KPMG published on Tuesday an interesting report on the UK banking sector. The standout finding was that, although pre-tax profits in the sector increased 62% in 2014, the profitability of the industry remains materially and structurally below pre-crisis levels.
The report shows that the effect of new regulation has done, in large part, what the regulators wanted: it has made the sector much safer, but much less profitable. Risk weighted assets have fallen significantly, loan impairments are down by 72% but with the corollary that no bank had a return on equity higher than 8%. The only major negative from the regulator’s point of view is that lending continues to contract.
In terms of profitability, it is unlikely to get much better. Sure, there will be some cyclical gains from a rising interest rate, for instance. But, there continue to be structural headwinds in the form of regulation (e.g ringfencing), new competition (from new challenger banks, like Metro, as well as non-banks like Apple), the impact of higher customer expectations and digitization, the role of which the report says is “not well understood”
We have long held that updating legacy technology in banking is one of the main ways that banks can improve profitability and we wrote a white paper in conjunction Deloitte on this topic (http://bit.ly/1IIHL6A) about a year ago. We also concluded that banks have an interest in addressing ageing IT systems that goes beyond just profitability. Legacy technology systems represent a systemic risk to the banking industry as a whole and are a major barrier to innovation in an increasingly competitive marketplace. Banks that do not keep up will lose out to new competitors, both non-traditional players and banks who break ranks with the status quo. Transforming legacy systems has become a necessity of survival.
This view is supported by a recent report from McKinsey who say that digital investments are best placed in back office automation. McKinsey analysed the cost-to-income ratio of banks compared and found that automation had the highest correlation with profitability. Most banks today remain burdened with manual processes as a result of their decades old IT systems.
In the original report published with Deloitte we found that banks can address 25-60% of the post-crisis drop in profitability through modernising legacy systems. Banks can improve profitability with modern systems in a number of ways including offering customers more customised products, launches new products more quickly, increasing cross-selling, having a single view of risk, improved straight-through processing and improve overall operational efficiency.
You don’t have to take our word for it: the KPMG report shows how more nimble challenger banks, like Metro and Aldermore, unencumbered by legacy systems, are taking market share (from 4% of retail lending in 2010 to 7% in 2013) with much higher levels of RoE.