Description
As unlikely as it may seem for an industry that has posted a 70 percent gain in net income since 2009—and strong growth in return on equity—banks face a major dilemma as they head into 2014.
Banking Outlook
2014: An Industry
at a Pivot Point
kpmg.com/us/banking
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The Banking industry Is at a Crossroads 2
Quarterly Income 2009–2013 2
U.S. Banks’ ROE (%) 2
Flat Revenue; Steep Decline in Loan-loss Provision 3
Net Interest Margin 1984–2013 (%) 4
Contribution of ALL Reversal to Net Income 5
FDIC-Insured Institutions 2004–2013 6
Connecting with Customers 9
Information Technology (IT) Transformation 11
Improve Data Analytics 15
Industrialize Internal Processes 17
Leverage and Empower Internal Audit 19
Increase Use of the Cloud 21
Reexamine M&A Opportunities 23
Price to Tangible Book Multiples Over Time 24
Rebuild Reputation 27
Getting Going 29
Contents
About the author:
[email protected]
Brian Stephens is the national leader of
KPMG’s Banking and Capital Markets practice,
which serves commercial banks, regional
and community banks, investment banks
and securities firms, and diversified financial
companies. He has 34 years of experience in
the banking industry serving large multinational
and national banks, as well as other global
financial services institutions.
©
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2 | Banking Outlook 2014: An Industry at a Pivot Point
1
“I.M.F. Puts Bank Losses from Global Financial Crisis at $4.1 Trillion,”
by Mark Landler, The New York Times, 4/21/09
The Banking Industry is
at a Crossroads
As unlikely as it may seem for an industry that has posted a 70 percent gain in net income since 2009—and
strong growth in return on equity—banks face a major dilemma as they head into 2014. There is no question
the industry has rebounded from the abyss of 2009, when, on the heels of a crippling credit crisis, bank
failures were surging, balance sheets were bloated with bad loans, and industry return on equity (ROE)
stood at a negative 3.7 percent. Since then, banks have slashed payrolls, shed noncore businesses, and
written off trillions
1
of dollars in bad assets.
Quarterly Income 2009–2013 ($B)
-8.4
4.51
-1.55
16.34
19.77
21.75
19.6
28.97 28.42
32.65
24.07
32.65 32.89
35.56
33.48
39.02
37.43
35.53
Net Operating Income Securities and Other Gains/Losses, Net
-10
-5
0
5
10
15
20
25
30
35
40
45
-6.49
03/09 06/09 09/09 12/09 03/10 06/10 09/10 12/10 03/11 06/11 09/11 12/11 03/12 06/12 09/12 12/12 03/13 06/13 09/13
Source: Federal Deposit Insurance Corp., December, 2013.
Industry ROE has moved higher than 10 percent for the first time since 2007.
U.S. Banks’ ROE (%)
-6
-4
-2
0
2
4
6
8
10
12
14
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
12.28
12.39
12.96
11.58
1.4
-3.68
5.75
7.5
8.73
10.44
Source: Federal Deposit Insurance Corp., December, 2013.
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Banking Outlook 2014: An Industry at a Pivot Point | 3
Still, the earnings improvements of the past several years have been attributable in large part to rapidly
declining expenses for loan losses and aggressive cost cutting. Now, while problem loans continue to
decline, the impact of shrinking loan-loss reserves on the bottom line is diminishing—and, given the trend
we see now in the credit cycle, the issue could be exacerbated as lending ticks upward gradually, possibly
leading to higher credit losses. More aggressive lending, fueled by competition among banks, could tempt
some banks to lower credit standards, potentially leading to higher credit costs, and even more scrutiny
from regulators concerned about deteriorating underwriting standards.
Flat Revenue; Steep Decline in Loan-loss Provision
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
$100
Net Operating Revenue Loan Loss Provision
0
9
Q
3
0
9
Q
4
1
0
Q
1
1
0
Q
2
1
0
Q
3
1
0
Q
4
1
1
Q
1
1
1
Q
2
1
1
Q
3
1
1
Q
4
1
2
Q
1
1
2
Q
2
1
2
Q
3
1
2
Q
4
1
3
Q
1
1
3
Q
2
1
3
Q
3
162.3 163.3
62.9
5.8
Source: Federal Deposit Insurance Corp., December, 2013.
And therein lies the rub. Because for all they have been able to accomplish throughout this four-year
recovery—scrubbing and bolstering balance sheets, adapting to new regulatory regimes, cutting costs—
one thing banks have not been able to do, collectively, is grow their top line.
And so we have reached a pivot point—a crossroads at which hundreds and perhaps thousands of the
country’s banks must—in addition to their current focus on cost reductions and continued process
improvement—include in their business strategy a major focus on selling products and services.
©
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4 | Banking Outlook 2014: An Industry at a Pivot Point
This raises legitimate questions for investors and other stakeholders, who eventually may chafe at funneling
money into an industry where returns in the third quarter of 2013 amounted to 0.99 percent of assets, down
from 1.06 percent in the third quarter of 2012 and 1.36 percent in the same period in 2003.
2
High on their list
of questions is this: Can the banking industry actually succeed in building its top line at a time when many of
the macroeconomic, regulatory, and geopolitical trends that have been pressuring revenues for the past four
years are poised to extend into 2014 and beyond?
Although the forecast for the U.S. economy is for continued growth, it is for growth only slightly above
the roughly two percent rate averaged over the past three years.
3
That sluggish pace suggests the Federal
Reserve will continue to keep short-term interest rates low at least through 2014—and even beyond, putting
continued pressure on banks’ net interest margins.
Net Interest Margin 1984–2013 (%)
3.00
3.20
3.40
3.60
3.80
4.00
4.20
4.40
4.60
4.80
5.00
3.87
3.21
0
1
/
8
4
0
3
/
8
5
0
5
/
8
6
0
7
/
8
7
0
9
/
8
8
1
1
/
8
9
0
1
/
9
1
0
3
/
9
2
0
5
/
9
3
0
7
/
9
4
0
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/
9
5
1
1
/
9
6
0
5
/
9
6
0
1
/
9
8
0
3
/
9
9
0
5
/
0
0
0
7
/
0
1
0
9
/
0
2
1
1
/
0
3
0
1
/
0
5
0
3
/
0
6
0
5
/
0
7
0
7
/
0
8
0
9
/
0
9
1
1
/
1
0
0
1
/
1
2
0
3
/
1
3
Source: Federal Reserve Bank of St. Louis, used with permission.
Prospects for political reforms that might help the economy—prudent measures to reduce the nation’s long-
term debt, an overhaul of the tax code, a sensible alternative to the next round of sequestration spending cuts
in the federal budget—are constrained by the prospect ongoing for political stalemate in Washington, DC.,
auguring poorly for the sort of “grand bargain” the business community has been seeking. Though near the
end of 2013, there was some movement toward political compromise on budget considerations that could
help economic growth, serious concerns remain that the politics of the past several years could get in the way
of real economic progress that is needed in the months, and possibly years, ahead.
Meanwhile, the costs and time stresses created by the regulatory environment are not going away, and
will continue to affect four areas for banks: strategy and business models, interactions with customers and
client assets, data and reporting structures, and governance and risk capabilities. Still, banks that continue to
concentrate first on regulatory issues will be focused on solving yesterday’s problems. Those that are ahead of
the curve are already looking to the next challenges.
Encouragingly, the industry has demonstrated resiliency in dealing with past crises, and leading banks have
already begun many of the transformations necessary to compete in the current postcrisis environment.
The question this time around, when a digital economy is driving lightning-quick change and consumers
have become accustomed to new, faster, and more mobile ways of doing business, is how fast the industry
can change this time. Banks that embrace change and systematically transform themselves to meet new
customer demands will achieve a competitive advantage in the marketplace. Those that continue to ponder—
or worse yet, resist—change will suffer.
2
FDIC: “Quarterly Banking Profile, Third Quarter 2013.”
3
“Fourth Quarter 2013 Survey of Professional Forecasters,” 11/25/13 –http://www.philadelphiafed.org/research-and-data/real-time-center/
survey-of-professional-forecasters/2013/survq413.cfm
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Banking Outlook 2014: An Industry at a Pivot Point | 5
What’s at stake
It isn’t only bankers who are dependent on the long-term health of the banking industry. So too are businesses,
consumers, and politicians. A strong U.S. banking system creates jobs, links business organizations,
nurtures and promotes technology transfer, builds human capital, and underpins the creation of our country’s
infrastructure. It is a critical catalyst for generating government tax revenues. Without sound and active banks,
the creation of products and services that benefit consumers and businesses would be nearly impossible. In
short, any hope of a sustained recovery by the U.S. economy depends in no small part on banks getting their
houses in order. Do all that, and the industry will earn its just rewards. The industry will find a more vibrant
market for its products and services, boosting its revenues. An industry in order also will buttress the argument
for a less volatile and convoluted regulatory environment than the one it faces now. At the moment, the
environment of uncertainty has hamstrung the industry’s long-term planning capabilities.
