Regulation Nation

But as financial services firms tried to ready their compliance responses to the Volcker Rule, all they had to go on was guidance from the Fed that banks should "engage in good-faith planning efforts" to comply with the Volcker Rule by July 21, 2014. Interpretations of "good faith" by law firms, economists and U.S. senators ranged from "phase it out immediately" to "continue business as usual until midnight on July 20, 2014."

This is exactly the type of vexing grey area financial services companies must contend with as a result of macroeconomic and regulatory upheaval following a decade in which profits forcefully swung from black to red. It's no wonder that financial services consulting leaders, like Capco CEO Ismail Amla, point to regulatory compliance as one of the industry's most formidable challenges.

Others, such as Roy Stansbury, managing director of Capgemini's financial services practice in North America, concur. "Many clients do not know what the regulators are going to come in and ask for next," Stansbury notes. "We have a client currently preparing for upcoming regulatory audits in eight different operational areas. This is not a company that you would ever expect to ask, 'Is my house in order?' Yet, they're asking if their house in order. All of these different regulatory changes have created disruption and uncertainty. We always talk about running the bank vs. changing the bank. So much of running the bank today means spending money on regulatory compliance requirements."

Running and Changing a Highly Regulated Bank

It also means doing so at a time when lending and trading revenues are down, the cost of generating additional revenue is growing and customer expectations are rapidly evolving.

"Margin pressures require fundamental changes in cost structure across the industry," notes Amla. "This will create a wave of change as businesses are divested, new operating models are created, new entrants emerge and more."

Macroeconomic volatility as well as cost pressure inside the organization feature prominently among the challenges confronting financial services companies. "Cost pressures are huge right now in this industry," says Stansbury.

All of these challenges are difficult to distill into a neat list, in part because of their complex nature, but also because of the nature of the industry itself. Regulatory changes, like Dodd-Frank, affect insurers, banks, investment banks and investment management companies, but large retail banks (including those with investment banking arms) face the greatest regulatory demands. For their part, insurance companies are more focused on economic and market forces that exert pricing pressure and influence customer demand.

Although more financial services companies across all sectors have grown increasingly global, the lingering effects of the global financial crisis are much more severe in some parts of the world (e.g., Europe and the U.S.) than in other regions.

All that said, the following challenges (in addition to macroeconomic conditions) are fairly, if generally, consistent throughout each sector of the industry:

• Regulatory change;
• Technology threats and opportunities;
• Changing customer expectations

Much of the language within the survey reports, white papers and point-of-view columns that consulting firms and practices churn out—"difficult environment," "fragile economy," "forces reshaping," "new normal," "creeping realization"—suggest that the financial services industry is on the precipice of historic change. Some firms maintain that the new era is well underway. "It is our belief that a structural, secular shift is under way," reads Booz & Company's 2012 Retail Banking Perspective. "The industry is transforming from a high-margin business to a lower-margin one."

The transformation is hardly a smooth or predictable one. Earlier this spring, who would have guessed that JP Morgan, the darling of Capitol Hill thanks to the way it refrained from the type of risk-taking that sparked the financial crisis, would be subjected to an FBI investigation after a $2 billion-plus trading loss (which, regulatory proponents point out, is exactly the sort of activity the Volcker Rule was conceived to prevent).

Strategic Opportunities on the Horizon

The consulting opportunities within any industry tend to boil down to a good-news/bad-news proposition. Within financial services, a string of bad regulatory news (for example, major legislative changes, like Dodd-Frank, combined with the politically charged and unsteady translation of the new law into specific rules) created good news for firms and practices with the regulatory and change-management expertise and resources to help clients with this "must-do" work.

The bad news is that many financial services firms have a growing need to invest in more strategic changes to their underlying business models—and how they manage customer experience, how they revamp decades-old technology environments, and how they adapt to a world in which the most powerful competitors may soon be Chinese and Brazilian banks—at a time when profits have decreased and they've just spent a lot on "must-do" work.

