an increase of 40% to 50% in your stock price.

AB: Aren't cost problems compounded because of declining revenues? HEDGES: As we see it, the revenue side of the cost equation is going to continue deteriorating over the decade.

Banks need to change pricing tactics - both to get paid for what they do and to incent consumers to use lower-cost delivery channels.

As they do that, they also need to strip down the old infrastructure. For example, today's 200-branch system may be able to afford only 25 branches in five or eight years.

Some might call these measures truly draconian. But anything short of that simply amounts to moving deck chairs around on the Titanic. McCORMICK: I agree that the revenue outlook of the industry is troubling. Consider, for example, First Manhattan Consulting Group's latest analysis.

It suggests that attractive intermediation revenues - those on which you can earn a 15% risk-adjusted return on equity - have been growing at inflation minus three for the past six years.

In the mind of the CEO, productivity must be near job No. 1 - every day. Cost cutting is not a fad; banks will have to deal with cost cutting for the next decade and beyond.

AB: Are the cost-cutting schemes bandied about by consultants applicable to both large and small banks? FURASH: Institutions in which two people - or three, at most - have their arms around the entire company share some very straightforward characteristics.

First, the CEO typically is very cost conscious. That's partly because there is often an owner who sees dollars going directly into - or out of - his own pocket. That creates an environment in the bank that drives for cost control.

Second, most community banks are run on a far more informal basis than large organizations. If you don't like what Mary is doing, you say: "Hey, Mary. Stop doing that. Go over there and do something else."

Third, in reaction to the market, they're able to change their cost structure faster. They feel the pulse of the market daily.

They have a keen sense of what is affordable and what is not. When they find things that are not affordable, they simply do without them.

AB: It's been said that large banks with the resources to purchase the latest technology enjoy a cost-cutting advantage over smaller banks. Is that true? FURASH: I think technology is running in favor of smaller concerns.

Call this arena "small technology," the capacity to run a loan or data system on small computer systems that you can buy, rent, or borrow from larger purveyors. This makes small banks inherently able to survive a lot longer, because typically they're in a better pricing position. HEDGES: Smaller institutions also deal in different markets from their larger counterparts in California and the Northeast corridor, where a lot of the right lessons and the right things to do in terms of cost cutting are supposedly being generated.

But if you go to Grundy County, Tenn., or Grand Junction, Colo., some of the correct ways to cut costs would chop away at the customer base. For example, the fact that a bank has to fax a loan application to Denver might run off half the commercial portfolio.

In many places, a national market is being created, in which consumers are prepared to deal with national players that employ national techniques. In some places, on the other hand, the name of the game is "outlocaling" the competition.

AB: Sounds like cost-conscious holding companies walk a fine line between wanting to be cost savvy and wanting to do things that will win over local customers. FURASH: When a company tries to do that, an enormous tension builds up.

To be more efficient, a bank might attempt to build up a core of manufacturing facilities. At the same time, it wants the people running the banks in a local market to deal entrepreneurially with that market and have the freedom to make decisions.

The solution involves discipline and management consistency across the organization. BIRD: Multibank holding companies are essentially supercommunity banks. They walk a tightrope between centralization and decentralization.

On the one hand, they want to compete with the service levels and the local franchise of the community bank, and that is key. On the other hand, they want to achieve cost efficiencies that reflect the overall size of the company.

AB: Costwise, are banks at a disadvantage to nonbanks? HEDGES: I think we're seeing that happen right now with major money-market mutual funds. Some of these have significant and variable cost advantages.

They are able to operate - depending on the numbers you see - at a cost advantage of 100 to 150 basis points. As a result, they are stripping funds out of the banking system.

Such moves are not for the timid. In most cases, you are putting businesses at risk that are healthy today and will probably be healthy again when next year arrives.

But look at competition, demographics, and your own customer base to see where your income is coming from. You might find that, in 10 years, you're not going to have that income. And customers might be somewhere else in the bank - or not in the banking system at all.