Contribution of ALL Reversal to Net Income
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
45.0
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
J
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45%
16%
Total Net Income (billions) Excess ALL charge-off ass a % of NI
Source: SNL Financial; KPMG Research
To expand on the credit point we raised earlier, our analysis suggests that reversing loan loss reserves, or allowances
for loan losses (ALL), contributed to approximately 40 percent of net income in 2010 and 2011 and more recently, as ALL
balances have declined, to roughly 20 percent of net income. In estimating these amounts, we viewed charge-offs in
excess of loan loss provisions as effectively reversing the ALL provision. We believe charge-offs in excess of provisions
(with no tax effecting) represents a simple and reasonable way to estimate the contribution to banks’ net income of ALL
reversals.
In the second quarter of 2010, for instance, excess charge-offs totaled $9.3 billion, or roughly 45 percent of total net
income. A comparable level of contribution continued through the second quarter of 2011. Over those five consecutive
quarters, ALL releases averaged 41 percent of net income.
As nonperforming loans and ALL balances declined, however, the magnitude of the ALL releases declined as well. From
the third quarter of 2011 to second quarter 2012, ALL releases dropped to $6.8 billion, or approximately 21 percent of net
income. This tapering trend has continued to date, as ALL reversals from third quarter 2012 to third quarter 2013 averaged
$5.5 billion, contributing approximately 15 percent of net income.
The impact of ALL releases will continue to wane as a contributor to net income as ALL balances decline and banks’ loan
portfolios either stop contracting or begin to grow. Total ALL balances measured $263 billion in the first quarter 2010 and
totaled $143 billion at the end of the third quarter 2013, a decline of 46 percent. Also, as lending ticks gradually upward,
banks’ exposure to credit risks will increase likely causing provisions in excess of charge-offs.
The impact of this reduced ALL releases as a contributor to net can be seen in results: FDIC-insured institutions saw
their year-over-year earnings fall by $1.5 billion or 3.9 percent in the third quarter of 2013, the first quarterly downturn
since the second quarter of 2009.
4
Increasingly, banking industry earnings will now be determined not by cyclically
low loan loss provisions, but the ability to grow revenues.
4
FDIC: “Quarterly Banking Profile, Third Quarter 2013.”
©
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6 | Banking Outlook 2014: An Industry at a Pivot Point
FDIC-Insured Institutions 2004–2013
8976
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6891
5000
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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Federal Deposit Insurance Corp., Quarterly Banking Profile, December, 2013.
The pivot: Defense to offense
History is replete with companies that failed to pivot when circumstances required it, including, just in the
past decade, numerous companies that were slow to embrace digital technologies: photo film makers who
didn’t appreciate the appeal of digital photography, home video distributors that resisted streaming, music
businesses that relied on CD and vinyl record sales, and book distributors that stuck too long with bricks-
and-mortar strategies.
As banks pivot from defense to offense, they will have to move from what has essentially become survival
mode—coping with the fallout from the credit crisis and complying with new regulations—to relentlessly
focusing on change that drives top-line growth. Among other strategies, this shift will require that banks:
• Find new ways to connect with customers, leveraging information technology to better understand
what customers want and how banks can deliver it.
• Improve their abilities to effectively manage and leverage data, including their analytics and
predictive modeling capabilities.
• Industrialize their internal processes to reduce complexity, risk, and cost while enhancing customer
service.
• Step up use of cloud and other emerging technology to contain costs and accelerate the pace at
which they can effect change.
• Reexamine merger and acquisition opportunities, not only to grow their businesses and squeeze
further efficiencies from operations but also to achieve the critical mass needed to undertake the
transformative changes required of them.
• Rebuild their reputations in the aftermath of a financial crisis that many still blame on the financial services
industry, so that they can better compete for customers in an industry built on a foundation of trust.
Let’s look more closely at some of the forces we expect will shape the industry in 2014.
©
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Banking Outlook 2014: An Industry at a Pivot Point | 7
8 | Banking Outlook 2014: An Industry at a Pivot Point
©
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Banking Outlook 2014: An Industry at a Pivot Point | 9
Connecting with
Customers
In the banking industry, connecting consistently with customers will require that banks understand the
demographics of their markets, including the characteristics that define their best customers, and knowing
which products and services they are willing to pay for. It also means developing the right distribution
channels, as consumers increasingly use more than one channel.
One recent study found that consumers handle four top banking activities—bill paying, viewing balances
and transactions, viewing statements, and transferring money—more frequently on the Web than any other
channel.
5
Additionally, the exceptional value propositions of banking are becoming increasingly unclear, as
consumers also can find banking services in many more nontraditional venues now, too, including mom-
and-pop, check-cashing storefronts and major retailers.
For some banks, the drive to connect with new customers may lead to providing services they haven’t
seriously considered in the past, for customers they haven’t previously courted—including the 34 million
Americans who are unbanked or underbanked.
6
How big are the opportunities? The direct-deposit-advance,
or payday-loan, market is estimated at $23.1 billion. The peer-to-peer payments market is estimated at
$17.1 billion. Both are served today primarily by nonbank institutions.
7
True, federal regulators have cautioned
banks not to operate direct deposit advance businesses in ways that could increase their credit, compliance,
legal, and reputation risks.
8
But that doesn’t mean smart banks can’t find a way to compete responsibly in this space. Check-cashing,
bill-paying, prepaid debit cards, and international money transfers are other services America’s unbanked
and underbanked have demonstrated they are willing to pay for. Banks must demonstrate that they are
willing to provide those services without abusing the customer, or risk forfeiting that business to the other
companies stepping in to fill the void. The FDIC has actually been encouraging banks on this front, urging
them to address the unbanked and underbanked with expanded offerings of low-cost checking and savings
deposit accounts, transaction services, and small-dollar loans.
9
The challenge isn’t miniscule—costs for
servicing such clients have, in the past, often exceeded the revenues they generate—but the opportunity is
too big to ignore.
In our view, few mandates are more important to the banking industry right now than a
relentless attention to connecting with customers as a means of building new revenue
streams. Banks must begin to act less traditionally and follow the path forged by other
customer-centric organizations that allow themselves to be shaped by customer demand,
using more mobile, more two-way, more “right-now” experiences to give customers what
they want when they want it. Examples are around virtually every corner, especially in the
online marketplace, where savvy merchants know what their customers buy and when they
buy it, and use that information to pitch other goods and services that may interest them.
5
“The State of North American Digital and Multichannel Banking 2013,” by Tiffani Montez, Forrester Research Inc., 4/2/13
6
FDIC: 2011 FDIC National Survey of Unbanked and Underbanked Households –http://www.fdic.gov/householdsurvey/
7
Aite Group “The Debanked: A US $1 Billion Prepaid Debit Card Opportunity,’’ Aite Group, February, 2012
8
FDIC, Proposed Guidance on Deposit Advance Products –http://www.fdic.gov/news/news/press/2013/pr13031a.pdf
9
“Walmart vs. Big Banks: The Battle for Poor Customers,” by Halah Touryalai, Forbes, 12/14/12
©
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10 | Banking Outlook 2014: An Industry at a Pivot Point
©
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Banking Outlook 2014: An Industry at a Pivot Point | 11
Information Technology
(IT) Transformation
In our view, the next crisis could revolve around IT, given the value and volume of data that banks generate,
the attraction of that data to cyber thieves and vandals, the complexity of banks’ IT systems, and banks’ utter
reliance on those systems, some of which are highly coordinated while others are dispiritingly disjointed.
All this will put a heightened burden on IT in the years ahead, when it must play a central role in allowing
banks to pivot from defense to offense. IT must provide the information needed to determine which
services and products will actually boost ROE. It must enable efforts to connect with customers, both retail
and commercial. It will form the backbone of new products and services. It must help drive the efficiencies
that still elude many banks. And, of course, it must continue to meet regulatory demands and defend
against cyber security breaches.
None of this will happen if banks don’t approach IT the right way, and don’t move past the notion that using
technology to attract and retain customers is an IT job. It is, unquestionably, a top-of-the-house strategic
imperative, and everything about these changes in technology must be driven by the customer and the
business imperatives.
Historically, banks’ IT strategies have been driven by internal demands (what business units and executive
leadership needed to run the business) and by regulatory imperatives (what banks had to do to comply with
state, federal, and global regulations). Banks must continue responding to these needs. But as they shift
their focus to revenue generation, they also must embrace IT strategies driven by customer needs, relying
heavily on social media and other vast sources of data to find out what those needs are. Banks may want to
take their cue from retailers, who have a history of mining customer data profitably.
Banks that are able to find the right information from the oceans of data available to them, that leverage the
required hardware and software to deliver the right products and services without breaking their budgets,
and that put in place the right people and processes to construct their control environment, will realize the
most value from their IT systems.
It is a common business mistake: fixate on yesterday’s crisis at the expense of
preparing for the next. For the banking industry, the last crisis was one of capital and
liquidity. It has consumed management’s attention for four years now, and most banks
have met its challenges—if only because regulators have forced them to do so.
©
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12 | Banking Outlook 2014: An Industry at a Pivot Point
To do all those things, banks will need to rethink their approach in four distinct areas:
• Core platform transformation. The scope of regulation is straining the technology platforms
on which banks operate, and will continue to do so in the years ahead. This is being driven by
many factors, including the requirements imposed by changing regulation, such as the data
aggregation and reporting capabilities required by early 2016 under recent guidance from the
Basel Committee. More than a few banks will find that making patches to existing IT systems
will not work in trying to meet regulatory mandates, never mind the demands of a more
aggressive approach to building and supporting new revenue-generating products and services.
