Trimming the Fat

There’s good news for bank directors in the cost-cutting arena: The day of the slash-and-burn, scorched earth policy is over. Mostly, anyway.

Not too many people want to remember what happened almost 20 years ago, when banking and S&L deregulation began and the first mergers and acquisitions were announced. Each promised “synergy,” new opportunities for customers, greater profits for shareholders. Everyone wanted to jump into the fray as quickly as possible, taking advantage of strategic opportunities to create the bank of the future.

And everyone wanted to cut costs, particularly personnel, without actually saying so. Middle managers were particularly hard hit, especially the hoards of vice presidents who had worked their way up from the teller ranks.

Employees were promised they would keep their jobs only to lose them weeks or months later. Worse, invariably employees of the acquired or “conquered” banks were the first or only ones to go. If technology and operations didn’t merge well, or at all, customers weren’t sure what to expect and took their business elsewhere.

What made cuts from this period particularly savage, everyone agrees, were their arbitrary nature, particularly the not-infrequent dictates from management that “all expenses must be cut across the board, no exceptions.” That may have helped in the short term, but such philosophies further undermined loyalty and undercut long-term strategic planning.

Of course, bank directors were forced to stand by as analysts and the media trashed the mergers and strategic alliances, and stock prices responded accordingly.

Bank of New York and Irving Trust? Wells Fargo and First Interstate? Thank goodness the public has a short memory.

But just because the chaos is over doesn’t mean the need to cut costs has subsided. Some of those early mergers may have been painful, but most agree that what was cutu00e2u20ac”jobs, duplicative functions, and buildingsu00e2u20ac”well, that was the easy stuff.

Those cuts will continue as long as banks are consolidatingu00e2u20ac”as they must if they are to compete on an even playing field.

The question that senior bank managers need to address, analysts say, regards other kinds of cuts that may actually provide them with a competitive edge. Clearly, there’s plenty of work to do.

“I think there’s a lot more that can be wrung out,” says Rodgers L. Harper, managing vice president of First Manhattan Consulting Group in New York. “That’s partly because banks have better information about what sales and service-delivery costs equate to value in customers’ minds and can cut selectively.”

Others agree. “I think there’s still a tremendous amount of cost cutting in the system,” says Katrina Blecher, a banking analyst with Gruntal & Co. in New York. “You’re going to see it through the continued merger and acquisition activity, of course, and beyond that, you’re going to see it as we reduce the total number of multibank holding companies, which, in itself, implies the ability to eliminate numerous duplications. The point is that you can’t stop looking: Bankers and bank directors need to be assiduous about this.”

Worshipping false idols?

By no means have banks forgotten the need to keep an eye on costs. The news is filled with recent examples, such as NationsBank Corp.’s announced layoff of 6,000 jobs following the Barnett acquisition and Citibank’s announcement last December that it would restructure, letting 7,500 people, or about 8%, of its worldwide work force go. These followed an October announcement by BankBoston Corp. about its own restructuring plans. Late last year, when Cleveland’s National City outlined its plans for buying First of America, it said it would save $243 millionu00e2u20ac”30% of expensesu00e2u20ac”and increase revenues by $65 million, all within a year. And in April, Chase Manhattan Corp., announced it would cut 4,500 jobsu00e2u20ac”6.5% of its workforceu00e2u20ac”in an effort to streamline its operations.

Moreover, the industry hasn’t completely abandoned its three-year-old interest in these widely publicized “restructurings.” Such corporatewide efforts are sometimes designed to tighten or streamline a company’s focus but always end up including layoffs and other cost-cutting efforts. Invariably these programs come with titles suggesting a grand strategy such as “Focus 59,” “Best,” “First Choice 2000,” “Vision,” and “Project Excellence Plus.” According to Keefe, Bruyette & Woods, at least two such programs were launched last year, one by Comerica in January, the other by Signet Banking Corp. in June.

What these announcements indicate is that financial institutions are working feverishly to lower their efficiency ratios. The ratio simply measures, in percentage terms, how much it costs for a bank to make $1 in revenue. It is calculated by dividing total overhead by total revenue.

According to SNL Securities, North Fork Bancorp. in Melville, N.Y. had the best efficiency ratio last year at a rock-bottom 35.87%; University Bancorp in Sault Ste. Marie, Mich. had the worst at 107.11%. (See figure.)

“The average efficiency ratio for the largest banks last year was 58.5%,” says David S. Berry, director of research at Keefe, Bruyette and Woods in New York.

