The Cross Roads for Financial Services

Many, not all, financial services institutions are established players who have enjoyed the largesse of high profits for extended periods. But it’s a different story when it comes to shareholder returns. Sure, dividends have been great for some. But share price growth has stagnated.

Take Citigroup for example. A massive financial services powerhouse with over 220,000 employees globally, that generated $19bn in revenues in the March, 2022 quarter.

On the face of it, you’d think that Citigroup, as a flagship of the face of successful financial services institutions, would be sitting pretty. But the reality is a lot different.

Year on year net profit margin is down by 40%.

It’s share price has tanked since the 2008 global financial crisis, struggling to get above $80 USD compared to its halcyon days of being a $500+ priced stock.

(source: Google)

Now this post is not intended to be a detailed critique of Citigroup or the industry wide financial performance obstacles of today's world. I’m a digital guy after all, and left my accounting days long, long ago. Plus I think Citigroup do some things, pretty well.

But I can read a balance sheet and an income statement. So when I look through the regular stream of financial results that feature in the media, it’s pretty obvious something isn’t right. You don’t need a university degree in accounting or a CPA to see that.

A headline that easily captures the problem that financial services is facing - courtesy of the bright minds at McKinsey and Company is this: Industry ROE (Return on Equity) in 2020 was 6.7 percent —less than the cost of equity. In other words, financial services shareholders are losing out and should be chasing returns elsewhere.

The hard facts, for many a financial services CEO to digest, are these:

• Banks are trading at about 1.0 times book value.
• The average across other industries is 3.0 times book value.
• 47 percent of banks are trading for less than the equity on their books.

Why are capital markets so pessimistic about financial services?

As financial services has navigated the 2008 financial crisis to our recent COVID 19 pandemic, their evolution into the modern era has meant a now familiar strategy of commoditization.

In other words, what were once assumed services a bank would provide at no charge, but with the assumption of higher interest margins, has been rationalised in an environment where bank margins continue to remain under intense pressure.

So in this environment, what do you do?

You commoditize your services and look for ways to increase revenue and reduce costs. No surprises there, right?

Hold on a second there. Easier said than done!

Anyone reading this post, who works in financial services, will know what I’m talking about here…Financial services is probably the most highly regulated industry on the planet.

I’m not saying it shouldn’t be regulated, by the way. Some of this regulation is a consequence of unconscionable conduct by banks.

In my own country, Australia, this was evidenced by our recent royal commission and parliamentary enquiry where evidence of this conduct was made public. It was painful to watch.

The understandable anger held by the community was and continues to be palpable. Clearly banks have been their own worst enemy at times, and the resulting regulation is attributable to a misalignment in banking industry priorities.

But when you understand the quantum of regulation and compliance that banks must adhere to, the costs and time invested is staggering. Deloitte estimated that these costs are 60% higher than prior to the 2008 global financial crisis.

Whether it’s product design, AML, codes of practice, legislation, or executive responsibility obligations - the amount of regulation is mind bogglingly complex. Doubly so for a simple minded digital product person like me!

So the consequence of commoditization (and misaligned priorities) has been layer upon layer of regulation and compliance.

The good news in all of this? Smart folks out there are figuring technology solutions out which allow financial services institutions to manage these obligations. But it’s a gradual process and ultimately technology solutions don’t outsource the need for responsibility and oversight.

But there’s a problem in all of today’s busy-ness of running financial services institutions.

There’s no room for differentiation.

If financial services institutions are dealing with the same problems the same way, then they’re all going to end up in the same place - as McKinsey’s terms it, in “the bread and butter of banking.”

It’s this bread and butter that’s eroding shareholder returns.

When you’re fighting over customers based on interest rates, in an ocean of competition where other financial institutions are doing precisely the same, as well as commoditizing every possible service they can, this is hardly the kind of imaginative thinking that creates differentiation for customers.

Particularly when these customers are spoilt for choice in a financial services market that’s evolving towards to specialised propositions such as Klarna (for store front BNPL), Tide (small business banking) and Venmo (peer to peer payments).

A contributing factor in the ‘relevance’ battle that financial institutions are fighting, is the impact that these dated strategies are having on attracting and retaining talented people.

Sure, financial services pays well - for example Macquarie pays around ￡55,000 in the UK for new starters. But if given the opportunity of working in some fantastic startup that’s using the Metaverse to create new virtual shopping experiences through NFTs versus working for a 100 year old bank that’s focused on providing deposit accounts, managing a lending portfolio and dealing with compliance obligations…I know what I’d be choosing!

But coming back to customers for a moment. The winners in financial services are focused not on tired playbooks that are about competing on margins and commoditizing every possible ounce out of their services. They’re fighting hard in origination and distribution.

Why wouldn’t you when you can achieve 20% ROE for shareholders in origination and distribution compared to a lousy ~4% in deposits and managing lending portfolios?

(Source: McKinsey & Company)

What this tells us is twofold.

The business of providing deposits accounts and running lending books, whilst integral to any financial system, is tired, unattractive and heavily regulated. Anybody with half a brain would be thinking twice about entering this market and thinking they could be competitive.

Where the real ‘flow’ is at, is in helping customers do things with their money, that matter for them at a personal level. Like living. Like buying a home. Like starting and running a business. Like travelling more and working less.

And the two words that ring magical in my ears here in enabling this flow are: Digital Distribution.

Digital has been the focus of my career for 8 years now, and I’m blessed to do something I truly, truly love and enjoy. Plus it’s a highly in demand skill set. I remember making the move to digital and my boss at the time said: “Are you sure that’s a wise career move?”.

With the benefit of hindsight…hell yeah!

But it’s only in the last couple of years that the lightbulb moment has started to happen for senior financial services leaders who see the trend I’ve simplified above.

Understandable of course. Running a financial services institution is a demanding grind, and it’s impossible to be everywhere and across everything. I’m just glad it’s not me!

Digital intermediates a world of high regulation, of perennial commoditization, to instead double down on understanding precisely what customers want to do and creating engaging and personalized ways to accomplish this. Like I said earlier - helping customers do things with their money that matter to them.

The secret sauce in this is your ‘how’. How is where the mojo is at, where the magic really happens.

The how, that can be emulated from the strategic patterns used successfully in big tech, is an amalgam of:

Integrated experiences. Ecosystems. Predictive personalization. Rapid product inception to go to market cycles. Adaptive, future proofed technology.

You only have to take a look at what fintech like Revolut and Starling (as poster children) and technology companies like Apple and Google are doing to understand the potential of this new world.

A world built on the already strong foundations they have with customers. But more about that in my next post. ??

So are financial services institutions doomed?

Not necessarily. But the challenge is enormous.

It’s going to take a massive mindshift change, at the executive and boardroom level to transform into digitally driven, customer obsessed and low cost to serve institutions.

The kind of businesses that are less focused on outdated financial services business models that drain capital and erode shareholder returns, and more concerned about how to remain relevant in a $28.5 trillion global market, by truly understanding customer needs and using the same playbooks that big tech use successfully.