For them, an enterprise-wide upgrade to their core systems may be warranted. Many banks are
also likely to rethink which systems should be outsourced, cosourced, and shifted to managed-
service options.
• Risk modeling. Despite the considerable work done on risk models in the wake of the credit
crisis, banks must continue to refine them. Regulators have been uniformly skeptical of the
work done so far. In 2012, the Federal Reserve criticized some of the nation’s largest banks for
the quality of their stress-test submissions,
10
and in 2013, the chair of the Financial Stability
Board said the risk models banks use to calculate their capital needs were still showing
“worryingly large differences.”
11
While these comments were aimed at the industry’s largest
banks, and while one can legitimately argue the merits of current risk-based standards, the
need for better risk modeling is disputed by few and relevant across the banking sector. There
have been a number of notable and widely reported reminders in recent months that some
banks have work to do to master their risk controls.
This isn’t entirely a technology issue, either. During the housing bubble, for example, some
banks had a better appreciation than others for how poorly loan originations were being handled
because they sent employees into the field to check on them.
12
Banks must invest not only in
improving their risk models, but also in the abilities of their people to use them.
• Analytical tools. According to a recent Gartner Group survey, chief information officers
estimate that their organizations realize only 43 percent of technology’s business potential.
13
That speaks to an enormous opportunity to do better, but only when banks have the ability to
make sense of the data their IT systems are generating. Some are turning to technology here,
too. In a recent interview with American Banker, for example, analytics software executive Jim
Goodnight observed that leading banks are taking advantage of high-performance computing
systems to engage in high-performance analytics, running, for example, as many 100,000
market-risk simulations in a matter of 15 to 20 minutes rather than the 15 to 16 hours it might
have taken in the past. On the retail side of the business, the emphasis in analytics must be
on using customer intelligence to drive revenues. This also requires a change in mind-set, with
efforts focusing on discovering relationships and correlations in large amounts of data rather
than determining their causes—moving from the “how” and “why” to the “what”.
10
“Fed Said to Criticize Banks on Risk Models in Stress Test,” by
Craig Torres, Dakin Campbell and Dawn Kopecki, Bloomberg, 5/1/12 –http://www.bloomberg.com/news/2012-05-01/fed-said-to-criticize-banks-
on-risk-models-in-stress-test.html
11
“Carney Calls for Bank Risk-Model Clampdown to Repair Trust,” by
Jim Brundsden, Bloomberg, 9/6/13 –http://www.bloomberg.com/
news/2013-09-05/fsb-s-carney-calls-for-bank-risk-model-clampdown-to-
repair-trust.html
12
“The Trouble with Banks’ Risk Models: Q&A with the Chief of SAS,” by
Penny Crosman, American Banker, 3/28/13
13
“Hunting and Harvesting in a Digital World: The 2013 CIO Agenda,”
Gartner Group –http://www.gartner.com/technology/cio/cioagenda.jsp
14
“Three Top Cybersecurity Risks for Banks,” by Victoria Finkle, American
Banker, 9/23/13 –http://www.americanbanker.com/issues/178_184/
three-top-cybersecurity-risks-for-banks-1062339-1.html
15
“Three Top Cybersecurity Risks for Banks,” by Victoria Finkle, American
Banker, 9/23/13 –http://www.americanbanker.com/issues/178_184/
three-top-cybersecurity-risks-for-banks-1062339-1.html
©
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Banking Outlook 2014: An Industry at a Pivot Point | 13
• Cyber security. Owing to the high value of their data, banks will always be a high-value target
for cyber criminals. Technological advances continue to push the cost of cyber attacks down,
which means banks must increase the resources they allocate to defending against them.
Adrienne Haden, an assistant director of banking supervision and regulation for the Federal
Reserve Board, notes that the cyber threat landscape has expanded to include not just fraud
but espionage, disruption of operations, and destruction of information.
14
Cyber security will
become an even broader responsibility in the years ahead as banks, eager to expand their
offerings and boost efficiency, partner with third-party vendors and service providers whose
networks are connected in turn to other banks, subcontractors, and third parties—all boosting
the risk that an attack on one could morph into an attack on many. New technologies in mobile
and cloud computing also are upping the ante. Banks will need to respond to these spreading
threats on multiple fronts, building sound and secure IT infrastructures, to be sure, but also
vetting and monitoring vendors and other service providers for their own compliance with
security protocols. Human resources will need to be involved, too, performing background
checks on new hires and providing employees with ongoing training in the safeguarding of
digital information.
15
Failure to maintain a robust cyber security profile could cripple efforts to
connect with customers and grow revenues.
©
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14 | Banking Outlook 2014: An Industry at a Pivot Point
©
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Banking Outlook 2014: An Industry at a Pivot Point | 15
Improve Data Analytics
Partly this is a problem of history; banks are accustomed to viewing data as a cost center; something to
be saved, but seldom used. Partly it is a problem of priorities; especially over the past several years, much
of the analysis banks have engaged in has been targeted at meeting risk-management imperatives. But it
is partly a problem of capabilities also. With so much customer information available—in the bank’s own
records (credit and debit card data, demand deposit data, loan data), in credit reports, from social media,
and from an array of resources that seem to be growing exponentially—banks have simply struggled with
where to begin. As one of our colleagues recently wrote, faced with big data, banks need big knowledge
and big perspective. They need the clarity that comes from an organizational capability to leverage data
in many forms, from many places, through many methods and for a variety of purposes.
16
Yet in one of
KPMG LLP’s (KPMG) recent surveys,
17
only a third of respondents said their banks had a high degree of data
and analytic literacy. Not surprisingly, they also said they need to get better if they want to make progress on
growing revenues.
Indeed. But front-line analysts won’t be able to pull this off on their own. For banks to make real progress
in data analytics, executive leadership will have to make it a priority, champion its benefits, and, most
importantly, allocate the necessary resources. To drive best results, executive leaders should make sure
their teams hew to these principles:
• Focus on business outcomes and critical goals, and then determine the information needed to achieve
them.
• Locate, access, and improve data quality so that it can be trusted and useful.
• Develop systems and capabilities that aggregate data across business lines to create a single view of the
customer.
18
• Overcome internal obstacles by managing, measuring, and compensating employees, at least in part, on
how well they use data to make decisions and drive business outcomes.
Banks that develop an infrastructure allowing them to analyze data quickly, that staff up to do that work, and
that make revenue-oriented analytics part of their culture, are the banks most likely to grow their top lines.
An ocean of water, but not a drop to drink. That image of a lost-at-sea sailor is an extreme,
but not wholly unfair, analogy for banks, which have oceans of data about their customers
but shockingly few insights into what to do with it. Of course, banks use data to manage
risk, but as they pivot from risk-mitigating defense to revenue-generating offense, banks
must make better use of data to understand their customers and provide to them the
products and services they want via the channels they want to use. Yes, most banks
already use customer data from time to time to decide which products to market to which
buyers—products like checking accounts, investment products, credit cards, mortgage
refinancings, and home equity loans. But far too infrequently are they using customer
data to create truly new products or services that leverage the information banks have on
file about their customers, either individually or collectively.
16
“Big Data + Big Analytics = Big Opportunity,” by Jeanne E. Johnson, KPMG, in Financial Executive magazine, July/Aug 2012.
17
KPMG 2013 Banking Outlook Survey
18
“The Trouble with Banks’ Risk Models: Q&A with the Chief of SAS,” by Penny Crossman, American Banker magazine, 3/28/13 ©
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16 | Banking Outlook 2014: An Industry at a Pivot Point
©
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Banking Outlook 2014: An Industry at a Pivot Point | 17
Industrialize Internal
Processes
Organizations that are able to industrialize their processes are typically less rigid and more flexible than
their competitors, and so are better able to develop and market differentiated products appealing to a wider
range of customers. They can more easily scale up, or down, in response to market trends and client needs.
Among several of the examples outside the banking industry, a major automobile manufacturer embarked
on this path more than a decade ago when it announced in 2002 what it called a “revitalization” effort
aimed at standardizing and simplifying its technologies. The multiyear undertaking included upgrades to
Ford’s systems and processes, which reduced the company’s dependence on vertically aligned operations
and moved it toward a more flexible operating model that could focus on a differentiated product portfolio.
That initiative has been credited, along with the company’s well-documented, balance-sheet overhaul, with
helping Ford weather the last financial crisis better than most of its peers.
Industrializing processes isn’t easy; however, process change is every bit as challenging as installing a new
IT system. Banks must first identify best-practice processes and adapt them to their own circumstances,
then overcome employees’ natural resistance to change. Success depends to a large degree on instilling
a culture of change, one that is demonstrably supported by the executive team, from middle management
straight through to the C-suite.
Fortunately, the payoffs can be large and wide-ranging, including reduced costs, improved customer service,
and faster transaction processing. And with less time required for transactional activities, bank personnel
can spend more time on the high-value work that drives revenue growth.
