Financial Services EUROPEAN RETAIL AND BUSINESS BANKING LAYING THE FOUNDATIONS FOR RECOVERY

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1 Financial Services EUROPEAN RETAIL AND BUSINESS BANKING LAYING THE FOUNDATIONS FOR RECOVERY

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3 CONTENT INTRODUCTION 1 1. CURRENT MARKET PERFORMANCE 2 MARKET DEFINITION RETAIL AND BUSINESS BANKING PERFORMANCE 2 2. PROGRESS REPORT AND MANAGEMENT AGENDA 7 LOOKING BACK: AN INDUSTRY REPORT CARD 7 LOOKING FORWARD: THE AGENDA FOR COUNTRY DIFFERENCES 9 3. THEMATIC PERSPECTIVES LIVING WITH LOW INTEREST RATES TRANSFORMING SMALL BUSINESS BANKING 13 I. ESTABLISHING BEST IN CLASS NPL MANAGEMENT 13 II. END-TO-END LENDING PROCESS REVIEW 14 III. SMARTER ORGANISATIONAL AND OPERATIONAL SEGMENTATION SCHEMES 15 IV. DIGITALISATION OF THE SMALL BUSINESS OFFER DELIVERING IMPACT VIA IMPROVED CUSTOMER EXPERIENCE 18 CASE EXAMPLE MOBILE PAYMENTS 20 CONCLUSIONS 22 REFERENCE MATERIAL METHODOLOGIES 23 REFERENCE MATERIAL TERMINOLOGIES AND SCOPE 24

4 INTRODUCTION It has been another challenging year for European retail and business banking. Macroeconomic headwinds exist in most of the Eurozone countries and loan losses remain a big issue in many markets. Lower interest rates provide a further drag on balance sheet profitability and the impact of conduct regulation has been more noticeably felt. As a result, 2013 profits were slightly down on 2012 in European retail and business banking. Despite this, we see a good return on equity (ROE) after adjusting for the many one-off Profit and Loss (P&L) impacts and regulator fines in the retail and business banking market as a whole, and opportunities for further improvement. We also observe widening differences across markets, ranging from rising returns in the UK and Swedish markets to weakening returns in Spain and Italy. While we see a common set of themes relevant for European retail bank management teams, their importance and prioritisation differ markedly across countries. At one extreme, challenges from regulation and changing customer behaviours provide both risks and opportunities for growth, whereas in the most crisis-hit European markets, low interest rates and credit loss management provide the biggest challenges. This report builds on last year s publication An opportunity for a renaissance and on the research and experience of Oliver Wyman consultants to provide an updated view of the underlying economics of Europe s largest retail and business banking markets, their resulting outlook and management agenda, and some emerging best practices in managing these issues. The report is structured into 3 sections: 1. Current market performance: a detailed, country level review of European retail and business banking profitability and the underlying drivers 2. Progress report and management agenda: an updated perspective on progress against last year s management agenda and a view on today s priorities by market 3. Thematic perspectives: Oliver Wyman s views on emerging best practices in three of the major challenges facing European retail banks in the next 3 5 years 3.1. Living with low interest rates 3.2. Transforming small business banking 3.3. Delivering impact via improved customer experience Copyright 2014 Oliver Wyman

5 1. CURRENT MARKET PERFORMANCE MARKET DEFINITION This report uses a broad definition of European retail and business banking: Customers: including both individuals and small businesses (less than 25 MM turnover), excluding private banking Products: core banking products (current accounts, savings, mortgages, loans, cards), bancassurance and investments Countries: focus on Europe s largest markets: France, Germany, Italy, Russia, Spain, Sweden, Turkey, United Kingdom For more details see the methodology section at the end of this report RETAIL AND BUSINESS BANKING PERFORMANCE Retail and business banking profits declined slightly in the markets covered in our study, driven by declines in net interest margin (NIM) and increases in credit loss provisions in several markets. Exhibit IN %, TOTAL 1: Retail IN and BN business banking profit before tax over time (in %, total in BN) 23 UK Turkey Sweden Spain Russia Italy Germany France Source: Oliver Wyman Analysis 2

