Strategic regulatory transformation: from box-ticking to value-creation
Dr. Daniel Diemers, Tom Steffens, Daniel Ickerott
Complying with the flood of financial regulations that we have seen since the 2008 crisis is a fact of life – and will continue to be so for some time to come.
But, too often, compliance is seen as a box-ticking exercise. That may not be so surprising, since the natural instinct of leadership and the rank-and-file in financial institutions is to ensure that regulations can be complied with properly and on deadline.
Yet we think that in order to avoid compliance becoming an ever-increasing cost burden, financial institutions need to take a new, more strategic approach that drives compliance and performance improvements in parallel — and sees them as interlinked. So, when a mandatory regulatory requirement crops up, we think this can actually represent a strategic opportunity to generate growth — or at the very least reduce costs, instead of simply adding to them.
UBS expects implementation costs for each of the largest bankers and brokers of between $80 million and $120 million1. These costs are mostly driven by required IT investments of which ~30% are expected to be spent on IT solutions sourced from third party vendors2. While banks can simply follow their usual IT procurement process, a strategic approach to vendor management using an IT vendor management office can generate savings on contracting volume of around 5% to 25%3.
The problem is that major change – and the kinds of regulatory transformations that compliance exercises usually trigger – often throw up three significant challenges, which are often met by short-term fixes rather than sustainable strategic solutions. These challenges can be summed up around lost business focus; grappling with complex organizational setups; and legacy IT infrastructure.
We think that a key starting point for any regulatory transformation is to address these three challenges head-on and to incorporate them into any regulation transformation plan. In other words, financial institutions should shift away from treating regulatory compliance as a box-ticking exercise and instead take a broader, strategic approach that looks at the business as a whole. We call it strategic regulatory transformation.
Transformation programs: a cost driver
There is evidence that traditional regulatory transformation programs significantly increase costs with no apparent efficiency gains. The cost of regulatory compliance at the world’s top 15 banks is expected by 2022 to reach 10% of each bank’s group revenue, on average, from around 4% currently4.
Typically, there are four cost drivers:
Lost revenue: New regulations generally limit revenue streams and squeeze margins. For example, they can limit the eligibility of clients to buy certain products and services and even prohibit markets. Increased transparency increases pressure on margins.
Labor costs: The biggest cost of any regulatory transformation. A lack of skilled compliance staff and a need for bigger teams will push costs higher still. Revenuegenerating staff can become less productive as they spend more time on compliance and reporting.
Regulatory fines: Banks globally have paid more than $300bn in fines since 2008 for failing to meet market regulations5.
Technology costs: Banks globally spent a total of $241bn on IT in 2016, according to Celent, a consultancy. Much of that has been – and continues to be – driven by regulatory requirements.
Strategic regulatory transformation: how it works
PwC’s Strategy& has developed a strategic regulatory transformation approach designed to help banks move beyond short-term fixes and build in sustainable strategic solutions. It is made up of three stages that run in parallel to the hands-on regulatory transformation itself:
1. Strategic impact assessment
By starting with a strategic impact assessment rather than diving straight into regulatory transformation, a bank can identify areas for potential revenue growth and costreduction opportunities right away. It may sound obvious, but it is important to assess the impact of the specific regulation on the financial institution’s overall strategy.
First, the regulatory agenda of a financial institution needs to be clarified. Which regulations need to be implemented in the next three years? How are they related to each other? And how does the regulation currently in focus fit in?
Second, the impact of the regulation in focus on the existing strategy of the institution needs to be assessed. What are the key requirements stemming from the regulation? Which areas of the organization are affected by the requirements? What are core and non-core segments?
Third, strategies for core and non-core segments need to be revised providing initial guidance on changes to clients, markets, products, services and the organization (e.g. keep, wind down).