Business strategies in the banking industry are of necessity multifaceted affairs
right now: continue to meet ever-growing regulatory demands, continue to cut and
contain costs, continue to manage through a low interest-rate environment, and
with the other hand, so to speak, boost revenues by developing new products,
services and delivery channels, and by connecting more deeply with new and
existing customers. Technology can help shoulder the load, but unless banks
“industrialize” their processes—simplify, standardize and consolidate—to reduce
complexity, lesser errors, and break down the walls that separate one part of the
bank from another—they’ll have a hard time executing on these strategies.
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18 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 19
Leverage and Empower
Internal Audit
One of the keys to understanding how banks can deliver the products and services customers want is to
understand the associated risks. This is where internal audit excels. We are not suggesting that internal audit
supplant the business and product development initiatives banks already support. What we are suggesting
is that executive leadership makes sure there is some mechanism in place by which internal audit can
periodically share with business leaders any findings and insights they might have developed in the course
of their duties—insights that could help the bank improve what it is doing for its customers today, and
perhaps develop new products or services for tomorrow. As part of that process, internal audit can provide
reviews of operational and financial performance, make recommendations for more effective and efficient
use of resources, and assess progress toward corporate goals.
Importantly, internal audit can bring special qualities to this endeavor that no other function in the
organization can offer. Steeped in a tradition of independence, it can present findings that have not been
watered down or filtered by others.
Other than the CFO’s office, few parts of the organization have a broader or deeper
view of a bank’s operations and financial resources than internal audit. To limit
that function to its historical role of helping the board discharge its governance
responsibilities is to forego potentially lucrative insights into not only how the bank is
operating but also how it might operate better and more profitably.
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20 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 21
Increase Use of
the Cloud
Many banks remain attached to their legacy IT environments and still harbor basic concerns about cloud
security, trust, safety, and privacy. But efficient organizations are becoming increasingly confident in their
use of cloud technology, both to avoid the high cost of hardware that is often underutilized over time, and
to speed time-to-market for new products and services. They recognize that cloud vendors who were once
relatively secretive about their operations have become much more open about the types of controls they
maintain and the reports they can provide, making it easier for banks to become comfortable with the
technology. And they see that cloud vendors employ vastly more people dedicated to data security than
they do, suggesting that data in the cloud could actually be more, not less, secure than data held internally.
TheInfoPro, a service of 451 Research, projects that the worldwide cloud computing market will grow at a
36 percent compound annual growth rate through 2016, to a total market size of $19.5 billion.
19
While cloud computing is becoming more common and trusted, banks must still approach the cloud
carefully. Among the issues they must consider:
• Data strategy and internal controls. Banks taking advantage of cloud computing must develop a robust
data strategy that allows them to evaluate cloud service providers empirically. Understanding how much
internal control the bank has over its data will help it make intelligent, business-driven decisions about
which data and business functions can shift to the cloud.
• Data sovereignty. Users of cloud computing may not always know where their data is being housed,
or under whose jurisdiction it may fall. There are no global standards governing data sovereignty or
residency, and many countries in the EU and Southeast Asia have rules not only around the privacy of that
data but also around how that data can or cannot be moved from country to country. Banks must work
with cloud service providers to make sure sovereignty issues and risks are addressed in their service
contracts.
As banks look to build new revenue sources via new product, service and channel
offerings, they will incur costs for new hardware and software—and will almost
certainly need to boost staff. An obvious option for mitigating hardware and software
costs is to take advantage of cloud computing.
19
“Predicting Enterprise Cloud Computing Growth,” by Louis Columbus, Forbes, 9/4/13 –http://www.forbes.com/sites/
louiscolumbus/2013/09/04/predicting-enterprise-cloud-computing-growth/
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22 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 23
Reexamine M&A
Opportunities
Number of Bank Deals and Deal Values Since 2003
0
2
4
6
8
10
12
14
16
Q1’11 Q2’11 Q3’11 Q4’11 Q1’12
Total deal Value ($B) Number of Deals
Q2’12 Q3’12 Q4’12 Q1’13 Q2’13 Q3’13 Q4’13
2.35
13.71
0.22
0.60
3.22
2.01
6.35
1.39
1.75
3.33
6.64
0.78
0
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20
30
40
50
60
70
80
35
15
Source SNL Financial, excludes FDIC–assisted transactions. Used with permission
Still, mergers, joint ventures, and strategic acquisitions remain a powerful tool for growth and are likely to
increase in 2014. Why? All the old reasons still exist, including the burdensome cost of regulatory reform
on smaller institutions and the dearth of organic growth opportunities. But now, finally, the gap between
what sellers think their institutions should command in the marketplace and what buyers are actually willing
to pay appears to be shrinking, and moving into closer alignment with reality. While some sellers continue to
hold out for prices in the range of two to 2.5 times book value,
20
some recent unassisted transactions were
completed at closer to 1.5 times book value.
21
The mergers and acquisitions “wave” that was widely expected to rush through the
banking industry over the past several years amounted to something more like a ripple.
There were 162 bank mergers in the United States through the first nine months of
2013, up from 111 in the first three quarters of 2011.
20
“Banks Must Lower Expectations to Jump-Start M&A,” by Neil Hartman and Ken Siegman, American Banker, 6/27/13 –http://www.americanbanker.com/bankt...ctations-to-jump-start-m-and-a-1060209-1.html
21
“Banks Must Lower Expectations to Jump-Start M&A,” by Neil Hartman and Ken Siegman, American Banker, 6/27/13 –http://www.americanbanker.com/bankt...ctations-to-jump-start-m-and-a-1060209-1.html
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24 | Banking Outlook 2014: An Industry at a Pivot Point
Price to Tangible Book Multiples Over Time
0.0x
0.5x
1.0x
1.5x
2.0x
2000 2008 2007 2006 2005 2004 2003 2002 2001 2009 2010 2011 2012 LTM
2013
Money Center Banks
Regional Banks Small Banks
2.5x
3.0x
3.5x
4.0x
Source SNL Financial. Used with permission
“
Generally P/B multiples still well below
precrisis levels (1.0x – 1.5x today vs. 2.0x –
3.0x precrises)
”
Banks looking to pivot their focus to growth cannot ignore the
opportunities presented in the M&A market—opportunities that
can not only expand their market share and geographic footprint,
but also, thanks to cost-saving synergies, free more resources for
finding new sources of revenue. Rigorous due diligence remains
important, of course. Among other things, banks will want to
make sure they understand any regulatory issues that could
stall or block a transaction. They also will want to ascertain the
extent of any toxic assets buried on balance sheets, the level of
sophistication (or lack thereof) of a target’s IT systems, and the
extent of any accounting issues that might create a problem for the acquirer. And they will want to look for
any cultural-fit issues between themselves and their proposed partners.
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Banking Outlook 2014: An Industry at a Pivot Point | 25
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26 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 27
Rebuild Reputation
So this, too, is another reason banks need to move in a new direction, to rethink their culture and the way
they reach out to current and prospective customers, and to bear down even harder on risk controls so they
can avoid the sort of headline developments that have drawn the public’s attention and ire over the past
several years.
Doing that will require understanding how those headline events happened in the first place, and putting
in place processes and procedures to prevent them from happening again. It will require communicating
the bank’s strategy for treating customers and clients fairly and respectfully, and then communicating that
message again—and again and again—via traditional and social media. It also may require spending more on
developing value-added products and services that delight clients and make them want to reward their bank
with repeat business.
Looking at matters from a glass-half-full perspective, when it comes to reputation,
the financial services industry has quite a bit of upside potential. According to the
2013 Edelman Global Trust Barometer, banks and financial institutions are still the
least trusted players in the global economy.
22
That presents a challenge to banks that
want to grow their revenues by connecting with customers, given that their business
depends at its very foundation on the customer’s trust—trust that they will get their
money back, trust that they will not be swindled or overcharged, trust that their
financial institutions will not be hobbled by fraud or poorly managed risks. It’s also a
challenge given that this reputational shortfall comes at a time when there are so many
potential nonbank competitors looming on the horizon, from small and large retailers to
tech companies, crowd sourcing vendors and social media sites, and when technology
is making it ever easier for customers to switch providers.
22
http://www.edelman.com/insights/intellectual-property/trust-2013/about-trust/ andhttp://www.edelman.com/trust-down-
loads/press-release/
©
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28 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 29
Getting Going
The U.S. banking industry can no longer cut its way to profit growth. After half a decade focused on
managing risk, cutting costs, and meeting regulatory requirements, the industry must pivot to a strategy
centered on growing revenues. With its reputation badly damaged by the last financial crisis, it will require a
new and unrelenting focus on connecting with customers and regaining their trust. It will require developing
new products and services that appeal to customers, and are available via the channels they want to use.
Ambitious banks will find ways to cater not only to their core customer base, but to the tens of millions of
unbanked and underbanked who are rapidly being co-opted by alternative providers of banking services.
In all cases, it will require that banks rethink their systems and processes to be more agile and to make
their analytical capabilities more insightful. Some institutions may find that the only way to meet these
imperatives will be through mergers, acquisitions, or joint ventures. No matter the course, the way forward
will not be easy, requiring nothing less, for many banks, than a wholesale cultural change. Yet, the alternative
will be even less palatable—a gradual slide into irrelevance, an opportunity missed. The time to begin the
transformation is now.
