The path to profitable growth in retail lending
Despite a significant recovery from the global financial crisis, the retail banking industry is witnessing significant pressure on margins due to stringent regulations, changing customer behavior and increasing competitive threat from Fintechs.
A recent McKinsey study predicted that profit growth of Asia-Pacific lenders may slow to below 4% annually between 2016-2021, down from about 10% in 2011-2014 if banks don’t take action to address the triple threat of slowing economic growth, technology disruption and weaker balance sheets. Another report from KPMG suggests that challenger banks in the UK continue to significantly outperform the Big Five UK retail banks which reported an average return on equity of just 4.6% in 2015. Even more disquieting is a review of global banking which reveals that as much as 40% of revenues and up to 60% of the profits in retail banking businesses – consumer finance, mortgages, small-business lending, retail payments and wealth management – are at risk from a combination of dwindling margins and competition from Fintech startups. The situation is alarming as retail lending which has historically been a profit driver for banks is deemed the most at-risk with the proliferation of peer-to-peer (P2P) and online lenders. While the situation varies from region to region, it is clear that the business model used by many traditional retail banks is under threat.
It is easy to understand why Fintechs are scoring over the banks. Without the burden of regulations, the limitations created by inflexible legacy IT systems or the huge costs of bank branches, many online lenders are able to operate business models that are much more efficient and cost-effective than the traditional bank model. For example, according to this article from The Economist, a typical online lenders’ ongoing business expenses as a share of outstanding loan balance is about 2%, compared to 5-7% for traditional lenders. With a lower cost structure, online lenders can offer better deals to the borrowers, or even make loans that might not have been cost effective previously.
So how do the traditional lenders make their business model pay? In my previous blog, I talked about the differential pricing of loans and how it could help to lower delinquency rates and increase profitability. However, this might not be enough, especially if the cost of servicing the loans is too high. Therefore an equally crucial battleground for the banks is how they can deliver loans at the lowest cost but the highest profit while maintaining a differentiated customer experience.
To bridge the profitability gap with Fintechs, banks must aggressively drive a step-change improvement in all aspects of lending efficiency. Banks must be ruthless in finding and eliminating unnecessary costs. While cutting costs is easy, driving cost reduction in a way that is both sustainable and supportive of the bank’s future growth opportunities is much more challenging. It requires an approach that can enable the bank to optimize operations while delivering enhanced customer experiences rather than just trimming operations. The good news is that the latest technology now provides an opportunity to achieve digitally enabled simplicity coupled while high operational efficiency. Digitizing lending operations involves rightsizing product portfolios, redesigning customer journeys to create seamless interaction across channels, replacing the complexity of multitude of systems with just a couple of platforms that can handle variety while industrializing and automating core processes from end to end.
This view is supported by a recent research which says that digital investments are best placed in back office automation. McKinsey analyzed the cost-to-income ratio of banks and found that automation had the highest correlation with profitability. Apart from that, when it comes to offering customized products or launching new products quickly, legacy systems at traditional banks generally have hard-coded rules for every product feature, such as interest rate structures, term lengths, up-front fees etc. Such inflexible hard coding does not allow banks to develop or modify products quickly. Capabilities such as paperless loan origination and self-servicing can be extremely difficult to achieve using these systems. Legacy systems therefore limit the bank’s ability to roll out new competitive features or service offerings, in addition to restricting their ability to compete on cost, speed or convenience.
Research shows that it is possible to build a new digital bank at substantially lower capex and lower opex per customer as compared to traditional banks. While the elimination of costly physical branches has a role to play here, is mostly due to simplified product offerings and streamlined processes which eliminate the challenges caused by expensive legacy systems. Replacing legacy lending applications with modern third-party systems is therefore a key in transforming lending operations.
While many banks have not made much headway in terms of digitization, BCG’s Global Retail-Banking Excellence benchmarking shows that banks leading in measures of operational and digital excellence are seeing significant results in both customer experience and operation efficiency. They are reducing cycle times for core processes, such as customer onboarding, while achieving higher rates of straight-through-processing and improving productivity The results speak for themselves, including 50% higher average pre-tax profit per customer than the median, while their operating expenses per customer are 30% lower.
As the top-performing retail banks in the world continue to extend their lead over the rest, banks that hope to follow suit will need to kick start their digital transformation now. Banks with an overly cautious approach, banks that simply try to wait out the storm will probably find themselves struggling for survival, but those that take action can uncover growth opportunities that could help regain their momentum.