6 Exhibit 2: European retail and business banking revenues (in %, total in BN) IN %, TOTAL IN BN UK Turkey Sweden Spain Russia Sweden ALM revenues Retail investments Bancassurance Small business liabilities Savings Current accounts Small business assets Italy Germany Spain Overdrafts Credit cards Personal loans France Mortgages Source: Oliver Wyman Analysis At a segment level we saw a proportional increase in revenues across the small business and individual segments and at a product level we saw asset products increase their share of revenues to growth in volumes and some improvements in margins due to lower funding costs (albeit mainly offset by a corresponding decline in retail deposits). During 2013, we saw a mixed picture in terms of ROE performance with large declines in Spain and Turkey and slight improvements in UK, Russia and Sweden with flat year on year performance in other markets. Exhibit 3: Retail and business banking ROE over time and across our European sample IN % France Germany Italy Russia Spain Sweden 15.1 Turkey UK Note: RoEs normalised with capital calculated as a percentage of RWAs, represented by the average of the Top 5 banks Core Tier 1 ratio in each country. ALM margin has been included in the total ROE calculation. UK figures excluding PPI redress Source: Oliver Wyman Analysis Copyright 2014 Oliver Wyman

7 Exhibit 4: Evolution of NIM, fees, costs, losses and capital across our European sample over time IN BN EVOLUTION OF NIM AND FEES*1 EVOLUTION OF LOSSES EVOLUTION OF COSTS +17% +9% -1% EVOLUTION OF CAPITAL REQUIREMENTS +18% 33% 34% 35% % 66% 65% Fees/N on interest income Small business Net Individuals interest income *1 ALM margin has not been allocated Source: Oliver Wyman Analysis In aggregate revenues, costs and capital were broadly flat versus last year but increased credit losses, in particular in the small business segment drove an overall decline in retail and business banking profitability in While costs remained flat in 2013 we continue to think that cost reduction provides the main lever for profit improvement in the near term in many markets. The Exhibit 5 below shows differences in branch network density and cost income ratio in retail and business banking. While we acknowledge that banking structures, customer behaviour and demand differ by market, the comparison across markets suggests that there is room for cost reductions in Germany, Italy and France in particular. We expect that a large proportion of this reduction will come from branch costs. Exhibit 5: Branch density across our European sample BRANCHES PER MM INHABITANTS Average Turkey UK Sweden Russia Germany Italy France Spain C/I RATIO IN % Source: ECB 2013, Oliver Wyman analysis based on the 8 largest European markets (Spain, Italy, France, Germany, UK, Sweden, Turkey, Russia) 4

8 Exhibit 6: Underlying profitability still varies significantly across European markets (in %) 2013 ROE POST TAX INDIVIDUALS France Germany Italy Russia Spain Turkey Sweden UK SMALL BUSINESS France Germany Italy Russia Spain Turkey Sweden UK France Germany Italy Russia Spain Turkey Sweden UK Note: RoEs normalised with capital calculated as a percentage of RWAs, represented by the average of the Top 5 banks Core Tier 1 ratio in each country. ALM margin has been allocated at segment level in the ROE calculation. UK figures excluding PPI redress Source: Oliver Wyman Analysis With the exceptions of Spain and Italy, underlying ROEs across European retail and business banking markets remain healthy, reemphasising the importance of this business to overall bank profitability and pointing to a more promising future for bank performance as legacy issues (non-core portfolios, legacy conduct provisions) dissipate in future years. Indeed we expect that retail and business banking will not only fuel the recovery of Europe s economies but will be the underlying driver of improving bank returns going forward. Exhibit 7: There are also notable differences between the retail and small business markets (in %) ROE AT SEGMENT LEVEL* 1 BREAKDOWN BY REVENUE SOURCE AND SEGMENT* 1 RISK ANALYSIS AT SEGMENT LEVEL ALM Servicing and third party distribution Liabilities NIM Asset NIM Individuals Small business Individuals Small business Total Individuals Small business Total 1* ALM margin has been allocated at segment level in the ROE calculation and revenue breakdown Source: Oliver Wyman Analysis Copyright 2014 Oliver Wyman