©
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The information contained herein is of general nature and is not intended to address the circumstances of any particular individual or
entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as
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As unlikely as it may seem for an industry that has posted a 70 percent gain in net income since 2009—and strong growth in return on equity—banks face a major dilemma as they head into 2014.
Banking Outlook
2014: An Industry
at a Pivot Point
kpmg.com/us/banking
©
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2
The Banking industry Is at a Crossroads 2
Quarterly Income 2009–2013 2
U.S. Banks’ ROE (%) 2
Flat Revenue; Steep Decline in Loan-loss Provision 3
Net Interest Margin 1984–2013 (%) 4
Contribution of ALL Reversal to Net Income 5
FDIC-Insured Institutions 2004–2013 6
Connecting with Customers 9
Information Technology (IT) Transformation 11
Improve Data Analytics 15
Industrialize Internal Processes 17
Leverage and Empower Internal Audit 19
Increase Use of the Cloud 21
Reexamine M&A Opportunities 23
Price to Tangible Book Multiples Over Time 24
Rebuild Reputation 27
Getting Going 29
Contents
About the author:
[email protected]
Brian Stephens is the national leader of
KPMG’s Banking and Capital Markets practice,
which serves commercial banks, regional
and community banks, investment banks
and securities firms, and diversified financial
companies. He has 34 years of experience in
the banking industry serving large multinational
and national banks, as well as other global
financial services institutions.
©
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2 | Banking Outlook 2014: An Industry at a Pivot Point
1
“I.M.F. Puts Bank Losses from Global Financial Crisis at $4.1 Trillion,”
by Mark Landler, The New York Times, 4/21/09
The Banking Industry is
at a Crossroads
As unlikely as it may seem for an industry that has posted a 70 percent gain in net income since 2009—and
strong growth in return on equity—banks face a major dilemma as they head into 2014. There is no question
the industry has rebounded from the abyss of 2009, when, on the heels of a crippling credit crisis, bank
failures were surging, balance sheets were bloated with bad loans, and industry return on equity (ROE)
stood at a negative 3.7 percent. Since then, banks have slashed payrolls, shed noncore businesses, and
written off trillions
1
of dollars in bad assets.
Quarterly Income 2009–2013 ($B)
-8.4
4.51
-1.55
16.34
19.77
21.75
19.6
28.97 28.42
32.65
24.07
32.65 32.89
35.56
33.48
39.02
37.43
35.53
Net Operating Income Securities and Other Gains/Losses, Net
-10
-5
0
5
10
15
20
25
30
35
40
45
-6.49
03/09 06/09 09/09 12/09 03/10 06/10 09/10 12/10 03/11 06/11 09/11 12/11 03/12 06/12 09/12 12/12 03/13 06/13 09/13
Source: Federal Deposit Insurance Corp., December, 2013.
Industry ROE has moved higher than 10 percent for the first time since 2007.
U.S. Banks’ ROE (%)
-6
-4
-2
0
2
4
6
8
10
12
14
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
12.28
12.39
12.96
11.58
1.4
-3.68
5.75
7.5
8.73
10.44
Source: Federal Deposit Insurance Corp., December, 2013.
©
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Banking Outlook 2014: An Industry at a Pivot Point | 3
Still, the earnings improvements of the past several years have been attributable in large part to rapidly
declining expenses for loan losses and aggressive cost cutting. Now, while problem loans continue to
decline, the impact of shrinking loan-loss reserves on the bottom line is diminishing—and, given the trend
we see now in the credit cycle, the issue could be exacerbated as lending ticks upward gradually, possibly
leading to higher credit losses. More aggressive lending, fueled by competition among banks, could tempt
some banks to lower credit standards, potentially leading to higher credit costs, and even more scrutiny
from regulators concerned about deteriorating underwriting standards.
Flat Revenue; Steep Decline in Loan-loss Provision
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
$100
Net Operating Revenue Loan Loss Provision
0
9
Q
3
0
9
Q
4
1
0
Q
1
1
0
Q
2
1
0
Q
3
1
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162.3 163.3
62.9
5.8
Source: Federal Deposit Insurance Corp., December, 2013.
And therein lies the rub. Because for all they have been able to accomplish throughout this four-year
recovery—scrubbing and bolstering balance sheets, adapting to new regulatory regimes, cutting costs—
one thing banks have not been able to do, collectively, is grow their top line.
And so we have reached a pivot point—a crossroads at which hundreds and perhaps thousands of the
country’s banks must—in addition to their current focus on cost reductions and continued process
improvement—include in their business strategy a major focus on selling products and services.
©
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4 | Banking Outlook 2014: An Industry at a Pivot Point
This raises legitimate questions for investors and other stakeholders, who eventually may chafe at funneling
money into an industry where returns in the third quarter of 2013 amounted to 0.99 percent of assets, down
from 1.06 percent in the third quarter of 2012 and 1.36 percent in the same period in 2003.
2
High on their list
of questions is this: Can the banking industry actually succeed in building its top line at a time when many of
the macroeconomic, regulatory, and geopolitical trends that have been pressuring revenues for the past four
years are poised to extend into 2014 and beyond?
Although the forecast for the U.S. economy is for continued growth, it is for growth only slightly above
the roughly two percent rate averaged over the past three years.
3
That sluggish pace suggests the Federal
Reserve will continue to keep short-term interest rates low at least through 2014—and even beyond, putting
continued pressure on banks’ net interest margins.
Net Interest Margin 1984–2013 (%)
3.00
3.20
3.40
3.60
3.80
4.00
4.20
4.40
4.60
4.80
5.00
3.87
3.21
0
1
/
8
4
0
3
/
8
5
0
5
/
8
6
0
7
/
8
7
0
9
/
8
8
1
1
/
8
9
0
1
/
9
1
0
3
/
9
2
0
5
/
9
3
0
7
/
9
4
0
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/
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5
1
1
/
9
6
0
5
/
9
6
0
1
/
9
8
0
3
/
9
9
0
5
/
0
0
0
7
/
0
1
0
9
/
0
2
1
1
/
0
3
0
1
/
0
5
0
3
/
0
6
0
5
/
0
7
0
7
/
0
8
0
9
/
0
9
1
1
/
1
0
0
1
/
1
2
0
3
/
1
3
Source: Federal Reserve Bank of St. Louis, used with permission.
Prospects for political reforms that might help the economy—prudent measures to reduce the nation’s long-
term debt, an overhaul of the tax code, a sensible alternative to the next round of sequestration spending cuts
in the federal budget—are constrained by the prospect ongoing for political stalemate in Washington, DC.,
auguring poorly for the sort of “grand bargain” the business community has been seeking. Though near the
end of 2013, there was some movement toward political compromise on budget considerations that could
help economic growth, serious concerns remain that the politics of the past several years could get in the way
of real economic progress that is needed in the months, and possibly years, ahead.
Meanwhile, the costs and time stresses created by the regulatory environment are not going away, and
will continue to affect four areas for banks: strategy and business models, interactions with customers and
client assets, data and reporting structures, and governance and risk capabilities. Still, banks that continue to
concentrate first on regulatory issues will be focused on solving yesterday’s problems. Those that are ahead of
the curve are already looking to the next challenges.
Encouragingly, the industry has demonstrated resiliency in dealing with past crises, and leading banks have
already begun many of the transformations necessary to compete in the current postcrisis environment.
The question this time around, when a digital economy is driving lightning-quick change and consumers
have become accustomed to new, faster, and more mobile ways of doing business, is how fast the industry
can change this time. Banks that embrace change and systematically transform themselves to meet new
customer demands will achieve a competitive advantage in the marketplace. Those that continue to ponder—
or worse yet, resist—change will suffer.
2
FDIC: “Quarterly Banking Profile, Third Quarter 2013.”
3
“Fourth Quarter 2013 Survey of Professional Forecasters,” 11/25/13 –http://www.philadelphiafed.org/research-and-data/real-time-center/
survey-of-professional-forecasters/2013/survq413.cfm
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Banking Outlook 2014: An Industry at a Pivot Point | 5
What’s at stake
It isn’t only bankers who are dependent on the long-term health of the banking industry. So too are businesses,
consumers, and politicians. A strong U.S. banking system creates jobs, links business organizations,
nurtures and promotes technology transfer, builds human capital, and underpins the creation of our country’s
infrastructure. It is a critical catalyst for generating government tax revenues. Without sound and active banks,
the creation of products and services that benefit consumers and businesses would be nearly impossible. In
short, any hope of a sustained recovery by the U.S. economy depends in no small part on banks getting their
houses in order. Do all that, and the industry will earn its just rewards. The industry will find a more vibrant
market for its products and services, boosting its revenues. An industry in order also will buttress the argument
for a less volatile and convoluted regulatory environment than the one it faces now. At the moment, the
environment of uncertainty has hamstrung the industry’s long-term planning capabilities.
