Back To Cost Reductions: Getting It Right This Time

RMA Journal, The, March, 2001 by Charles Wendel

To "get it right," banks' cost-reduction programs should not cause new and promising initiatives to wither on the vine. Important to using cost reduction as a growth tool is a focus on key market segments and product capabilities, strong credit and operation discipline, distribution systems tailored to customer requirements, and incentive compensation based on profit.

The year 2001 features a return to bank management's emphasis on productivity and cost reduction as two critical measures for success. This time, however, managers have a chance to get it right.

All too often, past attempts at cost reduction have occurred without effective linkage to bank strategy; in effect, cost reduction became the bank strategy. In addition, those leading the process have failed to assess the impact of cost reduction initiatives on internal morale and revenue generation. Employee morale and enthusiasm suffers as rumors abound and people fear the inevitable loss of jobs.

At the same time, revenue growth often begins to slip. Marketers are less focused on selling a bank's capabilities, and customers become increasingly skeptical about whether the bank will offer the same level of service as in the past. Customer concern is heightened by competitor activities that often focus on communicating that their bank is in the throes of an internal crisis.

Yes, the net result of these cost reduction efforts has been a lower cost base--at least for a time. The more pertinent issues concern the cost of these efforts to a bank's future.

The banking landscape is littered with banks that signed on with specialist consultants for dramatic cost-reduction initiatives that were packaged as bank-wide reengineering. Compensation for many of those consultants was tied to agreed-upon cost takeouts. In some cases, this may have encouraged supposedly independent resources to suggest staffing cuts without focusing on the strategic impact of their recommendations.

Many of the banks that followed this type of bank-wide, three to six-month cost-reduction process have disappeared, with most being purchased by other institutions. Banks that fall into this category include Corestates, First Security, Michigan National, Midlantic, Republic National, and Star Bank. In many cases, cost reduction was a precursor to sale rather than renewal.

Lessons from the Past

Past efforts at reengineering often failed due to a number of factors ranging from over-ambition to failing to focus on growth opportunities:

* Many cost take-outs are one-time savings that are not sustainable.

* Aggressive cost-reduction targets are not met because of poor implementation.

* One-time restructuring charges are not "earned back" through future cost savings or growth.

* Reductions in personnel costs are offset by increases in "other," non-interest expense as the companies turn to consultants or outsiders to perform internal functions.

* A lingering negative psychological effect reduces employee efficiency.

* Reengineering projects are lead by consultants who have a personal stake in high levels of proposed cost-reduction ideas, not in the actual realization of those cuts.

Why Cost Reduction Has Returned

The banking industry faces a near-term growth squeeze on both the asset and liability sides of the balance sheet. One approach management will use to address that squeeze is to cut costs.

On the asset side, a dip in consumer and business confidence may result in a slowdown in quality lending opportunities. Many banks are placing a greater emphasis on enforcing credit policies and improving collection activities versus generating growth. These same banks already are seeing some deterioration in new application credit scores and a decline in approvals; some warning signs are beginning to show.

In the small and middle commercial markets, many banks will reduce their appetite for lending due, at least in part, to the need for increased reserves related to marginal credits. At the same time, some of the most creditworthy borrowers will rethink their capital and borrowing requirements in light of what they view as an uncertain business environment. Small businesses, in particular, are known for being conservative in softer economic times. Both lenders and borrowers will become more conservative.

While loan demand slows and credit quality slips, "free" demand deposits may also become scarcer. We expect both consumers and businesses to reduce their DDA levels and move an increased percentage of balances to investment accounts. Either the banks will, in effect, cannibalize their deposits by actively selling sweep money market accounts or they will risk losing customers to the likes of Merrill Lynch or Morgan Stanley.

While deposit erosion is small and its growth is relatively slow, it represents one of the greatest threats to bank health. Year after year, many analysts have predicted a reduction in the absolute level of demand deposits. Yet, strong economic growth combined with customer inertia has allowed banks to continue to benefit from these profitable products.