9 Exhibit 8: Profits across our European sample, 2013 France 0,5 0,4 Germany 0,1 1,0 0,1 Italy Russia Spain Sweden Turkey UK 0,6 0,8 1,2 Profits as % of GDP Profits per capita in Source: Oliver Wyman Analysis Adjusting for population and GDP we find that the markets analysed fall into four clear segments: UK and Sweden, having repriced their assets (due to the nature of mortgage pricing in particular), avoided large credit losses and aggressive market deposit pricing are the highest return markets on a per capita basis. Turkey and Russia have benefited from significant growth in financial services penetration (particularly lending) and good margins during this expansion period. So while profits are low on a per capita basis (in line with GDP/ head) profits/gdp is high relative to other markets. We note in Chapter 2 that this now coming under pressure. France and Germany have lower profit per capita and profits/gdp than the markets above due to a greater reliance on liabilities where margins have been pushed down by lower interest rates and slower growth and heavier cost bases have constrained profit enhancement opportunities. Spain and Italy have low absolute returns due to high credit losses and low structural margins due to legacy asset margins and squeezed liability margins. Exhibit 9: Drivers of bottom line profitability across our European sample ASSET MARGIN FRANCE GERMANY ITALY RUSSIA SPAIN SWEDEN TURKEY UK LIABILITY MARGIN SERVICING AND THIRD- PARTY DISTRIBUTION TOTAL REVENUE MARGIN (INCL. ALM) COST: INCOME COST OF RISK POST TAX ROE Position relative to European average: Worse than European average At European average Better than European average Source: Oliver Wyman analysis based on the 8 largest European markets (Spain, Italy, France, Germany, UK, Sweden, Turkey, Russia) 6

10 2. PROGRESS REPORT AND MANAGEMENT AGENDA In last year s report we identified eight challenges for retail bank management teams. Here we first look at how banks have performed against these, followed by how this agenda has changed both at a European level and at a country level. LOOKING BACK: AN INDUSTRY REPORT CARD The Exhibit 10 provides a qualitative assessment of banks performance in addressing the 2013 management challenges. Performance has been strong in some areas, noticeably investing in digital technology and taking action to manage non-performing loans. In other areas performance has been less effective, in particular in cost reduction (due to underlying inertia and the costs of managing in difficult times) and customer experience delivery (due to both a lack of capability and organisational mind set, and long cycle times of the required process and service improvements). Exhibit 10: Performance assessment of 2013 management agenda 2013 MANAGEMENT AGENDA PERFORMANCE (1* 5*) RATIONALE A. Respond proactively to regulatory pressures, particularly around consumer protection and conduct B. Embrace changes in the structure and role of the branch network ** Low priority in crisis markets Good progress in tackling known issues in non-crisis hit markets (e.g. UK, Sweden); Proactive action is still the exception rather than the norm UK with much more progress than continental Europe given the presence of a conduct-focused regulator *** Acceleration of branch planning activities forced by customer behaviour and pressure on costs Mixed action on branch numbers due to political pressures and uncertainty over optimal timing Some innovative thinking over formats, staffing levels, workflow; but the beginning of a longer change towards smaller less heavily staffed branch networks C. Take on the cost base ** Progress has been too slow Costs grew in line with revenues in many markets and only declined slightly in aggregate despite a clear imperative to do so D. Commit to digital **** Huge investments across Europe E. Prepare today for interest rate rises tomorrow Broadening of spread between the best and the rest Much more to do in small business banking * Lower urgency in Eurozone than a year ago vs. dealing with low rates today (and tomorrow) F. Manage the NPL challenge **** High priority from necessity G. Question foreign market participation and the home-market regional mix H. Sharpen customer segmentation and proposition delivery A multi-year challenge and high on the agenda of all banks **** Good progress made Multiple exits or strategic reinforcements Further action expected ** Good progress made but much more to do on developing compelling segment propositions with attractive economics Copyright 2014 Oliver Wyman

