Managing Complexity

During the nearly two decade bull run in financial services, from the 1988 peak in interest rates until 2006, banks and insurers became larger and more complex. They increased the number and sophistication of products they offered, added new channels (such as phone and internet) and often expanded internationally.

This increased their revenues. But their costs increased at the same rate. Although absolute profits grew, the productivity of financial sector firms has not improved since 2001. And, as we now know, risk grew too.

Since the crisis, ultra-low interest rates and new regulations aimed at limiting risk have reduced the revenue accruing to the increased scale, scope and sophistication of financial firms. However the elevated costs remain. Average returns of large financial firms have fallen from over 20% in the early 2000s to 7% in 2013, the level of utilities companies.

The State of the Financial Services Industry 2015 Report looks at the topic financial firms must now grapple with: managing complexity.

For financial services firms, the central problem of complexity has distinct features. Complexity is unavoidable for successful financial firms because it arises out of the desirable features of their business models. Economies of scale, risk diversification, technological advance and ongoing globalization require financial firms to sustain a large number of diverse customers, to whom they offer many products through a range of channels. So, eliminating complexity completely is not an option for these financial firms.

Five important sources of complexity for the industry are explored in the report: regulation, channel proliferation, systems fragmentation, product proliferation and geographic expansion.

In order to reduce the costs of complexity while retaining its benefits, five measures are recommended for financial firms to manage complexity better:

Use common metrics for the core financial and non-financial metrics that measure complexity, available to all decision makers, to develop self-knowledge of the financial institution and its customers.
Use advanced statistical analysis and analytical decision-making culture to make tactical decisions involving increasingly complex trade-offs, drawing on the explosive growth of information created by in-house data systems and social media.
Automate or standardize core processes, taking advantage of rapid advances in technology such as artificial intelligence.
Delegate decision-making to those closest to the subject matter who therefore have the best information.
Build a strong corporate culture that supports consistent conduct standards without the need for micro-management.

Key Findings on the Cost of Complexity Include

Average returns of large financial firms have fallen from over 20% in the early 2000s to 7% in 2013, the level of utilities companies

Returns of the 8 American and 16 European banks designated GSIBs (global systemically important banks) have declined by 70% since 2006

Oliver Wyman estimates that between 2 .5% and 3.5% of North American, European and Australian financial institutions’ total costs come from meeting the elaborate new regulatory guidelines, that equates to US$0.7-1.5 BN per annum for the coming 2-3 years for large financial firms

The average bank in the US and Europe now has five board committees overseeing risk/compliance, whereas before the crisis the average was less than three

Over the last 15 years, within the top 100 global corporates, there have been more M&A deals on average in the financial industry than in any other, which has exacerbated IT fragmentation

An expensive growth of middle management has been another cost of increasing complexity. For example the number of banks in the US has fallen by 45% since 1993 while the number of employees grew by 15% over the same period

1Why is it important for financial firms to focus on managing complexity now?

Regulators and supervisors in Europe and the USA have identified this theme as one of the key risks facing the banking system today and have acted on imposing additional capital requirements. In addition, investors and equity analysts have identified complexity as key issue for large financial services groups as recent investor reports have demonstrated – there is doubt in the investor community that large institutions can reap higher benefits of scale that outweigh the capital charges. Reducing complexity and shrinking maybe part of the answer. However, the benefits of globalization and risk diversification demanded by investors mean that institutions must tackle complexity and deliver higher synergies then in the past.
2Of the five measures which can reduce the costs of complexity, which has the most significant, sustainable impact over the long-term? Which measure can deliver the highest benefits in the short-term?

Short-term impact can be best realized through the systematic deployment of analytics and big data in the organization – recent experience from the insurance industry suggests that net profit uplifts of 10% can be achieved. The highest long-term impact will come from process standardization and automation as well as downward delegation of decisions which leads to reducing the layers of middle management organizations historically relied on – however this cannot be achieved without a strong culture and a consistent view of the organization.
3Some examples of efficiency gains that can be achieved by managing complexity are?

• Better optimization of channel mix and customer targeting through analytics
• Identification of segment specific pricing issues through real-time information processing of new business based on big data
• Better sales in commercial and private banking enabled through hand-held devices allowing real-time exchange of information and front line data and sales ideas collection
• Significant scalability, flexibility and cost reduction of processes through standardization while achieving higher robustness, service standards and lower operational risk though standardization exercises
• More robust decision-making through common information across a streamlined set of committees and accountabilities
4What is a key indicator of a financial services company that is appropriately complex versus one that is overwhelmed by its complexity?

The number of middle management roles, specifically if these increased year by year in the past decade, as well as layers between the top and the bottom of an organization.
5What generally seems to be the most challenging aspect of a complexity management program for financial firms?

Finding the appropriate starting point and making it a core part of the CEO’s agenda. Our client survey indicated that some have complexity reduction or management programs but they are too low down in the organization (often IT and operations-driven). These programs almost all failed as they only addressed some of the 5 key dimensions on making complexity manageable. Any program needs to address these in unison. That requires not just the elevation to a core item of the CEO’s agenda, but also for the program to be driven by the CEO or CFO.