Between Rocks and Hard Places: The Revenue Dilemma Facing Banks

Banks have a big problem. They need to restart their revenue engines, which have been stalled for several years, held back by the forces of recession, financial crisis, massive credit losses, and restrictive new regulations.

In addition to these problems, however, which are very visible and well known, banks are caught in a tight convergence of several less-visible, more fundamental, but equally potent forces that have been building momentum for about two decades and are now converging (more accurately, colliding) with current events to bring about an operational transformation in the banking industry. These long-term forces are more than the ordinary industry trends that come and go; they will be very disruptive to the existing modus operandi of banks, and their convergence with present market forces will serve only to make the revenue challenge facing banks that much more difficult.

The "usual" answers to boost revenue that have worked for banks in the past -- raise fees and add a few new ones -- will be unable to provide sustainable growth and profitability as the new operating environment emerges. There will be no return to business as usual in banking. As the industry and the economy emerge finally from the worst recession in 80 years, the drivers, differentiators and success factors for banking are all changing. The bar has been raised, the industry is on the cusp of wholesale and permanent evolution, and the environment will require new models and new revenue sources in order to adapt.

For about 20 years, give or take, a number of forces have been slowly developing strength at a more fundamental level in banking, far below the radar screens of everyday activity and driven by events and trends that would appear to have little in common. But it now appears that spurred by the convergence with the many and severe current crises in banking, these forces will break through like volcanoes to disrupt and reform the landscape even sooner.

First, consider the industry consolidation that has been steadily reducing the number of banks in the U.S. Bank consolidation began in earnest 25 years ago, when state legislatures began repealing laws that prohibited or restricted interstate banking. Once those barriers were removed, consolidation has been proceeding steadily with no signs yet of slowing down.

For practical, everyday purposes, the most persistent and pernicious effect of this ongoing consolidation has been an intense competitive pressure on pricing, as banks constantly seek more customers, at the expense obviously of another institution. This pricing pressure has had a profound impact on another long-term force, namely, the steady erosion of net interest margins.

Across the banking industry, in every asset category, net interest margins have been sliding consistently downward, with only a few upward blips, for 20 years. Although net interest margins remain the single largest contributor to revenue at banks, this dramatic slide has taken about 100 basis points (measured as a percentage of earning assets) out of their revenue stream. At today's level of banking assets, that means about $120 billion annually in "lost" revenue.

Non-interest income, the other large element of banking revenue, has likewise stalled. As margins have dropped, banks have increasingly relied upon non-interest income to supplement their revenue, but here, too, revenue has hit a plateau. After increasing their proportion of non-interest income enormously in the 1980s, banks have been unable in the past 20 years to continue that growth. In 1982 banks in total derived 23 percent of their operating revenue from non-interest income. By 1992 that percentage was 33 percent, but now stands at only 36 percent in aggregate.

Finally, consider what is perhaps the most challenging operational trend for banks to deal with -- the inability to improve their efficiency ratio. One might expect, thanks to the rapid improvements in technology over the years, that banks would show a continuous improvement in operating efficiency, as automation displaces manual processes and ratchets up productivity. This improvement should likewise enable additional revenue growth in the form of new products and services. However, banks seem to have become unable to break through a barrier to continuous improvement. In 20 years they have barely improved, and in most cases have recently worsened, their efficiency components.

The financial services industry is in the midst of a massive transition. Unlike earlier industry changes this transition is not an incremental one, in which organizations, processes and technologies evolve in linear fashion into more "advanced" but still familiar models. This transition will be a much more radical one, essentially realigning the industry's basic business model. These changes will require institutions to adopt flexibility, speed and transparency across all of their operations. They will require a technology orientation that is fundamentally based on "horizontal" integration of information and processes spanning multiple business lines, as opposed to "vertical" integration of products within a single business line.

Banking is not just about banking anymore. Its strategic focus has changed, its operating orientation has changed, and its sources of revenue therefore need to change. Unfortunately, banks have not made nearly enough progress in transforming their operating models and technology to be able to exploit and support this new reality. They remain fixed in an operating and technology environment dominated by products, transactions, departments and short-term profit, when they need to move to an environment driven by customers, the customer experience, enterprise-level information, and delivering value-added information through integrated channels.

Revenue will not grow significantly or (more important) sustainably until banks invest in a near-total reorientation of their technology in order to develop new sources. The new revenue streams of the future must and will come from this new environment. Revenue increases that come from the "old" environment, such as product fee increases, will likely show a short-term effect, but will in many or most cases be either inimical to the longer-term interests of a bank or unsustainable. The sooner banks make that commitment to the future, the sooner they will see their revenues grow again.

Lee A. Kidder is a Practice Group Manager and Senior Consultant at CCG Catalyst Consulting Group.

This article is a summary of a full-length whitepaper.