AB: What's the role of a chief executive officer in cost cutting? FURASH: The only way cost cutting can succeed is as part of the CEO's attitude. In lots of cases, effective cost control is not possible because an organization hasn't adopted a cultural attitude that makes people accountable for running their businesses.

Until a management has the capacity to repudiate past ways of thinking about the business and selling the products, cost cutting can't happen.

AB: When you talk to a CEO about reducing expenses, how much of a sense does the guy on top have about what needs to be done? CLARK: Each bank has a different set of problems and opportunities, different product lines in different stages of development. And each CEO has done a different amount of homework on what he or she thinks needs to be done.

AB: How has the investment community received banks' cost-cutting efforts? HEDGES: We've been talking about whether cost will be king during the 1990s. But, in some ways, the king will be the crisis of confidence that analysts have about banks.

In the first half of the '90s, we're going to see a dramatic effort on the part of ambitious executives to demonstrate that they can manage their profit and loss. In that area, they can manage their cost structure better than anything else.

AB: Who are the top banks, in terms of cost control? CLARK: Fleet/Norstar Financial Group and Banc One Corp., to name two. HEDGES: Fleet has to be the best example of a smart, cost-minded bank.

First, they have a track record of doing a good job. In fact, their bid for Bank of New England was accepted because they had credibility. Not just with the investment community - as witnessed by the stock price reaction to their winning the bid - but with the regulators as well. McCORMICK: Society Corp. is also an institution trying to understand the economics of their business units, increase profitability, and run the organization more systematically. They've tried to understand the risk-adjusted return on equity by business units and they've gone through a comprehensive expense-control program.

AB: Who are the top cost-cutting CEOs? McCORMICK: Tony Terraciano. He's taken First Fidelity, Newark, N.J., as a phoenix out of the ashes.

First Fidelity may emerge as a powerhouse in the next acquisition wave. It's coming along rapidly. When Terraciano arrived on the scene, he said: "I am not wedded to producing anything myself. And I want a study that looks at everything: opportunities to outsource, use service bureaus, and to buy software rather than develop it internally." Nothing was sacred.

He was the first $30 billion banker to say: "I'm willing to consider outsourcing in my core technology."

AB: Is there a difference between a bank running cheap and running smart? FURASH: Lots of institutions have run cheap and lost their franchises.

AB: What are some of the biggest cost-cutting mistakes you've seen banks make? CLARK: It's probably easier to come up with a list of those mistakes than with a list of 10 things that work.

One mistake is an edict from management that all areas of the bank will be cut 10%..

Another mistake is when management continues to take bonuses and increases, while the work force is downsized and salaries are frozen.

Yet another is not taking care of the work force that remains after a downsizing. Training, retraining, and coaching are required to get people refocused on the tasks ahead.

AB: What else rates inclusion on a list of gaffes? BIRD: People at one bank were promised a bonus for selling some of the bank's real estate. The idea was to increase capital. But as soon as the people sold it, the bonus program was canceled.

As a result of the sale, senior management were forced to move to a temporary site, and they spent a significant amount of money renovating. The effect on rank-and-file employees was demoralizing.

In another case, a bank let two messengers go, for a total savings of $15,000 a year. The resultant cost of moving paper between uptown and midtown - and the amount of aggravation - was tremendous. Overall, no cost savings were achieved.

AB: Lots of people wonder why some CEOs make millions while their banks are struggling. Is there substantial room for savings in compensation costs? FURASH: At most banks, savings in compensation come from changing the ratios of managers to doers.

A lot of people in middle-management positions are monitoring, not doing. Most organizations need to look at these middle and upper layers. You could pay for a lot of customer service if you lay off even one middle-level executive or senior vice president.

The real issues involve the layers of management. In most cases, too many layers have been allowed to creep in between the customer and the top of the organization. If some of these managers disappeared, you wouldn't know the difference.

AB: How do things degenerate to this stage? FURASH: Perhaps a manager who couldn't really do the job was "Peter principled" to the next level upward. Or maybe someone was saved because he or she had key relationships with customers.

How many managers can be removed without damaging the organization's ability to deliver high-quality customer service? This crucial issue is related to the span of control, whether people are working managers or supervisory managers, and number of people reporting to them.

