Taking Expense Control to the Next Level

Even a normalized yield curve will not relieve the relentless pressure on banks to reduce costs.

BY GORDON GOETZMANN

Banks need to go beyond typical head count reductions in their drive to cut costs. Three areas to look at: shared services functions, future investments and compliance-related activities.

The good news is that the inverted yield curve won’t last forever. The bad news is that even when the yield returns to “normal,” banks will still find profitability under pressure. The belt-tightening that now characterizes the industry will need to continue, even escalate to a new level.

The important thing to know about a flat or inverted yield curve is that it's nothing new. FMCG’s recent analyses of the regional banking universe since 1996 have shown that spreads have been on a ten-year secular decline, amidst periods of both economic growth and slowdown and varying yield curve environments. This unwavering trend implies that competition, not the yield curve, has been the driving force behind the compression in net interest spreads. While a return to a more normal yield curve could provide some temporary relief, continued competitive forces will continue to squeeze interest spreads in the future.

Banks have been able to maintain their profitability in the face of this margin compression by boosting noninterest income, drawing down loan-loss provisions and cutting expenses. But further improvements in the first two areas are problematic. Fee income - divided by total assets—has been flat to down of late and is now no higher than the levels achieved in 1998. And the credit environment, currently the most benign in decades, is almost certain to return to historical norms.

That leaves further expense control initiatives, which need to focus on allocated costs—those not under the immediate control of business units—rather than direct costs, such as headcount. While business line managers typically shy away from cutting allocated costs because they must be addressed collectively, we at FMCG estimate that the industry’s capacity to shed additional direct costs is limited.

We suggest that bankers focus on three areas. The first is shared service functions, which include information technology, operations, human resources, finance, corporate marketing and other corporate support functions that have become material cost items. In some cases, we have found that the shared services allocations in total exceed the direct costs of the staff within the business lines.

Rationalizing these costs requires discipline on the part of both the service providers and the business line consumers of these services. Shared services very often tend to "over-serve" their internal customers while the business lines often provide poor guidance regarding their actual requirements.

The second opportunity lies in culling the “nice-to-have” investment initiatives that are not central to the basic mission of the institution. We continually find that banks' lists of such initiatives, while not containing illogical ideas, are probably three to four times longer than they should practically be. Shortening the list enables the bank to reinforce the approved initiatives and free up resources from support units.

And finally, there's the opportunity to go back to reexamine efforts that were taken in the rush to comply with recent audit and compliance requirements such as Sarbanes-Oxley and the Bank Secrecy Act. The all-hands-on-deck mentality required of many banks to meet these strengthened requirements led to high levels of redundancies in control functions and infrastructure. Careful scrutiny should reveal large opportunities to eliminate such redundancies.