Contribution of ALL Reversal to Net Income
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
45.0
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
J
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Total Net Income (billions) Excess ALL charge-off ass a % of NI
Source: SNL Financial; KPMG Research
To expand on the credit point we raised earlier, our analysis suggests that reversing loan loss reserves, or allowances
for loan losses (ALL), contributed to approximately 40 percent of net income in 2010 and 2011 and more recently, as ALL
balances have declined, to roughly 20 percent of net income. In estimating these amounts, we viewed charge-offs in
excess of loan loss provisions as effectively reversing the ALL provision. We believe charge-offs in excess of provisions
(with no tax effecting) represents a simple and reasonable way to estimate the contribution to banks’ net income of ALL
reversals.
In the second quarter of 2010, for instance, excess charge-offs totaled $9.3 billion, or roughly 45 percent of total net
income. A comparable level of contribution continued through the second quarter of 2011. Over those five consecutive
quarters, ALL releases averaged 41 percent of net income.
As nonperforming loans and ALL balances declined, however, the magnitude of the ALL releases declined as well. From
the third quarter of 2011 to second quarter 2012, ALL releases dropped to $6.8 billion, or approximately 21 percent of net
income. This tapering trend has continued to date, as ALL reversals from third quarter 2012 to third quarter 2013 averaged
$5.5 billion, contributing approximately 15 percent of net income.
The impact of ALL releases will continue to wane as a contributor to net income as ALL balances decline and banks’ loan
portfolios either stop contracting or begin to grow. Total ALL balances measured $263 billion in the first quarter 2010 and
totaled $143 billion at the end of the third quarter 2013, a decline of 46 percent. Also, as lending ticks gradually upward,
banks’ exposure to credit risks will increase likely causing provisions in excess of charge-offs.
The impact of this reduced ALL releases as a contributor to net can be seen in results: FDIC-insured institutions saw
their year-over-year earnings fall by $1.5 billion or 3.9 percent in the third quarter of 2013, the first quarterly downturn
since the second quarter of 2009.
4
Increasingly, banking industry earnings will now be determined not by cyclically
low loan loss provisions, but the ability to grow revenues.
4
FDIC: “Quarterly Banking Profile, Third Quarter 2013.”
©
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6 | Banking Outlook 2014: An Industry at a Pivot Point
FDIC-Insured Institutions 2004–2013
8976
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7357
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6891
5000
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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Federal Deposit Insurance Corp., Quarterly Banking Profile, December, 2013.
The pivot: Defense to offense
History is replete with companies that failed to pivot when circumstances required it, including, just in the
past decade, numerous companies that were slow to embrace digital technologies: photo film makers who
didn’t appreciate the appeal of digital photography, home video distributors that resisted streaming, music
businesses that relied on CD and vinyl record sales, and book distributors that stuck too long with bricks-
and-mortar strategies.
As banks pivot from defense to offense, they will have to move from what has essentially become survival
mode—coping with the fallout from the credit crisis and complying with new regulations—to relentlessly
focusing on change that drives top-line growth. Among other strategies, this shift will require that banks:
• Find new ways to connect with customers, leveraging information technology to better understand
what customers want and how banks can deliver it.
• Improve their abilities to effectively manage and leverage data, including their analytics and
predictive modeling capabilities.
• Industrialize their internal processes to reduce complexity, risk, and cost while enhancing customer
service.
• Step up use of cloud and other emerging technology to contain costs and accelerate the pace at
which they can effect change.
• Reexamine merger and acquisition opportunities, not only to grow their businesses and squeeze
further efficiencies from operations but also to achieve the critical mass needed to undertake the
transformative changes required of them.
• Rebuild their reputations in the aftermath of a financial crisis that many still blame on the financial services
industry, so that they can better compete for customers in an industry built on a foundation of trust.
Let’s look more closely at some of the forces we expect will shape the industry in 2014.
©
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Banking Outlook 2014: An Industry at a Pivot Point | 7
8 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 9
Connecting with
Customers
In the banking industry, connecting consistently with customers will require that banks understand the
demographics of their markets, including the characteristics that define their best customers, and knowing
which products and services they are willing to pay for. It also means developing the right distribution
channels, as consumers increasingly use more than one channel.
One recent study found that consumers handle four top banking activities—bill paying, viewing balances
and transactions, viewing statements, and transferring money—more frequently on the Web than any other
channel.
5
Additionally, the exceptional value propositions of banking are becoming increasingly unclear, as
consumers also can find banking services in many more nontraditional venues now, too, including mom-
and-pop, check-cashing storefronts and major retailers.
For some banks, the drive to connect with new customers may lead to providing services they haven’t
seriously considered in the past, for customers they haven’t previously courted—including the 34 million
Americans who are unbanked or underbanked.
6
How big are the opportunities? The direct-deposit-advance,
or payday-loan, market is estimated at $23.1 billion. The peer-to-peer payments market is estimated at
$17.1 billion. Both are served today primarily by nonbank institutions.
7
True, federal regulators have cautioned
banks not to operate direct deposit advance businesses in ways that could increase their credit, compliance,
legal, and reputation risks.
8
But that doesn’t mean smart banks can’t find a way to compete responsibly in this space. Check-cashing,
bill-paying, prepaid debit cards, and international money transfers are other services America’s unbanked
and underbanked have demonstrated they are willing to pay for. Banks must demonstrate that they are
willing to provide those services without abusing the customer, or risk forfeiting that business to the other
companies stepping in to fill the void. The FDIC has actually been encouraging banks on this front, urging
them to address the unbanked and underbanked with expanded offerings of low-cost checking and savings
deposit accounts, transaction services, and small-dollar loans.
9
The challenge isn’t miniscule—costs for
servicing such clients have, in the past, often exceeded the revenues they generate—but the opportunity is
too big to ignore.
In our view, few mandates are more important to the banking industry right now than a
relentless attention to connecting with customers as a means of building new revenue
streams. Banks must begin to act less traditionally and follow the path forged by other
customer-centric organizations that allow themselves to be shaped by customer demand,
using more mobile, more two-way, more “right-now” experiences to give customers what
they want when they want it. Examples are around virtually every corner, especially in the
online marketplace, where savvy merchants know what their customers buy and when they
buy it, and use that information to pitch other goods and services that may interest them.
5
“The State of North American Digital and Multichannel Banking 2013,” by Tiffani Montez, Forrester Research Inc., 4/2/13
6
FDIC: 2011 FDIC National Survey of Unbanked and Underbanked Households –http://www.fdic.gov/householdsurvey/
7
Aite Group “The Debanked: A US $1 Billion Prepaid Debit Card Opportunity,’’ Aite Group, February, 2012
8
FDIC, Proposed Guidance on Deposit Advance Products –http://www.fdic.gov/news/news/press/2013/pr13031a.pdf
9
“Walmart vs. Big Banks: The Battle for Poor Customers,” by Halah Touryalai, Forbes, 12/14/12
©
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10 | Banking Outlook 2014: An Industry at a Pivot Point
©
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Banking Outlook 2014: An Industry at a Pivot Point | 11
Information Technology
(IT) Transformation
In our view, the next crisis could revolve around IT, given the value and volume of data that banks generate,
the attraction of that data to cyber thieves and vandals, the complexity of banks’ IT systems, and banks’ utter
reliance on those systems, some of which are highly coordinated while others are dispiritingly disjointed.
All this will put a heightened burden on IT in the years ahead, when it must play a central role in allowing
banks to pivot from defense to offense. IT must provide the information needed to determine which
services and products will actually boost ROE. It must enable efforts to connect with customers, both retail
and commercial. It will form the backbone of new products and services. It must help drive the efficiencies
that still elude many banks. And, of course, it must continue to meet regulatory demands and defend
against cyber security breaches.
None of this will happen if banks don’t approach IT the right way, and don’t move past the notion that using
technology to attract and retain customers is an IT job. It is, unquestionably, a top-of-the-house strategic
imperative, and everything about these changes in technology must be driven by the customer and the
business imperatives.
Historically, banks’ IT strategies have been driven by internal demands (what business units and executive
leadership needed to run the business) and by regulatory imperatives (what banks had to do to comply with
state, federal, and global regulations). Banks must continue responding to these needs. But as they shift
their focus to revenue generation, they also must embrace IT strategies driven by customer needs, relying
heavily on social media and other vast sources of data to find out what those needs are. Banks may want to
take their cue from retailers, who have a history of mining customer data profitably.
Banks that are able to find the right information from the oceans of data available to them, that leverage the
required hardware and software to deliver the right products and services without breaking their budgets,
and that put in place the right people and processes to construct their control environment, will realize the
most value from their IT systems.
It is a common business mistake: fixate on yesterday’s crisis at the expense of
preparing for the next. For the banking industry, the last crisis was one of capital and
liquidity. It has consumed management’s attention for four years now, and most banks
have met its challenges—if only because regulators have forced them to do so.
©
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12 | Banking Outlook 2014: An Industry at a Pivot Point
To do all those things, banks will need to rethink their approach in four distinct areas:
• Core platform transformation. The scope of regulation is straining the technology platforms
on which banks operate, and will continue to do so in the years ahead. This is being driven by
many factors, including the requirements imposed by changing regulation, such as the data
aggregation and reporting capabilities required by early 2016 under recent guidance from the
Basel Committee. More than a few banks will find that making patches to existing IT systems
will not work in trying to meet regulatory mandates, never mind the demands of a more
aggressive approach to building and supporting new revenue-generating products and services.