The pain of reducing management is very difficult to face. It's easy to face the pain of saying we're going to have fewer people in the branches. You might think these people are all look alike - all modular.

It's much harder to look down the hall and figure out which of the three guys you have lunch with twice a week you're never going to see again. But that's where the money has got to come out in most organizations, in middle-management layoffs. CLARK: I would add that to the Big Mistake list. There are too many consolidations in which organizations have done an excellent job in the branch system and in the back office. Yet, they're still drowning because they haven't made necessary management cuts.

AB: In that vein, are top executives making too much? McCORMICK: Ultimately, the management groups that create productive banks deserve to get rewarded. But there might be some apparent inconsistencies.

You'll have situations in which a bank is going through an expense-reduction program, but the people who remain end up getting a bonus. Well, if the stock price goes up and shareholder value increases, those bonuses should be paid.

At about 70% of banks, pay-for-performance measures - against which managers must be targeted to get their bonuses - are problematic. It's all too possible to do well when measured by these targets, yet do poorly for shareholder value.

AB: What's the best way for a bank to incent its CEOs and employees to take a cost-effective approach? BIRD: One way is to let people share in ownership of the company. At some banks, each employee - from the lowest to the highest - has some stock, some options in the company.

Such incentives create a sense of pride. They encourage employees to find little ways to save. They prompt innovations such as changes in the minimums on interest rates, NOW accounts, interest payments on floating funds, and charges for mailing statements. Individually, these are all tiny things, but when you mail 100,000 statements at $1.50 a month, they become big bucks.

AB: Are banks increasingly tapping their employees for cost-cutting suggestions? FURASH: Yes. People at the line level always know where time is being wasted. You would be stunned - virtually - by how many things employees will identify as time wasters.

AB: Any examples of waste spring to mind? FURASH: You might find a report that has been circulating for 10 years without anyone looking at it. McCORMICK: Typically, there's low-value activity in virtually all staff areas, from legal to financial reporting, and in the line from branch to relationship management to transaction processing.

You often find people spending 20% to 30% of their time on such low-value activity. When scrutinized on a value-per-cost basis, these activities should obviously be reduced - or eliminated entirely.

AB: Don't employees fear that, by divulging information about waste, they might loss their jobs? CLARK: These people generally have too much on their plate, as it is. FURASH: They know they need to run faster and smarter. I think they want to get rid of this stuff.

The best managers often volunteer their own jobs in any cutback.

Along with increasing costs, waste has other fallout. Asking people to do things they think are a waste of time can engender disrespect for management and for people in other parts of the organization. Banks run better - and people feel better - when they get rid of waste.

AB: What's happening in the area of employee compensation? CLARK: Given escalating health-care costs, banks are looking at the benefit packages they give to employees. They are looking at ways to pull back on coverage.

Some are offering flexible plans with preset benefit values, allowing employees to choose the types of coverage they want.

AB: What is one of the quicker ways banks can cut costs? HEDGES: Reduce phone lines. Lots of branch systems have phones that are unused. BIRD: Another thought on telephones. The American Bankers Association has a program that buys volume discounts to be shared jointly by many small banks. About 1,200 banks participate.

The program facilitates savings of 20% to 25% a month.

AB: How can banks reduce paper costs? McCORMICK: One way is to encourage answering a written memo via a response on the back of the same sheet. That uses less paper than typing up a new memo that refers to the old memo, photocopying it, and so on. BIRD: One bank, with around $10 billion in assets, just stopped some photocopying and circulation -- and saved $2 million to $3 million a year. It was mind-boggling. FURASH: One of my favorite ways to help an organization save money is just to stop 50% -- at random -- of computer-generated reports. Much of the time, nobody ever bothers to ask for them.

AB: What does the average banker think about cost control as we approach the year 2000? FURASH: I think every banker lives with the fear that he will never be able to achieve escape velocity. He has to be asking himself: "How do I get up sufficient momentum in my cost structure to insure that I have a clear, competitive advantage?"

That's not going to happen overnight.