“Banks have done an adequate job of improving their cost structure over the last five years,” says Steve Tomasi, director of research at SNL Securities in Charlottesville, Va. “In this period, the industry has seen a 700 basis point improvement in their efficiency ratio, adds Tomasi.

“But I’m cynical,” he adds. “There’s no question that banks still have a long way to go. The bottom five banks’ efficiency ratios are horrendous. Their return on average equity is horrible, too.”

Why is the ratio used as a measure of cost cutting? Because of its expense component. Needless to say, anything a bank can do to reduce its expenses means it costs less to make money.

In fact, the efficiency ratio is “the only real way that analysts and shareholders have to monitor bank expenses,” notes Blecher. It replaces the expense ratio of old, now widely fallen into disuse, and is considered more valuable due to its revenue component. Management’s constant goal: to lower the efficiency ratio as much as possible, which it can do either by decreasing expenses and/or increasing revenues.

Not surprisingly, just about everybody watches efficiency ratios, if for different reasons. Analysts use it as a number that helps bolster their recommendations; bank management watches it with its board of directors and shareholders in mind and to benchmark its own performance; and possible investors are trained on it, as are other banks, looking for mergers and acquisitions opportunities.

Still, the ratio is not the “be all, end all,” analysts caution. “Anyone who’s worshipping at this altar is worshipping a false god,” says First Manhattan’s Harper. “It is a misguided investment tool if you’re using it for comparing one bank to another, because it doesn’t factor in differences in business mix, pricing, or capital structure.”

Others give it more credence. “A lot of people have been looking at their efficiency ratios for the last three, four, five years,” says Robert C. Colvin, managing director of the community bank division at Sheshunoff Information Services in Austin. “They’re focusing on it more as improving return on equity becomes increasingly important.

“If you’re going to use efficiency ratios you want to look at them to compare peer banks,” he says. “As your peer numbers go down you want to stick with them. If my efficiency ratio is X, yours is Y, and the industry’s is Z, I’m going to compare mine with Z. The industry is constantly benchmarking itself, and the regulators are doing the same. Bottom line is that everybody wants to know what it costs to make a buck.”

Adds SNL’s Tomasi: “Obviously banks with a consumer focus will have a higher cost structure, so those analyzing efficiency ratios should make sure they select their peer competitor targets appropriately.”

Room to grow

Ideally, banks should be working on improving both components of the efficiency ratio simultaneouslyu00e2u20ac”cutting costs and improving revenuesu00e2u20ac”to improve stock performance. But they don’t always seem to be doing that: At any given time they appear to focus primarily on one or the other.

If a bank’s business is stagnating or not growing at desired or projected rates, it turns its attention to cutting costs first to calm investors and Wall Street. That seems to have been Citibank’s intention, for example, when it announced its restructuring program last December. At the time, Citibank Chairman John Reed’s reason for the restructuring was declining profit margins and intensifying price pressures in “virtually all markets.” Analysts said they wanted to see the bank’s 56.5% efficiency ratio about six and a half basis points lower. Chase’s recent announcement said its reorganization would bring $460 million in annual savingsu00e2u20ac”no small chunk of change, even for the nation’s largest financial institution.

These programs are a “continuation of a trend that’s gone on for some time in the industry,” Raphael Soifer, an analyst at Brown Brothers Harriman & Co., commented. “There is a continuing stress on efficiency given that revenues have been sluggish.”

“One problem with cutting costs as the primary goal is that it creates only a one-year gain,” says Gruntal & Co.’s Blecher.”This is a one-year pop.”

Of course, if a bank and its business lines are growing robustly, then there’s little need to concentrate on cutting costs, because the efficiency ratio will improve naturally as fixed costs are spread over a greater revenue base. “One of the ways to measure who has been best at this is to look at increases in net interest income over a span of time,” says SNL’s Tomasi. “You can see that it’s difficult for banks: between fiscal years 1992 and 1997, the average increase for net interest income was just .85%. For 20 or 30 banks, net interest income actually decreased.”

Western Bancorp., a $1.4 billion bank in Newport Beach, Calif., did the best job in this period, Tomasi says. Its net interest income increased 20%. Next best: $322 million Atlantic Bank & Trust in Boston, whose net interest income increased 7.9%.

“Revenue growth is difficult in the industry because so much

of bank profitability is owed to the deposit business, and deposits have not grown in the past decade in any measurable sense,” KBW’s Berry points out. “There’s a limit to what you can do with interest rates.”