11 LOOKING FORWARD: THE AGENDA FOR months on, it is now time to recast this agenda. We suggest the following ten priorities for European retail bank management teams: A. Identify opportunities for profitable lending growth Markets with less structural issues, as the credit cycle begins to improve, there are likely to be opportunities for profitable lending driven by higher margins and lower risk levels. In an environment where there will also be political pressure to lend (in particular to small businesses), banks must ensure that they identify the profitable areas for new lending and grow in these areas, whilst ensuring that risk is prudently managed. B. Develop new fee based income streams Low interest rates put pressure on NIM (assets cannot be immediately re-priced and liability margins are squeezed). Growing fees (from bancassurance and retail investments in particular) provides an immediate opportunity to fill this gap. Our work with European retail banks suggests that improvements in basic processes and clarification of propositions to banking customers can provide significant benefits. C. Optimise deposit pricing using management science A low interest rate environment will put further pressure on deposit margins. In this environment it is important for retail banks to understand the relative costs of different sources of deposits and manage pricing to achieve the right balance between funding stability and profitability (see section 3.1 for examples of how banks have addressed this challenge). D. Use segmentation to differentiate customer propositions and experience Pressure on pricing from regulatory concerns and on costs means that greater segmentation of product and service levels by customer type will be required in many markets, particularly those where a generalist banking service and product range is provided to all clients. Better understanding of the economics by customer segment will result in more profitable propositions. Examples will include differentiating access to relationship managers, credit products and advice based on segment value. E. Transform distribution embracing digital channels and redefining the role of branches and call centres Cost reduction provides the best profit improvement opportunity in many of Europe s markets. Across most markets we see a steady decline in branch and call centre usage as the functionality of these channels is replaced by digital channels. F. Improve customer experience We see a simplification of product ranges and pricing structures in retail and business banking and regulatory pressure has reduced the impact of sales effectiveness as a performance lever. Increasingly customer experience will be used to differentiate retail banks, with points of dissatisfaction ( hassles ) being the most important aspect (see section 3.3 for more detail on this topic). G. Reduce costs in core banking operations Simplification and automation of middle and back office processes provides a significant opportunity for cost savings in retail and business banking and for improving customer experience at the same time. Many banks have yet to embark on this programme of work we note that those that have done so now have built a significant cost advantage, providing scope for improved margins or further price competition, thus putting pressure on others to follow. H. Embed conduct and values into day to day decision making Greater levels of customer centricity are required in retail and business banking to rebuild trust and respond to a regulatory agenda focussed on conduct. Where this has been a country focus, we have already seen major changes in banks policies and senior management decision making. However, further steps are still required to embed these changes into day to day decisions in the front and middle office. I. Maintain focus on NPL management and optimise via restructuring Non-performing loans remain a huge issue in some markets. While good progress has been made in terms of managing this issue, it will continue to remain a focus area. Going forward, we see more opportunities for restructuring in terms of loan sales or loan modifications, particularly where provisions have already been made, allowing this to be done with minimal capital impact. J. Transform small business banking Small business is a major source of credit issues and a major focus of policy makers to stimulate economic growth. It is an area that has received less investment than its consumer equivalent and suffers from cost and customer experience issues. Banks must transform their small business banking business models to meet the changing needs of their customers and improve the underlying economics of this business (See Section 3.2 for more detail on this challenge). 8

12 COUNTRY DIFFERENCES As observed above, we have seen a further segmentation of the markets in our study, in terms of underlying economics and outlook. Exhibit 11 shows our view on the importance of the different agenda elements for each market. For example, NPL management is only relevant in some markets (and a high priority there) whereas opportunities for significant lending growth do not yet exist in all markets. Exhibit 11: Management priorities across our European sample Revenue priorities Cost priorities UK, SWEDEN FRANCE, GERMANY SPAIN, ITALY RUSSIA AND TURKEY A. Lending strategy B. New C. Deposit optimisation D. Customer and and appetite income streams/fees product strategy E. Improve customer experience F. Distribution transformation G. Cost control Risk priorities H. Conduct I. NPL management Segment priority J. Transform small business banking Copyright 2014 Oliver Wyman

13 3. THEMATIC PERSPECTIVES This section expands on three specific challenges that sit across this agenda: 3.1. Living with low interest rates Eurozone interest rates have fallen and look set to stay low, in particular this provides challenges in terms of deposit margins. We look at how application of improved analytical techniques can help to manage interest margins Transforming small business banking Small business banking needs specific focus; it is an area of focus for most European governments as they look to boost lending to small businesses to generate economic activity (e.g. LTRO, FLS); it is also the least touched by digital transformation (a massive opportunity for better service at a better delivery cost) and the most affected by credit issues Delivering impact via improved customer experience As described above we see this as an increasingly important lever over financial performance in retail banking. Banks must prioritise their investments here wisely based on sound analysis LIVING WITH LOW INTEREST RATES Developments in the Eurozone have brought both short term and long term interest rates down and this has placed additional pressure on deposit margins across the Eurozone (Exhibit 12). Developments in 2014 suggest that interest rates will remain low for some time and so banks will need to learn to manage their retail and business banking businesses in this low rate environment. While banks will gain some benefits from increased asset margins, in many markets this will take a long time to take effect as 10+ year fixed rate mortgage products significantly slow the repricing speed of the bank s assets. Exhibit 12: Lending and deposit rates on new business over time NEW LENDING/DEPOSIT RATES IN % Rate for new lending Rate for new deposites 0 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Spread Note: New deposit rate: new business coverage of deposits with agreed maturity of over 1 year. Non-financial corporations, Euro area changing composition Source: ECB database. New lending rate: new business coverage of loans other than revolving and overdrafts, convenience and extended credit card debt. Non-financial corporations, Euro area changing composition 10

