Tightening Down

By Jack Milligan

Tough times are turning the focus back on expense control, but customer needs still must be kept in sight.

Cost control has returned to banking, albeit with less destructive energy than in the late '90s, when "reengineering" and merger-induced downsizing roiled the industry. Many of those projects misfired badly and weakened rather than strengthened institutions.

This time around, executives seem determined to avoid drastic actions that would demoralize employees and degrade service. The new efficiency programs seek to preserve revenue growth by keeping the customer in focus.

It remains to be seen whether that happy medium can be achieved. If the nation's current economic malaise is prolonged, pressures will mount on senior managers to cut more deeply. The institutions that recently have announced programs are tight-lipped about exactly where they're cutting, no doubt because of sensitivity about layoffs.

Wall Street analysts say they've obtained few details but view these efforts as appropriate in today's pinched economic environment. They also approve of the fact that the current round of cost cuts pales in comparison with the massive reengineering programs of the last decade, when institutions such as the former CoreStates Financial Corp. and Firstar Corp. were left weakened and vulnerable to takeover. "It's a fine line between cutting the fat out of an organization and cutting the muscle," says Jennifer A. Thompson, an analyst with Putnam Lovell Securities Inc. in New York.

Accordingly, senior managers are putting more emphasis on preserving vital customer relationships. The major rationale for the diversification drive of the '90s, after all, was to expand "share of wallet" by selling more products to current customers. Any cost-cutting that increases customer attrition betrays that effort. It takes a strong focus on both sides of the performance equation — expenses and revenues — to produce sustained improvements in profitability.

At the same time, there is a tendency for managers to relax their cost-control discipline when times are good. Expense control was rarely invoked during the last few years as the industry crested on a wave of record earnings. Now managers are increasingly reaching for that tool to help steer their institutions through a slowing economy. "This is the time when people need to make sure they have operating expenses under control," says analyst Gerald Cassidy, with RBC Securities in Portland, Maine.

One payoff is that effective expense control can magnify the effects of revenue growth when economic conditions do improve. Institutions that tighten down now will likely be better prepared to take advantage of any future upswing in business conditions.

Pinched Environment

Slowing growth is forcing the industry's hand on expense control. Total loans and leases remained flat over the course of 2002's first quarter and rose only 1.6% during the 12 months ended March 31, according to the Federal Deposit Insurance Corp. Even this meager performance would have been impossible without strong volume gains in residential mortgage and consumer loans, which offset continued shrinkage in commercial demand.

Atlanta's SunTrust Banks Inc. put the issue into focus when announcing its first quarter earnings back in April. Citing a weak economy, chief executive L. Phillip Humann declared that tighter expense control "has now moved to center stage" at SunTrust. "Our expense growth is outpacing our revenue growth," Humann told analysts. The bank said it would eliminate "several hundred positions" and instructed its managers to find "big cuts" in travel, entertainment, purchasing and marketing expenses. SunTrust declined to make its executives available to provide additional details.

Other banks that have recently elevated cost-cutting to a strategic priority include Charlotte-based Bank of America Corp.; KeyCorp, Cleveland; Chicago-based Bank One Corp.; Union Planters Corp. of Memphis; Mellon Financial Corp., Pittsburgh; Bank of New York Co.; and State Street Corp. of Boston.

Industry-wide, however, a sense of urgency seems to be lacking. After all, banks did report a record $21.7 billion in profits in 2002's first quarter, thanks to the widest net-interest margin in four years. While loan growth may have stalled, the bottom line is still growing nicely with the help of low interest rates and strong growth in deposits and consumer loans. "Cost-cutting is easier to do if banks are doing badly rather than well, and most banks today are doing okay," reasons Charles Wendel, president of Financial Institutions Consulting in New York.

That logic doesn't sit well with Robert Kelly, chief financial officer at Charlotte-based Wachovia Corp., who thinks it's dangerous to put off the tough but important job of cutting costs. "If you don't manage your expenses well in an environment where there's not a lot of growth, you're going to have serious problems," he says.