"Many companies in the industry are fatigued by that kind of spend," reports Scott Marcello, national leader of KPMG's financial services practice. "They don't view that type of [regulatory compliance] work as high value-add. It's a necessity to get them through a difficult stage. What they really want to focus on is the future: restoring and increasing profitability, repositioning the bank and deciding what their core operations should be."

Stansbury agrees, noting that the combination of macroeconomic and regulatory uncertainty have made many financial services companies less willing to spend.
What Marcello describes as the "next phase" of advisory investments financial services clients make may be a tougher sell, but also more lucrative. "I think there will be a fairly pronounced shift in what they spend [consulting dollars] on," says Marcello. "It's going to move into a more strategic area…"

Recent decisions within the capital markets sector, which tends to operate at the front end of economic patterns and cycles, supports Marcello's forecast. Many of the large investment banks have indicated that they plan to decrease spending in the coming year, in effect, waiting for market conditions to improve.

Most financial services companies across all sectors, "need to conserve," continues Marcello, "yet, at the same time, they have to transform some of their platforms and businesses to meet new needs, to be more cost-efficient. … At some point they will need to start investing again both internally and externally to make those things happen. Getting from here to there will be interesting.

398 New Rules and Counting

By "interesting," Marcello may mean "highly uncertain." And he wouldn't be alone."By far the largest driver of change in the financial services industry is the dramatic impact of regulatory reform," asserts Hank Prybylski, Ernst & Young LLP's Americas financial services office advisory leader and global financial services risk management practice leader.

"While there is still uncertainty concerning many facets of global financial reform, we are witnessing a shift in how financial institutions are considering the impact of the new economic and regulatory environment upon their business models and looking to best position their firms for future compliance and growth."

When an analyst asked a KPMG client executive for a return on equity (ROE) projection, the client responded that the problem wasn't the complex nature of the return calculation, but in figuring out the "E."

"He explained that he did not know what kind of capital the bank was going to be required to carry, according to changing regulations," Marcello relays. "Uncertainty in regulations dominates banking."

Besides Dodd-Frank and its nearly 400 new rules, regulatory and financial reporting requirements include the Foreign Accountant Tax Compliance Act (FATCA), the Fed's enhanced prudential standards, Basel III, U.K. Bribery Act, SEC disclosure requirements (FIN 48 and FAS 109), IFRS-GAAP convergence, FCPA and much more.

One of Dodd-Frank's 398 rules created a new Consumer Financial Protection Bureau (CFPB), which has its first director—Rich Cordray—in place, is staffing up and engaging with financial institutions. "If you walk into some of the largest banks, they are deploying hundreds if not thousands of resources focused on various work streams around regulatory compliance and regulatory reporting," Marcello notes, adding that the CFPB "brings a new level of scrutiny to how banks interact with and treat" their customers.
Future regulatory requirements may prove even more intimidating. For example, Capco Partner Sean Culbert points out that U.S. and European regulators will require "almost instantaneous access to transactions and counterparties," a capability banks do not currently possess.

"Regulation right now is the number-one, top-of-mind issue for essentially every banking and securities executive, and it also applies to insurance and asset management," asserts John Kocjan, a principal with Deloitte Consulting LLP who leads Deloitte Consulting's financial services practice globally.

"It's regulation, regulation, regulation front and center, and regulation has implications for financial performance … You're going to have to figure out new business models in the long run, but right now, it's almost as if it's a matter of getting through to the end of the day from a regulatory-compliance perspective."

Old Systems, Big Data
Technology also poses serious implications, positive and negative, on financial performance. On the threat side, aging technology infrastructure marks a source of unnecessary cost and also hampers financial services companies' ability to respond to changing customer expectations and needs in an agile manner.

IBM estimates that the cost of information technology (IT) complexity represents an opportunity of $200 billion in extra profit per annum based on a sample of 50 mature market banks in the U.S. and Western Europe.

