The Hindu Business Line : Bank on operational efficiency

Benchmarking and improving on cost-to-income ratio will help financial institutions drive efficiency while targeting growth, improve return on equity and be better prepared for portfolio contingencies.

The only way to ensure profitability on a sustained basis is to focus on efficiency even while targeting revenue growth.

Shyam Pattabiraman

During the past few years, banks and NBFCs have been among the fastest growing sectors in the country.

However, under the current economic scenario, financial services companies that rapidly expanded operations and increased fixed costs to drive growth are facing pressure on profitability.

The ghost of easy lending norms and increase in interest rates over the last three years has come to haunt in the form of rising delinquencies in the loan portfolio.

This trend is particularly accentuated in the consumer and SME lending segments where a portion of customers have overleveraged themselves.

Today, many financial institutions are down due to excesses of a one-dimensional ‘revenue growth’ strategy that has made organisations vulnerable during a slowdown in business cycle. The only way to ensure profitability when the tide is high as well as low is to focus on efficiency even while targeting revenue growth.

‘Growth for growth sake’ or ‘topline growth first, efficiency later’ is not sustainable in banking, at least not in the lending business – which is basically a ‘relay race’, driven as much by collections as by sales.

The famous Warren Buffet saying — “It is only when the tide goes out you learn who has been swimming naked” is not only applicable to the stock market but also to businesses.

Cost-to-income mantra

In the long term, the leaders will be those who consistently deliver on ‘return on equity’ (ROE) – which is the true driver of shareholder value. Banks and NBFCs should make use of the current environment to finetune their strategies and peg themselves to ROE. But how do financial institutions that work on metrics such as “spread”, “fee income” and “NPA”, internalise a shareholder metric such as “return on equity”? Enter, cost-to-income ratio, which acts as a bridge between banks’ internal business metrics and the external metric — ROE.

Cost-to-income ratio is the banking equivalent of the inverse of operating margin, defined as the ratio of operating expenses to operating income. Mandatory provisions on bad assets or standard assets, although not typically classified as operating expenses, can be included while computing the ratio - to reflect portfolio quality.

Using Dupont decomposition, the ROE of a financial institution can be expressed as the product of operational efficiency (net income/ revenue) and capital efficiency (revenue/ average equity). While business mix and regulatory requirements determine capital efficiency of a bank, the cost-to-income ratio is the key driver of operational efficiency. Banks with low cost-to-income ratio (high operational efficiency) achieve higher ROE than banks with high cost-to-income ratio.

Bloated costs

Compared to the global average (60 per cent), cost-to-income ratio of Asian banks (50 per cent) is significantly better: one of the reasons why they are coping well under the current scenario of increased write-offs and asset deterioration. Unfortunately, banks in the US, Europe and Japan, as a result of their heavy operating cost base, lacked the necessary cushion and witnessed their bottomlines being pushed into the red. ‘Systemic risk’, which manifested itself through the mortgage crisis, has been blamed as the sole cause for the losses reported by global banks. But the numbers seem to point to another key factor – bloated operating expenses.

Asian scenario

Extending the cost-to-income introspection within Asia, we find that banks in India need to catch up with their peers in Singapore, Malaysia, Hong Kong and China, to become more resilient to market shocks. After all, banking is a cyclical industry that lies on the borderline of commoditisation. It is only logical to expect the most cost-efficient service provider to be the one with maximum sustainability.

Hong Kong serves as an excellent example with an average cost-to-income ratio of 40.8 per cent — a benchmark in banking — that leaves significant room to weather a slowdown in business or asset write-down during a bad year, without dipping into balance sheet reserves.

Benchmarking and improving on cost-to-income ratio will help financial institutions drive efficiency while targeting growth, improve ROE and be better prepared for portfolio contingencies. Our research has shown that a 3 per cent reduction in cost-to-income ratio translates itself into a 1 per cent increase in ROE. This implies savings in the order of Rs 20-30 crore a year for a mid-sized bank/ NBFC and Rs 150-200 crore a year for a large bank in the country.

A related study on the impact of cost-efficiency in banking shows that – an M&A executed by a cost leader with a cost laggard, is able to achieve faster breakeven on investment than the alternative scenario of an M&A between two cost laggards. One of the reasons for this trend is that if the parent bank already has a cost-efficient platform it is relatively easy to insert the same into the acquired organisation.

But, when two ‘not-so-efficient’ banks merge, hoping to use the increase in scale to drive efficiency and achieve joint optimum, the risk of not deriving the integration benefits is higher. With M&A action expected to heat up in the country’s banking and NBFC space over the next two years (due to expected deregulation), there is an onus on financial institutions planning inorganic growth – to transform on the cost-efficiency plane before pursuing growth.

(The author is a management consultant with ECS Ltd. The views are personal. blfeedback@thehindu.co.in)