For them, an enterprise-wide upgrade to their core systems may be warranted. Many banks are
also likely to rethink which systems should be outsourced, cosourced, and shifted to managed-
service options.
• Risk modeling. Despite the considerable work done on risk models in the wake of the credit
crisis, banks must continue to refine them. Regulators have been uniformly skeptical of the
work done so far. In 2012, the Federal Reserve criticized some of the nation’s largest banks for
the quality of their stress-test submissions,
10
and in 2013, the chair of the Financial Stability
Board said the risk models banks use to calculate their capital needs were still showing
“worryingly large differences.”
11
While these comments were aimed at the industry’s largest
banks, and while one can legitimately argue the merits of current risk-based standards, the
need for better risk modeling is disputed by few and relevant across the banking sector. There
have been a number of notable and widely reported reminders in recent months that some
banks have work to do to master their risk controls.
This isn’t entirely a technology issue, either. During the housing bubble, for example, some
banks had a better appreciation than others for how poorly loan originations were being handled
because they sent employees into the field to check on them.
12
Banks must invest not only in
improving their risk models, but also in the abilities of their people to use them.
• Analytical tools. According to a recent Gartner Group survey, chief information officers
estimate that their organizations realize only 43 percent of technology’s business potential.
13
That speaks to an enormous opportunity to do better, but only when banks have the ability to
make sense of the data their IT systems are generating. Some are turning to technology here,
too. In a recent interview with American Banker, for example, analytics software executive Jim
Goodnight observed that leading banks are taking advantage of high-performance computing
systems to engage in high-performance analytics, running, for example, as many 100,000
market-risk simulations in a matter of 15 to 20 minutes rather than the 15 to 16 hours it might
have taken in the past. On the retail side of the business, the emphasis in analytics must be
on using customer intelligence to drive revenues. This also requires a change in mind-set, with
efforts focusing on discovering relationships and correlations in large amounts of data rather
than determining their causes—moving from the “how” and “why” to the “what”.
10
“Fed Said to Criticize Banks on Risk Models in Stress Test,” by
Craig Torres, Dakin Campbell and Dawn Kopecki, Bloomberg, 5/1/12 –http://www.bloomberg.com/news/2012-05-01/fed-said-to-criticize-banks-
on-risk-models-in-stress-test.html
11
“Carney Calls for Bank Risk-Model Clampdown to Repair Trust,” by
Jim Brundsden, Bloomberg, 9/6/13 –http://www.bloomberg.com/
news/2013-09-05/fsb-s-carney-calls-for-bank-risk-model-clampdown-to-
repair-trust.html
12
“The Trouble with Banks’ Risk Models: Q&A with the Chief of SAS,” by
Penny Crosman, American Banker, 3/28/13
13
“Hunting and Harvesting in a Digital World: The 2013 CIO Agenda,”
Gartner Group –http://www.gartner.com/technology/cio/cioagenda.jsp
14
“Three Top Cybersecurity Risks for Banks,” by Victoria Finkle, American
Banker, 9/23/13 –http://www.americanbanker.com/issues/178_184/
three-top-cybersecurity-risks-for-banks-1062339-1.html
15
“Three Top Cybersecurity Risks for Banks,” by Victoria Finkle, American
Banker, 9/23/13 –http://www.americanbanker.com/issues/178_184/
three-top-cybersecurity-risks-for-banks-1062339-1.html
©
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Banking Outlook 2014: An Industry at a Pivot Point | 13
• Cyber security. Owing to the high value of their data, banks will always be a high-value target
for cyber criminals. Technological advances continue to push the cost of cyber attacks down,
which means banks must increase the resources they allocate to defending against them.
Adrienne Haden, an assistant director of banking supervision and regulation for the Federal
Reserve Board, notes that the cyber threat landscape has expanded to include not just fraud
but espionage, disruption of operations, and destruction of information.
14
Cyber security will
become an even broader responsibility in the years ahead as banks, eager to expand their
offerings and boost efficiency, partner with third-party vendors and service providers whose
networks are connected in turn to other banks, subcontractors, and third parties—all boosting
the risk that an attack on one could morph into an attack on many. New technologies in mobile
and cloud computing also are upping the ante. Banks will need to respond to these spreading
threats on multiple fronts, building sound and secure IT infrastructures, to be sure, but also
vetting and monitoring vendors and other service providers for their own compliance with
security protocols. Human resources will need to be involved, too, performing background
checks on new hires and providing employees with ongoing training in the safeguarding of
digital information.
15
Failure to maintain a robust cyber security profile could cripple efforts to
connect with customers and grow revenues.
©
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14 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 15
Improve Data Analytics
Partly this is a problem of history; banks are accustomed to viewing data as a cost center; something to
be saved, but seldom used. Partly it is a problem of priorities; especially over the past several years, much
of the analysis banks have engaged in has been targeted at meeting risk-management imperatives. But it
is partly a problem of capabilities also. With so much customer information available—in the bank’s own
records (credit and debit card data, demand deposit data, loan data), in credit reports, from social media,
and from an array of resources that seem to be growing exponentially—banks have simply struggled with
where to begin. As one of our colleagues recently wrote, faced with big data, banks need big knowledge
and big perspective. They need the clarity that comes from an organizational capability to leverage data
in many forms, from many places, through many methods and for a variety of purposes.
16
Yet in one of
KPMG LLP’s (KPMG) recent surveys,
17
only a third of respondents said their banks had a high degree of data
and analytic literacy. Not surprisingly, they also said they need to get better if they want to make progress on
growing revenues.
Indeed. But front-line analysts won’t be able to pull this off on their own. For banks to make real progress
in data analytics, executive leadership will have to make it a priority, champion its benefits, and, most
importantly, allocate the necessary resources. To drive best results, executive leaders should make sure
their teams hew to these principles:
• Focus on business outcomes and critical goals, and then determine the information needed to achieve
them.
• Locate, access, and improve data quality so that it can be trusted and useful.
• Develop systems and capabilities that aggregate data across business lines to create a single view of the
customer.
18
• Overcome internal obstacles by managing, measuring, and compensating employees, at least in part, on
how well they use data to make decisions and drive business outcomes.
Banks that develop an infrastructure allowing them to analyze data quickly, that staff up to do that work, and
that make revenue-oriented analytics part of their culture, are the banks most likely to grow their top lines.
An ocean of water, but not a drop to drink. That image of a lost-at-sea sailor is an extreme,
but not wholly unfair, analogy for banks, which have oceans of data about their customers
but shockingly few insights into what to do with it. Of course, banks use data to manage
risk, but as they pivot from risk-mitigating defense to revenue-generating offense, banks
must make better use of data to understand their customers and provide to them the
products and services they want via the channels they want to use. Yes, most banks
already use customer data from time to time to decide which products to market to which
buyers—products like checking accounts, investment products, credit cards, mortgage
refinancings, and home equity loans. But far too infrequently are they using customer
data to create truly new products or services that leverage the information banks have on
file about their customers, either individually or collectively.
16
“Big Data + Big Analytics = Big Opportunity,” by Jeanne E. Johnson, KPMG, in Financial Executive magazine, July/Aug 2012.
17
KPMG 2013 Banking Outlook Survey
18
“The Trouble with Banks’ Risk Models: Q&A with the Chief of SAS,” by Penny Crossman, American Banker magazine, 3/28/13 ©
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16 | Banking Outlook 2014: An Industry at a Pivot Point
©
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Banking Outlook 2014: An Industry at a Pivot Point | 17
Industrialize Internal
Processes
Organizations that are able to industrialize their processes are typically less rigid and more flexible than
their competitors, and so are better able to develop and market differentiated products appealing to a wider
range of customers. They can more easily scale up, or down, in response to market trends and client needs.
Among several of the examples outside the banking industry, a major automobile manufacturer embarked
on this path more than a decade ago when it announced in 2002 what it called a “revitalization” effort
aimed at standardizing and simplifying its technologies. The multiyear undertaking included upgrades to
Ford’s systems and processes, which reduced the company’s dependence on vertically aligned operations
and moved it toward a more flexible operating model that could focus on a differentiated product portfolio.
That initiative has been credited, along with the company’s well-documented, balance-sheet overhaul, with
helping Ford weather the last financial crisis better than most of its peers.
Industrializing processes isn’t easy; however, process change is every bit as challenging as installing a new
IT system. Banks must first identify best-practice processes and adapt them to their own circumstances,
then overcome employees’ natural resistance to change. Success depends to a large degree on instilling
a culture of change, one that is demonstrably supported by the executive team, from middle management
straight through to the C-suite.
Fortunately, the payoffs can be large and wide-ranging, including reduced costs, improved customer service,
and faster transaction processing. And with less time required for transactional activities, bank personnel
can spend more time on the high-value work that drives revenue growth.
Business strategies in the banking industry are of necessity multifaceted affairs
right now: continue to meet ever-growing regulatory demands, continue to cut and
contain costs, continue to manage through a low interest-rate environment, and
with the other hand, so to speak, boost revenues by developing new products,
services and delivery channels, and by connecting more deeply with new and
existing customers. Technology can help shoulder the load, but unless banks
“industrialize” their processes—simplify, standardize and consolidate—to reduce
complexity, lesser errors, and break down the walls that separate one part of the
bank from another—they’ll have a hard time executing on these strategies.