“We still see a lot of emphasis on cost cutting, but growth will become a much more prevalent consideration in the future,” predicts Sharon Weinstein, an analyst with ratings agency Fitch IBCA in New York. “For capacity and scale reasons, growth must be the focus.”

Earlier in this decade, banks’ efforts to improve their operating efficiency came mainly on the cost side, according to a report issued by KBW in February. “Many banks were focused on lowering costs, with numerous companies undergoing restructuring efforts. Today, banks’ efforts to continue improving their efficiency measures focus more on revenue growth [which] has been healthy for many banks, particularly on the fee side,” states the report.

Finally, and perhaps most important, banks can, in effect, cheat their way out of efficiency ratio concerns simply through mergers and acquisitions. When banks make an acquisitions in new market, typically their expense savings totals 25% of the acquired bank’s expense base; it can be as high as 50%, however. (With the recent NationsBank acquisition of Barnett, projected savings are likely to be as high as 55%.)

“Since compensation is 50% of noninterest expense for an average bank, tremendous efficiency gains are realized in overlapping markets during consolidations,” SNL’s Tomasi notes.

“Acquiring companies are able to spread costs over a larger base of customers and build scale and revenues,” the KBW report says. “Potential revenue enhancements have become more important in recent transactions. In addition, in recent years, acquiring companies have become more successful in realizing expected expense savings quickly and increasing the level of realized savings.”

Mixed reviews

Regardless of how banks work to improve their efficiency ratios, results to date have been mixed. Over the past three years they’ve been coming down (as have expense ratios). For instance, banks with assets of $25 billion or more had an average efficiency ratio of roughly 62% in the fourth quarter of 1994; by the third quarter of 1997, that average had fallen to 58%.

For banks with assets between $10 and $25 billion, the ratio fell from almost 64% to 59% in the same period.

The banks’ reengineering efforts have had mixed results at best; many were outright failures. “They started falling out of favor about two years ago,” notes analyst Blecher. “They’ve been a massive disappointment. That’s because they’ve revolved around the old slash-and-burn philosophy, with 20% across-the-board cuts.”

Adds Sheshunoff’s Colvin: “Often these haven’t worked because management sets unachievable targets, and the people down the line know it. They don’t want to fail so they say, ‘Here’s what I can do at no risk, here’s what I can do at a little risk,’ and so on, so you don’t get the results you need. [They] simply don’t pony up as much.

“For these reengineerings to work they need to start with the line people, from the bottom up, determining what they need to do that’s crucial to the mission…. Unfortunately, that’s rarely the way it happens.”

Concludes KBW’s study: “Reengineering may be good to shake up stagnating corporate culture, but it would seem that whatever problem that led a company to reengineer is still there when the reengineering is done. We think that’s why there’s been a higher incidence of sale at reengineered companies than at others.”

Last year Firstar discovered how tricky it is to successfully launch a reengineering program, in its case called “Firstar Forward.” After three quarters of failing to meet analysts’ earnings estimates, Salomon Brothers downgraded its recommendation from buy to hold, and the bank’s stock fell immediately on a day when other bank stocks surged.

Have shareholders benefited either from reengineering efforts or the constant short-term focus on efficiency ratios? Analysts offer somewhat differing views.

“Whether shareholders have benefited depends on the nature of the transaction and the competency of management,” says Fitch IBCA’s Weinstein. “Generally, I’d say results are mixed.”

Others offer a more upbeat assessment. “I do think investors have been rewarded; the benefits have not been short-term,” says Tomasi.

Says KBW’s Berry: “There’s no question that for investors, better efficiency has translated into higher returns and less variability of earnings as a result. But we can still do a hell of a lot better job.”

The long and winding road

Meanwhile, many banks continue to have no long-term strategy for continuous cost cutting and strategic planning. Simply put, long-term cost cutting has been lost in the continuous frenzy of merger activity and the preoccupation with efficiency ratios.

“It’s easy to get caught up in a 10%, across-the-board cutting mentality,” notes Tomasi. “By definition that flows from a short-term outlook.

“Unfortunately, those who follow that approach often end up making the wrong cuts and end up losing revenues in the process,” he says. “It’s imperative that cost cutting be aligned with a long-term strategic plan, and this isn’t always the case.

