Disadvantages of overlooking expense management
A bank's profitability comes down to charging the right fees for the services it provides. This sounds simple, but any attempt to understand a bank's cost structure in detail soon reveals just how complex it is. The costs of doing business - not least transactions elements such as clearing and exchange fees - constitute a big expense, and getting a clear view of them across many markets and relationships is no easy feat.
Addressing this challenge is, however, becoming more important than ever. Judging by the number of banks that have raised their fees during the past year, it would appear that the costs of running a bank are on the rise. Increased regulation certainly imposes a cost burden but, as new entrants into financial services come to challenge the incumbents, it is essential that the established players focus on delivering efficient services at competitive prices that maintain profitability. In this environment, focusing on expense management could deliver a big win.
"A major issue for banks is that the nature of their expenses is diverse. It is a complex ecosystem across different entities and regions. The operating model to manage it requires substantial investment so there is a cost incurred to bring it into line. That creates barriers across the organisation, and there is limited transparency and a lack of accountability in terms of who owns certain costs. That prevents banks from realising savings," says Bharat Malesha, executive vice-president of fees and expense management at SmartStream Technologies.
"It is important for the CEO or heads of trading to understand that their business generates different returns and that they must measure client profitability; for example, by knowing what to charge their customers. During the past five years or more, most of the investment dollars have been going towards regulatory projects, so expenses management has been put on a back-burner. But it is a major expense on the P&L - one of the biggest - so even though banks have not been very interested in it, they have started to look at it more closely in the past two years. After all, the bottom line is heavily driven by it," he adds.
Counting the costs
SmartStream is a global software and managed services provider that serves more than 1,500 clients in the financial markets sector. It assists more than 70 of the world's top 100 banks, as well as many leading asset managers, custodians and broker dealers. Its core focus is the provision of post-trade processing solutions and data-management services that enable a real-time and pre-emptive approach to reducing trade failures. When it comes to fees and expense management, the company provides transparency around costs through the forensic analysis of data in order to help financial institutions understand the true cost of providing services, down to individual transactions.
"Having a clear matrix of costs is essential. It enables you to see which customers are profitable, for example, and it is important to measure business profitability and get a clear view of where margins are squeezed. There is a need in the industry to implement solutions to optimise expense management and rationalise operations, which will improve cost transparency. There is a real opportunity to improve efficiency and controls," says Malesha.
The proper management of fees and expenses is critical to achieving financial targets and ongoing business profitability, and it requires a clear view of the core costs of banking, which are mainly accounted for by brokerage, clearing, exchange and custody (BCE) fees. These alone can cost hundreds of millions of dollars each year. Beyond BCE, however, there are other costs that have a significant impact on profitability.
"Market data fees are a big component of costs. Banks use many different market data vendors, and it is important that you calculate these costs and allocate them to the right client accounts. A large bank with, say, $2 billion in expenses may be spending 25% of that on market data fees. It's a cost of doing business. Organisations are limited by BCE and market-data fees, and by labour-intensive customer processes," Malesha explains.
While hikes in bank fees suggest that banking is an increasingly expensive business to be in, the situation seems different from SmartStream's perspective.
"With our clients, we see their effective rate of doing business across specific floors, and we observe that the cost is falling as they mature in terms of their strategy, and a more automated and optimised model. We see more internal cost-efficiency and the ability for them to pass that advantage back to their clients because they have better effective rates of execution for customers. There is a clear advantage in working with us to manage costs," Malesha says.
"Most banks are straightforward in terms of their execution flow. There is no difference between them. So, we can assess volumes, client fee structures, costs on the ledger and so on. Then we work up to transactional data at the trade level. We consolidate rate cards into a single repository that gives the cost per unit across agent banks, brokers and exchanges. We can then see the biggest pain points and where the volumes of trade are. That gives us a view on how we will approach automation and optimisation."
One of the biggest challenges in realising these efficiencies in any financial services organisation is the quality of data. SmartStream's experience in dealing with banks' data flows has enabled it to develop ways to identify all sources of data for completeness and then integrate that data into a form that provides the necessary transparency to start looking for efficiencies. Data flows and processes can differ greatly by region, for instance, but SmartStream investigates data sources to identify gaps, and uses its own tools to bridge those gaps and clean the data.
"We validate the data against invoices, compare volumes and look at external sources such as copies held by exchanges. For instance, in forex options or rate products, the trades are done in such a way that you don't know what trades make a spread or a butterfly. We conduct forensic data analysis using our tools to identify the structure within those trades. That is how we can rationally identify what the opportunities are for savings when analysing a book of work," Malesha remarks.
"We take clean and standardised data for an enterprise-wide view of an organisation's spend. We can look at the transactional level, then slice that data in any way - by trader, entity, region, market, client and so on. All of the data is held in a central repository, so the client can go in, and slice and dice it in any way they want. The CEO might look at the spend in a month and compare the effective rate with previous months in order to make forecasts. The desk heads might look at the daily flow to an exchange to optimise flows, or reach a discount tier with a specific broker."
Follow the data
As one example of how savings can be made through a clear view of trading data, Malesha imagines analysing settlement and custody fees for settling with an agent bank. If settlement with that bank does not happen via straight-through processing (STP), then it will cost substantially more. Whether or not it happens through STP is determined by the reference data the agent bank maintains for the client. Some accounts are tagged as STP or non-STP depending on arrangements such as whether the bank has the power of attorney to run the account on behalf of the client.
"If that information is not set up correctly, then the agent bank might be billing incorrectly. It could be billing for more non-STP transactions than it should. In some cases, we saved up to 10% on bills just by looking at the reference data. Another option is to do structured negotiations on the basis of volumes. It is about optimising flows to take advantage of what is available on the market and what you can negotiate," he explains.
The advantage of managing BCE and other major costs through an enterprise-wide view of fees and expenses - and a consolidated and consistent set of data - is clear. It may require some significant investment in systems and integration but it is part of a back-office overhaul that, in many cases, is long overdue. SmartStream is focused on back-office operations such as reconciliation, cash and liquidity management, collateral management, and reference-data utility, and its work on expenses management dovetails with its aim of providing additional value to the front office.
Build a better model
Nevertheless, SmartStream is already looking beyond the enterprise-wide view of transaction data. The next step is the utility model, in which a number of participants from among the biggest financial services providers can unlock economies of scale through automation and integration.
"We are trying to create an operational utility because every bank gets standardised information, such exchange-fee schedules. Someone has to read that information, understand it and render it electronically. Standardisation does not change across banks so we could do it centrally as a service to all of them. Banks could make more savings as part of a bigger ecosystem. You can multiply those savings across many exchanges in many regions. We can drive the standardised reporting back to banks and interoperate with them as a middle layer between two parties," says Malesha.
"We are already creating that utility. We can focus on specific asset classes. It will ultimately evolve as a utility in many areas of fees because of the commonality across banks. We also have the platform to adapt to different accounting models. Building that utility model is about creating awareness of the challenges and showing banks that it is a problem they need to solve. The ownership of fees is very fragmented across business entities and geographies so it needs a global CFO to view the problem at the enterprise level in order to drive cost-efficiency. Some banks have achieved that already and we have six banks using our utility model, so it is building momentum. More organisations are seeing the advantage and are looking to follow the leaders."
Focusing on fees and expenses management could play a big part in keeping banks competitive while also boosting profitability. Through the utility model, it could also fuel the engine of cooperation and collaboration that has been starting to spread throughout the industry as it recognises that the biggest challenges are often best met with concerted efforts. It could be time to take the issue from the bank-burner and move it to the top of the agenda.