Forget M&A. Small banks could form cost-sharing alliances to shoulder the increasing regulatory burden and compete with larger rivals, according to a new report.
Banks can resist the pressure to merge by sharing infrastructure, including back-office functions and even branch space, while also focusing on strategic niches where they have advantages, according to the Global Banking Outlook for 2014 and 2015 released Monday by EY, formerly Ernst & Young.
The report argues that alliances between individual banks and across the industry would allow lenders to spend less money in areas where they offer little or no strategic advantage preserving their customers' account data, for instance and invest more in products and services where they could have an edge.
For the next two years, EY says, the pressure to increase return on equity will force banks to seek "revolutionary reform" of how they deploy their resources, according to Steven Lewis, EY's lead global banking analyst.
"[D]o smaller U.S. banks all need to have their own infrastructure or develop all products in house?" asks Lewis, who wrote Monday's report. "For some, consolidation may be the only viable solution, but others may be able to develop sustainable models by forming alliances with others."
The report offers an alternative to the gloomy merge-or-die vision for the future of community banks. Collaboration and specialization, it argues, can be an alternative to consolidation.
While collaboration between banks is common in certain areas, such as payments processing, Lewis predicts that banks will look to share back-office costs, possibly through the creation of industrywide utilities, while also outsourcing more administrative and recordkeeping tasks.
Retail banks, for instance, could look to create a master database in which all customer accounts would be stored in a central utility. Banks could also outsource customer compliance checks for know-your-customer and other anti-money laundering rules, for example to a single third-party utility, or create a central library that would provide customers' references and background checks.
Another alternative for smaller banks is to contract to use a company's existing back-end systems, Lewis says. Larger banks may be reluctant to share systems, but for small, newer banks it could be a means to save the cost of developing their own infrastructure from scratch.
In addition, banks could lower occupancy costs and consolidate their real-estate footprints by sharing branch space, Lewis says. While he doesn't know of any branch-sharing arrangement in the U.S., Lewis thinks it could make sense, especially for small-town and rural banks.
"Not only is [branch-sharing] more efficient for the banks, but it provides customers with more choice and hopefully better service as a result," Lewis says. Branches could develop into a department-store model, where multiple brands have a presence in a single store, the EY report suggests.
Even larger banks could benefit from forming alliances, the report says. National lenders could partner with similar-sized foreign institutions, and global banks could opt for collaboration in order to enter new markets.
"The future business model may be universal banking, but it won't be solo banking," the report says.
In addition, the need to share the cost of infrastructure will become increasingly acute as information-technology expenses keep rising, the EY report says.
EY predicts that the current "immense" pressure on bank IT infrastructure will continue for the next two years, leading to increasing costs to maintain old systems and invest in new ones. The report cites a study by the research firm Celent forecasting 4% growth in IT cost for banks in the Americas, to $59.4 billion, in 2014. (The study did not provide figures for U.S. banks alone.)
Along with increasing IT costs, the next two years will see a continuing shift to a "digital first" model, in which banks develop their digital products first, rather than adapting existing products to digital or online platforms.
EY's banking outlook also reemphasizes the importance of data security and the risk to banks from data breaches. Thirty-five percent of retail customers said the most important thing they want from their primary financial-services company is to keep their personal information safe, according to a forthcoming survey of retail banking customers cited in Monday's report. Another 35% said it was keeping their financial information safe was the most important, and 31% said convenient access to automated teller machines and branches was most important.