Since merging with First Union Corp. in September 2001, Wachovia has been energetically working to reduce the combined institution's cost base. Executives aim to eliminate $890 million in annual costs by September 2004, including about 7,000 full-time positions or 7.5% of the workforce. Such belt-tightening is standard operating procedure following a large merger. But Kelly is also targeting a permanent reduction in the company's "efficiency ratio," from the current 61% to the lower 50s by next year.

This efficiency ratio, or operating expenses as a percentage of spread and fee revenues, is the standard measurement of expense control. Lower means better. The average efficiency ratio for the 50 largest banks (excluding Citigroup) was 57.5% during the second quarter of 2002, according to SNL Financial LC, Charlottesville, Va. Most aim for the low 50s, although some institutions possess a business mix (lots of fee-generating activities, for example) that makes that difficult.

One reason the efficiency ratio gets so much attention in banking is that it correlates so closely with profitability. Indeed, a more apt moniker would be "operating leverage ratio," which measures the degree to which revenue grows vis-à-vis overhead. The stronger a bank's operating leverage, the stronger its earnings performance and (usually) its stock valuation.

The concept of operating leverage tacitly acknowledges an important truth in this business: Cost-cutting alone won't create sustained profitability. The big payoff comes when you control expenses and grow revenue at the same time. "It's amazing how many people lose sight of that," says Wachovia's Kelly.

Cuts Big and Small

During the past two years, as the national economy began to weaken, a number of banks did move to bring costs more in line with current revenue opportunities. SunTrust and State Street announced major programs in 2002's first quarter. Bank of America's second-quarter numbers were helped by a 6.9% reduction in non-interest expense, which included 8,800 job cuts, or about 6% of the company's payroll. These announcements followed earlier moves by Bank One, Mellon, and Union Planters.

Bank One, under CEO James "Jamie" Dimon, has spent the last two years pruning an organization that grew exponentially in the '90s through a string of large deals. The company declined to make Dimon or any other top executive available for an interview. But a spokesman did say the company has cut $1.5 billion in expenses over the period, including the elimination of nearly 12,000 positions, or 14% of its total employment.

The Bank One cuts run the gamut, from the very large (consolidating deposit systems and a variety of back-office processing and sales support centers) to the very small and mundane. Employees are no longer supplied with company cell phones, for example, but must use their personal phones for company business and then apply for reimbursement.

The company's efficiency ratio fell to 47.4% last year, from 65.8% in 2000. The spokesman says results would have been even more impressive had the bank experienced stronger revenue growth.

Mellon launched its efficiency program early last year, with CEO Martin G. McGuinn citing a "sudden downturn" in the "external economic environment." The bank was assisted by EHS Partners, a New York-based consulting firm that helps banks identify targeted cost savings and revenue enhancement opportunities. Over a four-month period, beginning in March 2001, Mellon employees across 85 business lines or functional activities were asked to come up with ideas for either cutting costs or generating more revenue. Out of a total of 7,500 suggestions, the company selected 2,500 for implementation, beginning in September 2001.

Most of these were rather small in terms of their individual monetary impact. Executive vice president Robert Parkinson says the average idea was worth about $100,000 in either expense reductions or revenue enhancements. "You'd like to have some easily understood, light-bulb ideas that saved $10 million, but this is really pick-and-shovel stuff," he says.

When pressed to reveal the aggregate savings or additional revenue produced by the program, Parkinson would only cite a combined annual monetary value of $300 million. Analysts confirm that Mellon has been tight-lipped about the program, which the bank describes as an effort to free up resources for deployment elsewhere in the company rather than a cost-reduction initiative per se.

Other banks that have relied on EHS to guide them through major efficiency programs within the last two years include Union Planters and KeyCorp. Union Planters declined interview requests. But according to reports published earlier this year, the company expects to gain up to $30 million a year in additional revenue while reducing its overhead by as much as $70 million a year.

KeyCorp concluded a two-year efficiency program in the first quarter of this year, and Wall Street credits the effort with keeping expenses more or less flat during that period. Executive vice president Kevin Riley, who served as chief financial officer during the program, says one of the single largest cost-saving moves was a reduction in the amount of cash the bank keeps on hand to meet customer demand, which was well in excess of Federal Reserve requirements. The move saves KeyCorp about $6 million a year, according to Riley. The bank also saves about $3 million a year by eliminating the float customers were enjoying on ATM deposits, bringing that policy in line with the one used at KeyCorp branches.