2. Business model redesign
Following the changed business segment strategies, corresponding business and operating models need to be reviewed to a) become compliant and b) improve the financial performance of the business. This can be achieved in four steps:
First, the initial guidance on changes to clients, markets, products, services and the organization needs to be further detailed and turned into actionable change requests.
Second, areas for change need to be reviewed to identify additional improvement potential, e.g. legacy IT issues, to define and implement more comprehensive change requests.
Third, new services and products in line with the new business segment strategy need to be developed and additional cost-saving programs and profitability targets implemented.
3. “Smart PMO” (project management office)
A Smart PMO uses the information learned throughout the regulatory transformation to identify additional improvement potential on a continuous basis by conducting the following steps:
First, the Smart PMO consolidates all information from the regulatory transformation and exchanges best practices with other regulatory programs running in parallel.
Second, areas for performance improvement (cost savings or revenue potential) are identified based on the information consolidated and selective follow-up discussions.
Third, improvement opportunities are analyzed more in detailed and concrete actions for pursuit of the opportunities defined that will be the basis for a management decision.
Besides activities related to performance improvements, the Smart PMO will also cover activities related to the regulatory transformation such as status tracking of requirements implementation.
Applying this in practice
Sound a bit theoretical? Let’s apply this to a concrete example: FATCA – or the Foreign Account Tax Compliance Act - compliance.
To be compliant with FATCA, banks need to review their “know-your-customer” (KYC) rules and procedures, classify FATCA-relevant clients and collect information for US authorities. While banks could simply review their KYC processes and adapt this to meet the new requirements, strategic regulatory transformation would also look at the current cost structure and assess potential outsourcing options as a way of generating savings. According to Thompson Reuters, KYC outsourcing can generate annual savings of 30% to 40%6. Additional revenue can be generated by using the data needed to meet regulatory standards to cross-sell tax-favored products to FATCA-affected clients. In our experience, such cross-selling initiatives can yield revenue increases of around 8% within respective client groups after three years, and a recent Cisco study found similar outcomes. Continuous reviews across all client portfolios produces a further increase in revenue of about 4%. According to Fidelity National Information Services, more than 50% of retail clients have negligible returns of less than $25 per month while our project experience shows that the most unprofitable clients can destroy up to 25% of annual profit7. Further gains can come from outsourcing IT. A recent Strategy& Fit-For-Growth study found outsourcing FATCA IT solutions can cut annual IT spending for FATCA by around 4%8.
Our strategic regulatory transformation plan can be applied to any regulation and allows financial institutions to realize significant performance improvements by combining a thorough review of their strategy and business models with new information thrown up by the transformation itself. We are already helping clients implement this approach in:
OTC derivatives reform
Strategy& is designing an OTC derivatives compliance program for a bank based in central Europe that will also strengthen the bank’s positioning in the OTC market. Following a strategic impact assessment of the reforms on the bank’s OTC department, a new operating model and service offering is under design. This includes restructuring the department (including legal entity set-up) and streamlining existing operations. So far, “Smart PMO” insights have helped identify measures that are expected to deliver significant cost reductions. Processes and IT applications will be significantly simplified, reducing manual interfaces in data capture. In addition, the portfolio is currently under review to phase out the least profitable products.
Preparation for changes to the London Interbank Offered Rate (Libor) benchmarking system
We are helping a number of banks adapt their current interest rate models to take into account the replacement of the Libor benchmark rate ahead of a 2022 deadline. For most banks this means embarking on a large transformation program looking at things like amendments to and the renegotiation of client contracts, complex changes to IT systems, processes and controls, and legal and tax demands that differ by region.
Bloomberg: Deutsche Bank May Suffer Most in MiFID Trading Hit, UBS Says, 10/2017
IHS Markit: Counting the Cost of MiFID II, 09/2016
Forbes: The Emerging Importance Of An Information Technology Vendor Management Office, 12/2017
Duff and Phelps: Survey of 183 senior staff at asset managers, brokers and banks, 04/2017