The return on equity for the financial industry is lagging behind that of other industries while also falling considerably against the returns enjoyed in the 2000s. Financial institutions are having to deal with their already convoluted complexity and the added regulator load created to prevent systematic risk after the financial crisis. While returns are slowly recovering, more focus on efficiency and managing complexity has the potential to again grow the RoE of financial institutions.
In a recent report, produced for the World Economic Forum, Oliver Wyman assessed the state of the financial services landscape. Complexity, the consultancy suggests, is one of the elements that is inhibiting the financial services sector returning to the extremely high return on equity enjoyed in the 2000s, still enjoyed by other industries. Cutting through the complexity may be able to improve efficiency in the financial services industry and improve the return on equity (RoE).
The (apparent) problem
The financial services industry had, before the crises, enjoyed a bull run. From the 1988 peak in US interest rates until 2006, financial firms increased the scale, scope and sophistication of their business and thereby greatly increased their revenue. However, through the addition of scale and new financial services, complexity too became an inherent element of the financial system, bringing with it increased operating costs as more personnel were hired as well as increased (systematic or otherwise) risks. After the global financial crisis (GFC), the stringent regulatory and business environment has reduced the benefits of this complexity but left financial firms with the costs.
Falling back to earth
The effects of regulatory intervention and risk adverse business environment has led to a decrease in the RoE enjoyed by financial services in the 2000s. Deeper than this, the two decades before the GFC, there was a relatively close return on equity between the financial services, banking and insurance, to that of other industries – financial services generally trending slightly higher. However, since the RoE collapsing for financial services after the GFC the RoE has recovered but not to pre-crisis levels and far below the RoE enjoyed by other industries. For instance, returns in the healthcare sector average 16%; in technology, they average 18%. Financial services returns now hover around the 7% average of utilities.
In terms of breaking down the loss of RoE, prior to the GFC global list of systemically important banks (GSIBs) enjoyed the high life in terms of RoE, with large banks returning 31% on tier one equity in 2006 and smaller banks pushing 19%. Now however, the GSIBs are returning 6% while smaller concerns have dropped back to 7%. The largest loss for both types are in NIM and liquidity costs, with 14% of the loss of ROE for GSIBs and 8% of the loss for all other banks. With Capital & Leveraging costs contributing the rest of the drop in ROE.
Efficient rather than risky RoE
One of the major issues flagged by the consulting firm for the low RoE relative to other industries is that complexity is limiting the ability for managers to introduce efficiency which is limiting the ability of banks to decrease their operating costs. Efficiency in the financial services industry has been flagging behind that of other industries, with the productivity of finance & insurance not changing greatly between 2001 and 2012, while Computer system design & related services has moved 40 points against the baseline. Oliver Wyman suggest that part of the problem is that financial services in this period have had to deal with massive expansion of complexity such that management finds it difficult to find ways of increasing efficiency. One way to increase RoE is to lower operating costs, which banks are striving for, however the consultants note that banks may be too optimistic on this note: “The analysts expect 15% while the banks promise 20%. Given banks’ recent performance on operational efficiency, even the analysts may be optimistic.”