Banking -- even corporate banking -- is a form of retailing. And no form of retailing ever disappears: It simply waxes and wanes.

AB: What are the industry's prospects for success? FURASH: I think we'll go through a decade of transition. We'll see a structure in which 5% of all players control 85% of the market.

More and more, assets are moving out of the banking system and into nonbanks, competitors that have either a better cost structure or better access to the marketplace because of better credit ratings.

As a result, the first job of a bank is to stabilize its cost structure at the lowest level possible. Second, it must stop losing market share.

The fundamental economics of the banking business has changed so dramatically that costs must be controlled -- just to tread water. But that still doesn't produce escape velocity.

To get there, you need a sustained attitude that says: "I'm going to hunt the paper clips, or I'll even try to do some things a little better, or be more efficient.

"I'm going to run faster and smarter, or make my branch network a little more efficient, or reduce my ratios by 50 or 60 basis points." McCORMICK: Ultimately, the guys who provide the best services in the market and the most cost-effective methods are going to win, and make good returns.

We already have multiple products in security processing: credit card, personal trust, and asset businesses based on direct mail. All of these, along with branches and cash management, will become scale-based businesses.

That's not just because 1,000 clerks can complete transactions cheaper than 10. Scale will enable these players to afford better management, marketing, and technology.

Suppose a low-cost player emerges in your region, with a 50-basis-point expense advantage. And suppose this player uses that advantage not only to make higher returns, but to change the pricing in the market.

The board will start asking: "How can this guy price more attractively to the customer than we can and make a higher return?"

That question will make a lot of players uncomfortable. The day that happens, they'll realize: "I've got to consolidate -- or sell out." CLARK: I agree: In the next five to 10 years, 10 to 15 organizations will revolutionize the way they handle cost reduction. And they will pick up major market share in the United States.

Cost reduction must not be at the expense of service quality and delivery. They must be in tandem.

AB: If a bank tacks up a cost-cutting motto on its walls, what should it say? CLARK: Cost reduction and service quality must be a participatory process, involving all levels of the organization. McCORMICK: Acknowledge the power of productivity and believe that if you get on with it, tremendous strides can be made without debilitating your revenue streams or quality levels.

Don't underestimate the increased importance of scale in technology-intensive businesses. FURASH: Get what you expect. Never let people think you're not coming back, that you're not connected. Monitor constantly. Keep the pressure on. BIRD: Don't be penny wise and pound foolish. And don't mortgage your future to achieve short-term results. HEDGES: Time is running out to get cost cutting done right. Ten years from now, a lot of people will be discussing what might have been.

PHOTO : SAVINGS COACHES Robert B. Hedges, left, and Anat Bird map out some playing strategies -- both offensive and defensive -- for banks and thrifts.

PHOTO : Arthur E. Clark Jr. is a partner in Business Dynamics, a privately-held management consulting firm in Nyack, N.Y. He specializes in post-merger, acquisition and cost-reduction work for regional brokerage firms and banks with asset sizes ranging from $1 billion to $10 billion.

PHOTO : Robert B. Hedges Jr. is a director of the Western region financial services practice for Cambridge, Ma.-based Mac Group. He works out of the group's Chicago office, and focuses partly on the strategic development of money-center and superregional banks.

PHOTO : James M. McCormick is founder and president of First Manhattan Consulting Group in New York. Mr. McCormick primarily advises large and medium-sized financial institutions on capital and business strategies, lending, technology management, and expense reduction.

PHOTO : Anat Bird is director of financial institutions consulting at BDO Seidman in New York. Ms. Bird, who has published two books for the American Bankers Association, is a specialist in asset-liability management. She works most often with banks ranging in asset size up to $20 million.

PHOTO : Edward E. Furash is president of Washington-based Furash & Co. Mr. Furash's areas of expertise include retail bank marketing and delivery strategies, and management design and practices. He has also advised non-banks on their entry into the financial-services arena.

PHOTO : CRACK COST CUTTERS, comparing notes, include Edward E. Furash, left; Robert B. Hedges Jr., center; Arthur E. Clark Jr., right; and James M. McCormick, lower right.

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