Since KeyCorp doesn't want expense management to be a one-time event, it has established an "office of continuous improvement" to keep the lid on expense growth. Each department within the company is required to submit cost-saving ideas on a regular basis, and Riley says this sort of discipline is now "built into the organization."

Steady Diet

So why don't more banks strive for continuous efficiency? A recent study by Deloitte Research found that large banks with the best efficiency ratios saw an average annual 13.6% increase in their share price from 1997 to 2000, compared with 9.6% for the world's 100 largest banks overall. Large banks that improved their efficiency ratios enjoyed an even bigger improvement in share price: 19.2%. "It wasn't the absolute value of the efficiency ratio; it was the change in the ratio," says Randi Brosterman, national financial services industry leader for Deloitte's management solutions and service practice in New York City.

The message is clear: Wall Street rewards efficiency. But institutionalizing that discipline is a formidable, long-term managerial challenge. It's typically the cumulative effect of a great many small things rather than one or two big initiatives that produces an industry-leading efficiency ratio. Highly efficient banks share several characteristics, beginning with a culture that expects employees to spend money carefully. They also have policies in place that make it difficult to do otherwise, and a senior management team — including the CEO — that pays close attention to spending patterns.

"There should be a constant process of efficiency improvement, kind of like keeping your weight down," says Joseph Stieven, director of corporate finance with Stifel Nicolaus & Co. in St. Louis. "Doctors say the best diet is never to get out of shape."

This steady-as-she-goes strategy, exemplified by institutions such as Cincinnati-based Fifth Third Bancorp and U.S. Bancorp, Minneapolis, contrasts with the crash-diet approach utilized by others. Prior-decade reengineering programs at institutions such as FleetBoston Financial Corp., the former CoreStates in Philadelphia, and Milwaukee-based Firstar gave efficiency a bad name in banking because attempts to slim down in a hurry often impaired revenue growth by demoralizing and distracting employees. Significantly, both CoreStates and Firstar were later acquired by stronger institutions.

The problem with reengineering projects, as well as merger-related downsizing, is that banks tend to go for the easy solution on cost reduction: they simply hack away at their employment rolls, their single biggest expense category. "Banks tend to do a lot of across-the-board cutting, which doesn't enhance revenue streams very much and in fact hurts them," says consultant Wendel.

Since many inefficient processes remain in place, these cost reductions are rarely permanent. So it's important to improve basic processes rather than merely fire employees and sell off or close under-performing operations.

For example, standardization of redundant processes in loan administration, credit analysis and call centers offers a "huge opportunity" to improve efficiency and lower costs, according to consultant Steven Turner, a managing vice president at First Manhattan Consulting Group in New York. "You end up with a better process that doesn't ask people to work harder." And because the process itself has been changed, "you can go back two years later and there's no back sliding," Turner says.

Neil Smith, a managing director at EHS Partners, says managers need to make sure employee morale remains high during these exercises, otherwise customer service will suffer. Cost-cutting initiatives that ignore the revenue issue tend to be the least successful, he says. This concern is echoed by Howard Atkins, chief financial officer at Wells Fargo & Co., San Francisco. "The real issue," Atkins says, "is not getting less expense for each revenue dollar — it's getting more revenue for every dollar of expense."

Wells Fargo's corporate philosophy on efficiency is notable because it has one of the industry's most highly valued stocks, even though its efficiency ratio last year (55.51%) was only a little better than average. It's not that Wells Fargo is wasteful; it just prefers to invest as much energy in growing sales as holding down costs. A case in point is southern California, where the company is adding staff and new branches to fill out its franchise. "Our philosophy is to go for revenue growth in all our markets," Atkins says.

As with most things, it comes down to balance. You can't cut your way to prosperity. It takes expense control and revenue growth working together to generate operating leverage, which is what produces earnings growth. The question is whether the industry can keep that truth in sight as it works through these challenging times.

Mr. Milligan is a freelance writer based in Charlottesville, Va.

Copyright © 2003 by Banking Strategies, published by BAI.

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