“Of course,” he continues, “the reengineering programs themselves are not long-term in nature. They implement these, often conclude it’s difficult to continue cutting expenses once the reengineering is done, and turn their attention to increasing revenue through acquisitions, repricing their programs, improving service, and offering a new slant.”

One result: If revenues increase, costs creep up at the same time. “In a growing market where revenues are out of control, you’ve got to keep your expense structure in place,” says Tomasi. “Unfortunately, there’s a tendency to provide excess capacity. The focus on capital expenditures should be on the technology and delivery side, not on the human resources side. With the efficiency ratio, you want that net interest income, the denominator, to grow and the costs, the numerator, to shrink or keep constant.”

KBW’s Berry says that often what’s missing “is a long-term mindset to cut costs. Your attitude and efforts should be focused on continuous improvement in cutting costs, not on any particular cutting program. You need to live [with] those cost improvements rather than doing business as usual and saying, two years later, that costs are out of control. That’s no good for shareholders or employees.

“I’m much more impressed with a management that has a great efficiency ratio and never announces a restructuring program,” Berry says.

Back to basics

Lost in the debate about efficiency ratios is any concrete steps banks should be taking now to continue making effective, long-term cost cuts that will benefit customers and shareholders without driving employees away.

Some industry observers argue simply that banks have done as much as they can: What they started in the 1980su00e2u20ac”cutting staff, buildings, and overlapping functionsu00e2u20ac”was enough; anything more would simply provide incremental gains to the bottom line. In any case, new technology and continued merger and acquisition activity, by spreading costs, will assist with the rest. The nascent development of electronic check presentment, electronic home banking, and smart cards are all examples, experts say.

“Without a merger, there’s only so much you can do to lower costs without lowering employee morale and productivity,” says Fitch IBCA’s Weinstein.

Adds Sheshunoff’s Colvin: “Unquestionably, in human resources, banks have cut back to the bone.”

Others say that banks can still make considerable progress in cutting certain specific costsu00e2u20ac”for example, occupancy costs, which account for about 10% of total bank costs, can get out of hand when consolidation creates excess building inventory or inattention to building space allocation standards.

But bankers may have another alternative that would require rethinking and redesigning customer acquisition and service delivery processes. The idea is that costs should be built around customers and what they’re willing to purchase. If customers want a product and are willing to pay for it, hire the appropriate staff, rent the necessary office space, buy the needed equipmentu00e2u20ac”and get rid of everything else. In effect, a customer-up approach rather than a bank-down approach.

A good example is procedures that’s already being utilized, eliminating the return of checks. Today many banks are simply informing customers that they will no longer receive returned checks unless they request them; in a customer-driven model, services like this and the accompanying bank bureaucracies would be eliminated if customers chose not to use those services or pay for them.

“What you’d be doing here is marrying superior information, technology, and analytical skills with existing cost-cutting measures,” says Harper. “If banks went this way, CEOs concerned about efficiency ratios would breathe a lot easier.”

Banks are already assembling some of the tools that are necessary to make this happen, but they’re being developed in a vacuum. For instance, many banks are engaged in better determining who their existing customers areu00e2u20ac”how many accounts they have, what might be the next product they would buy, whether they’re profitable currently and, if so, why. Right now, though, that’s being done strictly as a marketing mechanism geared to increasing cross sales.

According to Tomasi, those efforts hurt in the short-term but make sense, long-term. “The pressure for banks to provide multiple retail delivery systems, as well as state-of-the-art technology, has negative implications for the efficiency ratio in the short term,” he says. “When you have Wall Street saying ‘reduce expense ratios,’ the banks have to say, ‘I’m going to swallow hits to the ratio today so I can be a player in the year 2000.’ If they don’t do something themselves, they’re going to be bought up.”

Taking cost cutting and cost analysis a step further, First Manhattan helps banks determine individual customer profitability by assigning them, or at least groups of them, their own efficiency ratios. If the customer’s or group’s ratio isn’t what the bank wants, then the bank will have to sell them additional products or price them out of the bank, because they are, in the final analysis, another cost to be cut. “Every bank is striving to get efficiency down to the customer level,” says Tomasi. “Right now they’re struggling just to get it down just to the branch level.”

Of course, retaining profitable customersu00e2u20ac”those with a desired efficiency ratiou00e2u20ac”would carry forward, helping restructure the bank through their product and pricing choices.

Which raises an interesting question: What if Wall Street and shareholders were to assign senior bank managers and board members their own efficiency ratios and include those in analysts’ reports? Food for thought.