14 In addition to overall cost management (described above), deposit margin management is likely to provide the greatest opportunity for protecting and enhancing overall margins in a low interest rate environment. Fortunately, for many banks, deposit products have yet to benefit from the advanced analytical techniques applied to lending products (in part driven by capital management programmes) and so there are clear opportunities for better management of deposit margins across the different stages of the value chain. Exhibit 13: Overview of capabilities for deposit management From... traditional approach...to advanced approach Comments LOANS Paper based, credit decisions, case by case creditworthiness analysis Economics based on gross interest margin Credit decisions supported by comprehensive statistical analyses Advanced internal credit risk methodologies increased sophisication of analysis Economics moved to performance assessment on risk-adjusted returns Enabled by strong upgrade in statical capabilities applied to credit risk, and motivated by Basel 2 internal advanced methodologies for assessing credit risk DEPOSITS P&L focus Behavioural element typically considered at broad portfolio level, rarely used at more granular level (e.g. acquisition/retention marketing initiatives) Economics mostly based on mark-down vs. benchmark Funding value assessment basic and contractual based Holistic approach, fully addressing the P&L/funding value trade-off Economics based on careful assessment of opportunity cost Thorough management along the full value chain e.g. to avoid overpaying deposits in low elasticity clients segments Capabilities for full deposit understanding and analysis/ forecast still lagging behind Current status at most banks Source: Oliver Wyman Analysis The Exhibit 14 below outlines a set of capabilities that banks should be using to improve margins in deposit products: Exhibit 14: Suggested framework to improve profits deposit products FRAMEWORK More stable deposits Lower cost More deposits volume Higher % of stable POTENTIAL COMMERCIAL INITIATIVES Campaigns Pricing Products 1. Targeted marketing 2. Review pricing autorithy levels based on stability/ duration 3. Optimise pricing based on elasticity 4. Dedicated product offering 5. Active margin management More new customers More deposits from exiting customers of deposits Commercial initiative goal Source: Oliver Wyman Analysis Copyright 2014 Oliver Wyman

15 1. Targeted marketing campaigns Specific customer segments will be more attractive in terms of pricing or deposit stickiness and so marketing campaigns need to be targeted at the optimal segments. For example, many banks have actively targeted small business deposits in recent years to improve their overall funding mix. 2. Optimise authorisation levels Price discretion in deposit pricing is a major source of value leakage where customers are over-discounted either due to a fear of the customer leaving or as a reward for the overall customer relationship. Oliver Wyman s experience has shown that providing simple tools to manage pricing along with revised authorisation levels (this does not always mean more centralisation some pricing decisions can be made better locally) can provide significant improvements in realised rates. 3. Optimise pricing based on elasticity Many banks have developed analytical tools to understand the relative costs and sensitivities to pricing of different customer segments and products. This allows them to price the product suite to achieve the best funding mix and price for the bank overall. Differentiated pricing by segment, product and channel as well as carefully applied price discretion at the front line provide the levers for implementing the insights from these tools. Oliver Wyman s experience of working with banks on implementing pricing strategy and tools has shown that significant benefits can be delivered via very simple approaches e.g. product pricing bands for customer segments supported by a supporting tool for relationship managers. 4. Develop targeted products Based on the understanding of deposit value and customer behaviour by segment, banks should develop products tailored to the segment and funding objectives of the bank. For example we have seen the introduction of flexible longer term deposit products that meet customer needs for flexibility (e.g. the ability to withdraw funds in an emergency) and behaviourally meets the banks need for stable longer term funding (as most customers do not withdraw their funds). 5. Actively manage margins Market pricing and customer behaviour will change over time in response to macroeconomic conditions, reputational factors and the relative attractiveness of alternatives to deposits. It is therefore important that banks constantly monitor their funding and margins on deposits and look to adjust pricing to manage towards their targets. Analytical models that are updated regularly and provide projections of the impacts of price changes on volumes and profits are extremely valuable in supporting weekly price management and can provide early warnings of structural shifts in profitability where more holistic balance sheet management and pricing is required. 12