"Many of the heavy applications banks still run are from the 1960s," reports Kocjan. And the professionals who know how to operate and maintain these legacy systems and applications have reached retirement age.

"People are leaving, the machine is still running, it's starting to make smoke, and there's nobody around to figure out how to fix it," Kocjan continues. "That's just one example of the need for technology transformation."

And here's another one: "The availability of emerging technologies in distribution, data analytics and social networking is enabling firms to renew customer relationships by delivering innovative customer value propositions that create higher client satisfaction and deliver growth and higher profitability," explains Doug Butler, managing partner, financial services for IBM Global Business Services.

"Technology is also enabling firms to improve their risk and reporting capabilities to improve capital allocation decisions… By transforming their operating models, firms can increase their efficiency, flexibility and speed, enabling them to deliver higher service levels at a lower cost."

The need for technology upgrades—consolidation and transformation projects that put aging infrastructure (and with it, costly complexity) to pasture while equipping companies with lighter, more responsive systems and applications—pervades in all subsectors of the industry.

The need to access the right compliance, finance and customer data is also pervasive, given the need to "meet customer expectations, generate revenue, manage risk, achieve effective regulatory reporting, conduct day-to-day operations, and drive growth and profitability," notes Prybylski. "The volume, variety and speed of information needed to conduct business is continuing to grow rapidly and this growth is far outpacing most organizations' staffing requirements and policies and procedures for storing and maintaining the integrity of the information."

As a result, he says that financial institutions "need a strategy and methodology for managing data both internally and externally to meet the increasing pressures and to be competitive."

Stansbury agrees, calling data management a "constant question across the entire industry." Cyber security has also emerged as a major technology threat. Booz Allen Hamilton Vice President Thomas Sanzone says that financial services companies need to "re-build outmoded infrastructures, keep pace with regulatory change, and reinforce their ability to fend off cyber-attacks, all while trying to manage demands of shareholders and clients."

'Figuring Out What Customers Really Value'

One of the most important data questions also qualifies as a strategic concern. "The way they [financial services companies] historically made money has been challenged and business models are changing, in some cases significantly," says Marcello.

It's a challenge but it's also a big opportunity. If companies can do a better job of positioning themselves to their customers, figure out what customers really value, and figure out how deliver differentiated services and capabilities while at the same time navigate this very difficult regulatory environment, they can thrive." Those are big ifs, possibilities that require financial services leadership teams to address equally imposing questions, including the following that Capco's Culbert identifies in a white paper titled "7 Critical Questions for Financial Services Firms:"

• Is your firm operating with a global strategy to enter new markets and gain share?
• Have you explicitly considered where you might lose share and how you would guard against that?
• Do you have the personnel and operations to execute the strategy?
• How will your firm meet the technological requirements of doing business across jurisdictions around the world?

"I think our clients are going to have to start investing in radically different business models," says Kocjan. Sanzone agrees, asserting that the industry's current challenges require "re-imagining the enterprise to minimize the cost of commoditized functions and maximize the investment made in differentiated functions that drive revenue generation."

To devise new strategies and new business models, another lingering effect of the global financial crisis must be addressed: trust. That intangible but incredibly valuable asset lost significant value during and after the crisis among customers as well as the general public.

Rebuilding trust among direct customers is easier to accomplish; banks interact with customers regularly and have a daily opportunity to demonstrate excellent customer service and to demonstrate their corporate values through decisions and conversations.

Restoring trust among taxpayers is a tougher nut to crack, particularly in politically charged times and in a world where social media enables information—including perceptions, interpretations and rumors—to spread quickly and broadly.

"Restoring credibility is important because it influences the tone of new rules," Marcello says. "This challenge undergirds a lot of what the industry is focused on from a strategy standpoint. There always seems to be an element of strategic discussions devoted to restoring trust and confidence while at the same time restoring profitability."

—E.K.