A MODEL FOR THE UK BANKING INDUSTRY TRANSFORMATION

This paper reviews the existing issues about the UK banking industry competition, examines the reasons why a conventional approach to boost it might not be effective,

and outlines an alternative approach to industry arrangement with consideration of IT implications.

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Introduction

With the crucial role that banking industry plays in the

economic growth and stability, the public and regulators quite

expectedly pay increasing attention to the health condition of

the industry.

Deficit of competition with its direct impact on the consumer

detriment is one of the key health checks, which has been getting

a progressive attention in the UK. This paper reviews the existing

issues about the UK banking industry competition, examines the

reasons why a conventional approach to boost it might not be

effective, and outlines an alternative approach to industry

arrangement with consideration of IT implications.

Insufficient level of competition has been a long-standing public and regulatory concern about the UK banking industry. Throughout the last decade the issue has been addressed by a number of supervisory examinations: the Cruickshank report on “Competition in UK banking” (2000) with follow-up responses from FSA (2000) and HM Treasury (2004), the report by the Treasury Committee of the House of Commons “Competition and choice in retail banking” (2011), the joint HM Treasury and BIS white paper “Banking reform: Delivering stability and supporting a sustainable economy” (2012) - to name a few.

The concerns have become even more pronounced in the wake of the financial crisis fostering consolidation of the UK banking industry throughout the last years, which effectively triggered consolidation of dominating position of the “Big Five” financial institutions in the UK. According to the Treasury Committee 2011 report mentioned earlier, it varies from a staggering 85% in the Personal Current Accounts (PCA) sector to above 60% for savings accounts and unsecured personal loans segment.

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Major discontent about the current state of business is a perceived inadequacy of the banking services quality as reflected by customer satisfaction surveys which rests pretty much on the deficit of choice for banking clients. The sources to remove the impediments to the competition in the industry have been clearly articulated: When it comes to the agenda of increasing the number of suppliers, the discussion evolves pre-dominantly around the emergence of new banking institutions as a required outcome. At the same time there is more or less unanimity in this discussion that barriers for entry are paramount. The predicaments for new entrants come from a number of sources. They are challenged with high fixed costs of compliance with a regulatory framework – would that be qualification effort of the licensing process or Basel capital adequacy requirements which favour larger incumbent “experienced” players while requesting more capital from the newcomers. Indeed, the capital requirements issue has been addressed this year with the Bank of England lowering the amount of capital required for the new entrants. Still, even with the gates to run business wide open by the regulators, what poses a much greater challenge is competition itself. Competition puts the newcomers in the middle of the cost game in which economies of scale and greater efficiency are the key drivers. Neither of these drivers, however, is the newcomer’s comfort zone. On one hand, PCA segment in UK demonstrates very low switching rates, which are attributed

substantially to the “free-if-in-credit” banking practice around PCAs and obscure disclosure to the client of associated costs as the root-cause. That sets very reserved expectations for the new entrants about their capacity to get a rapid growth of PCA clientele. As PCA is generally recognized to be an important gateway product in retail banking, eventually the “Big Five” are in the spearhead to enjoy the privilege of the economies of scale. On the other hand, the efficiency these days to a large extent comes with technology, and technology comes with investment: banking production lines come in gigabytes of code of core banking systems loaded on powerful hardware racks with total cost of ownership measured in dozens of mega-pounds for the business volumes of a “Big Five”-type entity. In a nutshell, creation of new participants which are of the same kind and scale as the incumbent ones implies assembling a powerful processing capacity at profoundly high costs with dim prospects of its full utilization. In fact, the processing capacity in the UK banking industry seems to be quite sufficient as it is now and the future growth in transactional volumes can be catered by scaling up the existing processing lines.

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So, instead of bringing new entrants which are replicas of the existing ones, a plausible alternative is reframing the operating model of the industry as a whole with a component-based approach in mind - by the same token as the break-down of banking services into 29 economic functions done recently by FSA in their Recovery and Resolution Plan exercise. However, rather than applying componentization from the product silos angle like in the FSA case, one can consider the components of high-level business lifecycle and use them to define profiles for market participants in a new model (see Chart 1).

Chart 1. Business cycle components

Essentially, in this model each element of the lifecycle could be represented by a separate type of entity. Thus, a community of banks as encapsulated vertical silos would recompose into the horizontal communities of participants on the basis of the service role they perform (see Chart 2).

Chart 2. Banking industry landscape recomposed along the business cycle roles

Within this framework the competence of running the banking business together with the banking licenses would accrue to banking business managers - the group of entities in the driving seat of planning and control, which in terms of existing banks would encompass bank-wide management functions (like strategy and marketing, finance, risk, legal) and product management groups. Strategic acumen, competencies about proper product engineering and mix, and expertise in maintaining balanced financial management would constitute the job description for the banking business player. Transaction processing facilities - the existing ones or the ones yet to emerge if needed - would spin-off into the community of processing factories operating under fee-based SLA arrangements with the rest of the industry, open to render services to players other than the one from which they originated. Opening access for the banking business players to consume services across processing factories would provide opportunities for the industry to excel in efficiency – to consume services of a particular factory in the business area where this factory excels compared to the peers.