16 3.2. TRANSFORMING SMALL BUSINESS BANKING Small business banking is an area of heavy focus in European banking today. It is major source of credit issues in the weakest economies, but at the same time lending to small businesses is the focus of efforts by many policy makers to stimulate economic growth. A combination of cost and regulatory pressures are forcing many banks to revisit their sales and service models. Furthermore, the needs of the small business customer are rapidly evolving, as the expectations of business owners (in terms of channel access, connectivity of applications, speed of turnaround, etc.) are set by their experiences as a consumer. The current model has resulted not only in unsustainable credit losses, but also a cost base that is too high for the revenue generated. Furthermore, it is only tolerated by an unhappy customer base, that often feels that it is not receiving the service it has been promised, because of the lack of alternatives. In short, the small business banking model needs to be transformed. We would prioritise four areas for small business banking management teams: I. Establishing best in class NPL management II. End-to-end lending process review III. Smarter organisational and operational segmentation schemes IV. Digitalisation of the small business offer I. ESTABLISHING BEST IN CLASS NPL MANAGEMENT Small and medium businesses have been a major source of NPLs for many banks across Europe, and a significant backlog of lower value (particularly small business) cases remain unresolved. These cases must be tackled quickly and consistently. Both bank and the economy will benefit from the reallocation of resources post-restructuring or resolution, but it is imperative that individual customers are treated fairly throughout the process. However, small business NPLs demand a different approach employed in consumer or corporate lending. Neither the policy settlements used in the former (characterised by the clearly defined central rules and highly standardised elements that allow banks to handle high volume, small ticket problem loans) nor the bespoke restructuring of the latter (with its complex underwriting and solution set of restructured debt, new equity or Payment In Kind ) are appropriate when tackling small business NPLs. Best in class small business NPL management is anchored on a set of structured processes and decision trees, that allow a standard set of solutions (such as debt consolidation, basic debt restructuring) to be deployed according to well defined objective criteria. Banks must develop the analytics to support an NPL strategy that is focused on small business borrowers, including segmentation of the portfolio, development of resolution options, and the implementation of triage and impact assessment models. Furthermore, they must establish an operating model anchored on a mass customised approach to NPL management: standard forms that distil key information for decision makers, workflows that ensure processes are structured and efficient, triaging criteria that focus scarce resource on the highest priority assets, etc. Adopting such an approach will allow banks to work quickly and consistently through the small business NPL backlog by enabling case managers to take responsibility for the delivery of appropriate solutions, while at the same time removing inconsistencies at front line and driving faster decision speed. Copyright 2014 Oliver Wyman

17 Exhibit 15: Key decision tree modules CO OPERATION DEBT TERISTICS CHARAC- Determines whether treatment set can be applied Customer should be communicating, willing to pay and providing requested information to be classed as co-operating Other borrowing with our bank and other banks (business or personal) Under customer-level treatment, drives combined treatment and payment priority VIABILITY CAPACITY ASSETS Whether business is likely to succeed and generate free cash flow Drives long-term ability to repay debt Free cash flow available to service debt, today and in future Free cash flow available to service debt, today and in future Assets available for sale to support debt repayment Potentially reduces debt through asset sale TYPICAL APPROACH Decision tree which assesses whether customer should be classed as co-operating Decision tree which splits customers according to the debt they hold at the bank and elsewhere Scorecard assesses viability based on a set of weighted category scores compared to threshold value Policy and methodology for assessing the income and expenditure of trading, property and personal accounts Total repayment capacity calculated Decision tree which segments customers to identify those with non-essential material assets that they are willing to sell Source: Oliver Wyman analysis II. END-TO-END LENDING PROCESS REVIEW Small business lending remains a focus of policy makers, at both a European and national level, given its ability to stimulate and support economic growth. This is particularly true for markets like Greece and Italy, where small businesses constitute a large proportion of national GDP and drive the majority of employment. Central bank initiatives, such as the Bank of England s Funding for Lending scheme and the ECB s Long Term Refinancing Operation (LTRO) scheme, have become more targeted at small business lending. Bank recapitalisation programmes have sought to ensure that banks have the capital to lend into the economy, while development institutions, such as the pan-european JEREMIE fund or Greece s IfG, have boosted the availability of equity funding for small businesses themselves. However, while these initiatives have removed many of the balance sheet constraints that may hinder European banks from lending to small businesses, we believe that in some cases they will not be sufficient to ensure the free flow of funds to the sector. The experience of the Royal Bank of Scotland, the UK s largest small business lender is instructive: an independent report written towards the end of 2013 highlighted how softer factors can also reduce the ability of banks to lend. Even if banks have the capital and funding to support the sector, it will be important to ensure that there is also sufficient management bandwidth to champion small business lending again, and that front line staff are not overly focused on other priorities (such as risk management or deposit gathering). Institutional risk appetite must also be matched by individual risk appetite: changes made after the crisis (to risk policy, incentives, delegated authorities and so on) may have dented the latter to the extent that risk aversion level at a deal-by-deal level is preventing portfolio level targets being reached. Changes in focus (away from lending against property to lending against cashflow) may also expose latent capability gaps that were not as evident pre-crisis. 14