©
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18 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 19
Leverage and Empower
Internal Audit
One of the keys to understanding how banks can deliver the products and services customers want is to
understand the associated risks. This is where internal audit excels. We are not suggesting that internal audit
supplant the business and product development initiatives banks already support. What we are suggesting
is that executive leadership makes sure there is some mechanism in place by which internal audit can
periodically share with business leaders any findings and insights they might have developed in the course
of their duties—insights that could help the bank improve what it is doing for its customers today, and
perhaps develop new products or services for tomorrow. As part of that process, internal audit can provide
reviews of operational and financial performance, make recommendations for more effective and efficient
use of resources, and assess progress toward corporate goals.
Importantly, internal audit can bring special qualities to this endeavor that no other function in the
organization can offer. Steeped in a tradition of independence, it can present findings that have not been
watered down or filtered by others.
Other than the CFO’s office, few parts of the organization have a broader or deeper
view of a bank’s operations and financial resources than internal audit. To limit
that function to its historical role of helping the board discharge its governance
responsibilities is to forego potentially lucrative insights into not only how the bank is
operating but also how it might operate better and more profitably.
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20 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 21
Increase Use of
the Cloud
Many banks remain attached to their legacy IT environments and still harbor basic concerns about cloud
security, trust, safety, and privacy. But efficient organizations are becoming increasingly confident in their
use of cloud technology, both to avoid the high cost of hardware that is often underutilized over time, and
to speed time-to-market for new products and services. They recognize that cloud vendors who were once
relatively secretive about their operations have become much more open about the types of controls they
maintain and the reports they can provide, making it easier for banks to become comfortable with the
technology. And they see that cloud vendors employ vastly more people dedicated to data security than
they do, suggesting that data in the cloud could actually be more, not less, secure than data held internally.
TheInfoPro, a service of 451 Research, projects that the worldwide cloud computing market will grow at a
36 percent compound annual growth rate through 2016, to a total market size of $19.5 billion.
19
While cloud computing is becoming more common and trusted, banks must still approach the cloud
carefully. Among the issues they must consider:
• Data strategy and internal controls. Banks taking advantage of cloud computing must develop a robust
data strategy that allows them to evaluate cloud service providers empirically. Understanding how much
internal control the bank has over its data will help it make intelligent, business-driven decisions about
which data and business functions can shift to the cloud.
• Data sovereignty. Users of cloud computing may not always know where their data is being housed,
or under whose jurisdiction it may fall. There are no global standards governing data sovereignty or
residency, and many countries in the EU and Southeast Asia have rules not only around the privacy of that
data but also around how that data can or cannot be moved from country to country. Banks must work
with cloud service providers to make sure sovereignty issues and risks are addressed in their service
contracts.
As banks look to build new revenue sources via new product, service and channel
offerings, they will incur costs for new hardware and software—and will almost
certainly need to boost staff. An obvious option for mitigating hardware and software
costs is to take advantage of cloud computing.
19
“Predicting Enterprise Cloud Computing Growth,” by Louis Columbus, Forbes, 9/4/13 –http://www.forbes.com/sites/
louiscolumbus/2013/09/04/predicting-enterprise-cloud-computing-growth/
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22 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 23
Reexamine M&A
Opportunities
Number of Bank Deals and Deal Values Since 2003
0
2
4
6
8
10
12
14
16
Q1’11 Q2’11 Q3’11 Q4’11 Q1’12
Total deal Value ($B) Number of Deals
Q2’12 Q3’12 Q4’12 Q1’13 Q2’13 Q3’13 Q4’13
2.35
13.71
0.22
0.60
3.22
2.01
6.35
1.39
1.75
3.33
6.64
0.78
0
10
20
30
40
50
60
70
80
35
15
Source SNL Financial, excludes FDIC–assisted transactions. Used with permission
Still, mergers, joint ventures, and strategic acquisitions remain a powerful tool for growth and are likely to
increase in 2014. Why? All the old reasons still exist, including the burdensome cost of regulatory reform
on smaller institutions and the dearth of organic growth opportunities. But now, finally, the gap between
what sellers think their institutions should command in the marketplace and what buyers are actually willing
to pay appears to be shrinking, and moving into closer alignment with reality. While some sellers continue to
hold out for prices in the range of two to 2.5 times book value,
20
some recent unassisted transactions were
completed at closer to 1.5 times book value.
21
The mergers and acquisitions “wave” that was widely expected to rush through the
banking industry over the past several years amounted to something more like a ripple.
There were 162 bank mergers in the United States through the first nine months of
2013, up from 111 in the first three quarters of 2011.
20
“Banks Must Lower Expectations to Jump-Start M&A,” by Neil Hartman and Ken Siegman, American Banker, 6/27/13 –http://www.americanbanker.com/bankt...ctations-to-jump-start-m-and-a-1060209-1.html
21
“Banks Must Lower Expectations to Jump-Start M&A,” by Neil Hartman and Ken Siegman, American Banker, 6/27/13 –http://www.americanbanker.com/bankt...ctations-to-jump-start-m-and-a-1060209-1.html
©
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24 | Banking Outlook 2014: An Industry at a Pivot Point
Price to Tangible Book Multiples Over Time
0.0x
0.5x
1.0x
1.5x
2.0x
2000 2008 2007 2006 2005 2004 2003 2002 2001 2009 2010 2011 2012 LTM
2013
Money Center Banks
Regional Banks Small Banks
2.5x
3.0x
3.5x
4.0x
Source SNL Financial. Used with permission
“
Generally P/B multiples still well below
precrisis levels (1.0x – 1.5x today vs. 2.0x –
3.0x precrises)
”
Banks looking to pivot their focus to growth cannot ignore the
opportunities presented in the M&A market—opportunities that
can not only expand their market share and geographic footprint,
but also, thanks to cost-saving synergies, free more resources for
finding new sources of revenue. Rigorous due diligence remains
important, of course. Among other things, banks will want to
make sure they understand any regulatory issues that could
stall or block a transaction. They also will want to ascertain the
extent of any toxic assets buried on balance sheets, the level of
sophistication (or lack thereof) of a target’s IT systems, and the
extent of any accounting issues that might create a problem for the acquirer. And they will want to look for
any cultural-fit issues between themselves and their proposed partners.
©
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Banking Outlook 2014: An Industry at a Pivot Point | 25
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26 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 27
Rebuild Reputation
So this, too, is another reason banks need to move in a new direction, to rethink their culture and the way
they reach out to current and prospective customers, and to bear down even harder on risk controls so they
can avoid the sort of headline developments that have drawn the public’s attention and ire over the past
several years.
Doing that will require understanding how those headline events happened in the first place, and putting
in place processes and procedures to prevent them from happening again. It will require communicating
the bank’s strategy for treating customers and clients fairly and respectfully, and then communicating that
message again—and again and again—via traditional and social media. It also may require spending more on
developing value-added products and services that delight clients and make them want to reward their bank
with repeat business.
Looking at matters from a glass-half-full perspective, when it comes to reputation,
the financial services industry has quite a bit of upside potential. According to the
2013 Edelman Global Trust Barometer, banks and financial institutions are still the
least trusted players in the global economy.
22
That presents a challenge to banks that
want to grow their revenues by connecting with customers, given that their business
depends at its very foundation on the customer’s trust—trust that they will get their
money back, trust that they will not be swindled or overcharged, trust that their
financial institutions will not be hobbled by fraud or poorly managed risks. It’s also a
challenge given that this reputational shortfall comes at a time when there are so many
potential nonbank competitors looming on the horizon, from small and large retailers to
tech companies, crowd sourcing vendors and social media sites, and when technology
is making it ever easier for customers to switch providers.
22
http://www.edelman.com/insights/intellectual-property/trust-2013/about-trust/ andhttp://www.edelman.com/trust-down-
loads/press-release/
©
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28 | Banking Outlook 2014: An Industry at a Pivot Point
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Banking Outlook 2014: An Industry at a Pivot Point | 29
Getting Going
The U.S. banking industry can no longer cut its way to profit growth. After half a decade focused on
managing risk, cutting costs, and meeting regulatory requirements, the industry must pivot to a strategy
centered on growing revenues. With its reputation badly damaged by the last financial crisis, it will require a
new and unrelenting focus on connecting with customers and regaining their trust. It will require developing
new products and services that appeal to customers, and are available via the channels they want to use.
Ambitious banks will find ways to cater not only to their core customer base, but to the tens of millions of
unbanked and underbanked who are rapidly being co-opted by alternative providers of banking services.
In all cases, it will require that banks rethink their systems and processes to be more agile and to make
their analytical capabilities more insightful. Some institutions may find that the only way to meet these
imperatives will be through mergers, acquisitions, or joint ventures. No matter the course, the way forward
will not be easy, requiring nothing less, for many banks, than a wholesale cultural change. Yet, the alternative
will be even less palatable—a gradual slide into irrelevance, an opportunity missed. The time to begin the
transformation is now.
©
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