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Such a detachment would also provide much more transparency on the costs and profitability of “free banking”, lack of which was pointed out in supervisory findings as a serious problem. This consequently would put more pressure on banking business entities’ pricing to pass on the benefits of the economies of scale to the clients. The detachment would also insulate the critical account holding and transactional functions from the impact of redundancy cases in the banking business team. Furthermore, it would diversify the financials of the processing factory and decouple their direct dependency from financial risk-taking activities of the banking business, leaving operational risks mitigation as the main focus. It’s true that dependency is a two-way road here and the resilience of processing factories is crucial for stability of the banking system. Stringent operating controls and operational risks mitigation matter no less than efficiency especially when service vendor support goes beyond one member of the industry. The precedents in the financial services industry in the areas of custodian or mortgage servicing areas prove however that this task is quite manageable. BPO services domain also demonstrates that a professional services organization setup can successfully cope with the challenges of this kind. Moreover, unlike financial institutions it is a norm for professional services organizations to subject themselves to the scrutiny of certifications across a broad spectrum of relevant standards and methodologies like ISO, COPC, eSCM, ITIL. Therefore explicit and formal SLA contracting within advanced certification and methodological framework

for processing factories would boost greater transparency and accountability over quite often blurred internal OLAs – for a tangible benefit of prudential supervision of systemic risks. As for the third category of entities in a deal origination role, they are perhaps those very new players which are required to bring the transparency and access to information about market supply so much sought after – the first two tasks mentioned in the beginning as means to improve competition. Having independent status from the banking business entity and acting on a non-exclusive basis as the deal origination distributor for the latter, their competitive edge would be to maintain the customer focus, deliver a fair and comprehensive coverage of market supply to the clients. Similar to production factories case, the detachment from the banking business entities and acting in the interests of the clients would be a crucial ingredient to support with fee-based service contracting between the deal origination agents and the clients. This way the new industry architecture creates a layout to support truly the idea of a financial supermarket, which so far has been heavily constrained as the sales channels would be dedicated to selling banking products of the bank owning those channels. A fairly close proxy to this kind of a new construct is an existing white-labelling practice. Again current context and rationale are often different though in the latter case – arrangement with financial services peers to complete own product mix presenting white-labelled products under own brand.

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Naturally, there is an IT dimension to any organisational transformation of this kind. Technology-wise, current capabilities of IT domain look quite up to this challenge in terms of the industry solutions and expertise. The SOA integration framework has been around for quite a while now, the difference being that rather than driving a corporate architecture it would raise to the industry design level. The IT solutions components of a corporate IT architecture in terms of their functional coverage are considerably aligned with the components of the business cycle. Therefore, the participants with different roles could wield relevant available component of IT architecture. The integration agenda here becomes more about connectivity, security and data protection matters of the inter-entity data exchange rather than a technical challenge. Banking business entity activities rest heavily on the treasury management systems (supporting dealing room, ALM and risk management functions), gateways to the OTC or exchange trading systems, BI solutions for economic and financial planning, budgeting and analysis, as well as financial accounting and reporting tools for the business portfolio owned by this entity. Granularity of some core banking solutions also renders support for the banking products engineering as separable from a deal execution stage.

For the processing factories the key elements would be the OLTP core banking system, as well as gateways to RTGS/DNS systems (like TARGET and SEPA) and international financial messaging systems like SWIFT. The accounting data for the scope of business services provided by the factory to a particular banking business entity would be fed back to the financial accounting and reporting packages of the latter. Ensuring an adequate IT solution for a deal origination community could be quite tricky until recently. The issue is not about the required CRM solutions as these have been available for quite a while now. The challenge could be about the multi-channel client interaction platform to deliver comprehensive coverage of market supply, originate deals for the selected options with multiple banking products suppliers and then establish collaboration with processing factories at deal execution stage. The advent of the modern User Experience Platforms (UXP), however, has filled in this gap by contributing a powerful engine to consolidate a spectrum of functionalities needful for this role. Unlike the portals family, due to the components pre-integration and built-in UX design and management tools, UXP solutions would be much more digestible for the deal origination entities in terms of associated solution costs and effort.

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To summarise, the transformation initiative of the UK banking landscape is gaining shape and pace fuelled by the concerns over the state of competition in the industry. The country’s newly created Competition and Markets Authority have declared the UK banking sector as their prime focus. Here we have considered one of the potential recomposition approaches to attain more transparency, better quality, wider client choice and switch-over flexibility, and fairer price setting for the banking services. The technological advances of IT industry can provide ample foundation for the proposed transformation. So, the pieces of the puzzle are at hand in the form of already existing banking industry practices and arrangement constructs, supporting IT concepts and solutions. The question is if they will get together into a new construct with pertinent regulatory institutionalization.

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Oleg has over 20 years of professional experience in financial services industry domain, gained across different geographies and through different roles including senior positions and key roles in organizational transformations. His solid knowledge of banking practices is leveraged by 15 years of expertise in banking software solutions involving top-ranking international vendors. Oleg holds MSc degree in Financial Economics from BI Norwegian Business School, Oslo.