18 Exhibit 16: Conversion rates along the lending process SMEs STAGE PASS THROUGH RATE PER APPROACH FOR BORROWING Initial engagement SMEs contacting bank to discuss financing 100% Application, approval and appeal SMEs submitting a formal application to the bank 51% Bank approves the application 39% Competition, contracting and draw down SMEs accepting the approved facility 37% SMEs drawing down on the approved facility 27% Source: RBS Independent Lending Review We expect the political pressure to lend to small businesses to continue to mount. As a result, all small business lenders should challenge themselves sooner rather than later to ensure that they are doing all they can. This should include a review of the end-to-end lending process, including the effectiveness of marketing activity designed to stimulate demand, conversion rates at the pre-application stage (where many marginal deals are filtered out by front line staff) and the behavioural implications of policy changes introduced post-crisis. III. SMARTER ORGANISATIONAL AND OPERATIONAL SEGMENTATION SCHEMES Over the past year, we have seen many banks re-segment their customers across organisational boundaries. In some instances, small business banking has moved from the Retail to the Corporate division, although in most cases it has gone in the other direction. This shift in organisational responsibility is a cyclical (and often political) event which occurs every few years. However, we also observe a number of powerful forces at work that suggest a more definitive solution is required. For example: Which core banking platform (Retail or Corporate) is best able to meet small business needs? With so much investment now going into the development of both (see the section on digitalisation below), it is all the more important to have small business customers on the right platform from the start. How do the regulators define small businesses (for example, as unsophisticated, vulnerable or qualifying for retail treatment )? Wherever these definitions apply, small businesses must be served by a (retail) operating model that has the necessary processes and controls in place, to avoid exposing the bank to unnecessary conduct risk. At what point do automated processes break down? There is no point in offering a direct model to small business customers if every major interaction (from account opening to incremental product sales to credit underwriting) requires information that a relationship manager would be best placed to gather and qualify. What value do individual small business customers place on having a named relationship manager (and what incremental value does the bank get from assigning one)? It is clear that turnover-based segmentation schemes assume a generic inflexion point, and apply it to the whole portfolio. Other indicators (such as whether the small business has a CFO or professional finance function) may provide a more reliable guide. The most thoughtful players are seeking an organisational segmentation scheme that solves for all of these questions; so that the overall proposition offered to small business customers (whether they be above or below the Retail/Corporate boundary) is internally consistent, and therefore more effective and efficient. Within each organisational unit, we also expect to see a continued focus on operational segmentation. Quantitative research techniques need to be deployed to refine and enhance the differentiated propositions being offered to the smallest businesses served by a direct or branch-led model, as a way of both growing share (by focusing on the attributes that each sub-segment values) and profitability (by ensuring that value is recovered through differential pricing). Equally, banks must find a way of delivering mass customised propositions to the larger small businesses served by a relationship manager: the latter cannot be given the discretion to create bespoke solutions for each individual client, but a one size fits all solution will not be sufficient for such a heterogeneous client base. Copyright 2014 Oliver Wyman

19 Exhibit SUBSEGMENT 17: Illustrative COMPANY - organisational TURNOVER segmentation BUCKET schemes for SMEs and corporates Multinational Large Corporate Large Mid-cap Mid-cap Small Mid-cap SME Micro > 3 5 BN 5 BN to 1 BN 1 BN to 500 MM 500 MM to 250 MM 250 MM to 10 MM 10 MM to 1 MM 1 MM to startup Micro Business Banking: no dedicated RM, remote sales and servicing via internet, telephone Small Business Banking: branch-based RM/SB specialist, with large portfolio size (300+ customers), offering face-to-face point of contact Commercial Banking: dedicated RM, often based in commercial centres (rather than branches) offering standardised product solutions Corporate Banking: dedicated RM, supported by multiple product specialists, tailoring banking solutions to customer need International Corporate and Investment Banking: Product driven or high-calibre RMs with deep product expertise, ability to deliver the bank and relevant product experts are key IV. DIGITALISATION OF THE SMALL BUSINESS OFFER Digital is setting a new standard for small business banking. In part, this is being driven by ever more demanding small business owners, whose expectations of their business bank account have been raised by their experience as a consumer (in banking and beyond). Equally, of course, small business banking is often able to piggy-back off the investments that have already been made into retail banking digital platforms. Banks that visibly succeed in setting these standards can benefit enormously: in North America, both Bank of Montreal and PNC claim significant increases in customer numbers as a result of well thought through online and mobile banking offers targeting small business owners. In most European markets, all major players are already adding new features and functionality to existing platforms. In many of the banks that Oliver Wyman has worked with, the driving force is therefore the desire to maintain market parity: falling too far behind in any particular area that is valued by small business owners (such as mobile or user access management) risks an uptick in customer attrition and the erosion of the customer base. Exhibit 18: New digital standards in small business banking VALUE CHAIN DESCRIPTION OF KEY THEMES EXAMPLES Customer interaction Integrated banking solution for personal and business needs of the small business owner Standard Chartered Channel Product/Service IT/Back office Source: Oliver Wyman analysis Consumer Web 2.0 experience is influencing SME user interface design, leading to a more intuitive layout and visualisation of information User access management tools support multiple different modes of interaction (e.g. transaction initiation vs. authorisation vs. reporting) Increasing differentiation of client service levels, pricing and product offering, based on modular approach Mobile Banking applications offer streamlined access to core functionality, with a focus on owner/manager oversight and authorisation Social Media used for marketing/promotions and customer servicing, and moving towards collaboration and transactional banking Video/webchat used to enhance basic servicing, and increasingly to access product or industry expertise Aggregator and portal models combine bank and third party services (e.g. community, learning hub, service hub, group purchasing schemes, etc.) Banks begin to leverage core attributes (e.g. trust, security) to offer new products and services to existing customers (e.g. data storage, secure , digital signature, etc.) Mobile payment solutions to allow businesses to take payments remotely Increasing automation of processes (STP) and/or decision making, to meet SME client service level expectations (e.g. KYC/KYB) Process enhancing features such as real-/near-time delivery, alert system, full product view, review tools, research Wells Fargo La Caixa ASB Bank of America Barclays Citibank 16

20 Exhibit 19: Small business value chain 1 Business Activities (international and local) Purchase order Invoice/Goods SME Purchase order Invoice/Goods Pre shipping Shipping Domestic/International At destination Pre Shipping Shipping Domestic/International At destination Supplier Payment 2 1 Accounting software Payment 2 Money out Money out Taxes, salaries Cash CHAPS CHAPS BACS SEPA Inventory BACS SEPA SWIFT Accounts Accounts SWIFT CARDS Payable Receivable CARDS MOBILE MOBILE PayPal PayPal Cash Cash Cheques Cheques Local FX Data 4 Info-mediaries Finance Local FX Buyers 3 Working Capital Management Term Lending (e.g. commercial mortgage, asset finance, long term working capital finance) Professional production and management of paperwork and record keeping that supports business activities, via dedicated software Using open architecture to encourage the creation of business-specific applications by independent developers that can then be deployed through point of sale devices (e.g. loyalty/voucher schemes, table booking, bill splitting, etc.) Leverage financial and payment information to develop comprehensive liquidity forecast and cashflow management tool, and to facilitate one touch financing of working capital Analysis of small business data to improve small business outcomes Source: Oliver Wyman analysis However, being good at delivering core banking products and services online and through mobile and tablet applications will not be enough to stand out from the crowd in the medium term: to do this, banks need to find ways of supporting small businesses in their own business activities, solving their day-to-day problems and helping them acquire and retain more customers. In the graphic above (Exhibit 19), we highlight four areas along the small business value chain where we see significant innovation. These areas are adjacent to core banking services, but the innovation is not typically being led by banks. What is clear is that the pace of change in small business banking has accelerated rapidly with the advent of digital technologies. Small business bankers rely on retail (and occasionally corporate) platforms for developments in core functionality, and must now be able to articulate crisply and clearly what the small business specific requirements are, if compete for their share of digital investments. They will also have to develop capabilities (such as data management, customer analytics and proposition design) that are not traditionally associated with the sector, and to establish partnership frameworks to allow them to access technologies, software and skills that simply don t exist in most banks. Above all, they will have to get used to a much, much faster pace of change. Copyright 2014 Oliver Wyman

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