The Journal - PwC · The Journal • Global perspectives on challenges and opportunities PricewaterhouseCoopers. Whilst structured finance is a world of complex jargon and structures

The JournalGlobal perspectives on challenges and opportunities*

Banking & Capital Markets

April 2008

*connectedthinking

PricewaterhouseCoopers

Contents

Editor’s comments 2

Structured finance: Does it have a future? 4

Chief Risk Officers are from Babylon, Chief Financial Officers are from Florence

10

Watch the wealth management gap: Are you in danger of falling behind?

18

Transforming the finance function: So much more than numbers

26

Banking 2050 32

Page


Editor’s comments

by Authorby Thomas Pirolo and James Hewer


The Journal • Global perspectives on challenges and opportunities

2

Thomas PiroloEditor-in-chiefPricewaterhouseCoopers (US)

Tel: 1 646 471 [email protected]

Welcome to the April 2008 edition of The Journal. We are currently living in interesting times for the banking and capital markets industry with the continuing credit crisis and the challenges this has presented. In this edition, we have brought together a diverse range of articles which look at some of those challenges as well as some of the other global issues facing organisations operating in the evolving environment that is today’s banking and capital markets industry.

The credit crisis has had thousands of column inches devoted to it over the last six months and as part of that coverage the structured finance industry has come under the microscope. Indeed the structured finance industry has taken some heavy criticism in the press, some justified and some less so. In our first article entitled ‘Structured finance: Does it have a future?’, Peter Jeffrey, Frank Serravalli and Michael Codling look at the structured finance industry, and consider some of the recent events and issues that have arisen. The article highlights some of the benefits the structured finance industry has brought to the capital markets over the past couple of decades while also asking what the industry needs to do to ensure it does have a future.

In our next article, ‘Chief Risk Officers are from Babylon, Chief Finance Officers are from Florence’, Richard Barfield, Steve Anderson and Shyam Venkat consider the benefits to be gained from aligning, as opposed to integrating, your risk and finance functions. Using interesting analogies with ancient traders from Babylon and merchants from Florence they highlight the issues to consider and the challenges facing today’s finance and risk functions and how by working more closely together they can help each other address and overcome these challenges.

Moving on to consider the Private Banking industry, 2007 saw the publication of our Global Private Banking/Wealth Management Survey and in this article, ‘Watch the wealth management gap: Are you in danger of falling behind?’, Bruce Weatherill, Natasha McMillan and Justin Ong highlight the key themes arising from the research. The article highlights the key challenges facing today’s wealth managers and what they need to be focusing on to ensure they emerge as the leading wealth managers of tomorrow.

Back with the finance function, effectiveness and transformation are increasingly becoming buzz words and hot topics in the banking and capital markets industry. Those undertaking

such effectiveness reviews or transformation projects need to consider not only the cost benefit analysis but also the people issues involved with such an exercise. In our article ‘Transforming the finance function: so much more than numbers’, Christopher Box, Brian Furness and Jonathan Shepherd share their experience and views on how to ensure you have considered in your project and highlight the key people issues to ensure you have considered in your project.

In our final article, ‘Banking 2050’, we look to the future and do some crystal ball gazing to consider how the global banking and capital markets landscape may look in 2050. Nick Page, Mervyn Jacob and John Hawksworth take us through some of our recent PricewaterhouseCoopers1 research on the subject and their key conclusions, before then considering what this means for today’s leading banks in the G7 economies and their long term strategic plans.

We hope you find this edition of The Journal of interest. Please do continue to provide us with feedback on both the content and topics you would like to see addressed in future editions. Online copies of this edition and other PricewaterhouseCoopers publications can be found at www.pwc.com/banking and www.pwc.com/publications.

James HewerEditorPricewaterhouseCoopers (UK)


1 ‘PricewaterhouseCoopers’ refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.



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by Peter Jeffrey, Frank Serravalli and Michael Codling

Structured finance: Does it have a future?

4



Michael CodlingBanking LeaderPricewaterhouseCoopers (Australia)


Frank SerravalliCo head of US Securitisation GroupPricewaterhouseCoopers (US)


Peter Jeffrey European Leader of the Structured Finance GroupPricewaterhouseCoopers (UK)


Introduction

In the current market turmoil, structured finance vehicles (be they traditional securitisations, conduits, CDOs or SIVs) are very much under the spotlight. They have been impacted significantly both by losses on investments and by a lack of liquidity, but are they the cause of this market turmoil or a victim of it?

Certainly a number of these structures took advantage of the significant margin to be earned through investing in high quality asset-backed securities and funding these investments through the short-term debt markets. However as all bankers know, lending long and borrowing short is not sustainable through all market conditions and unfavourable conditions hit in the second half of 2007.

What were these conditions?

In summary, the short-term funding markets ‘froze up’ as lenders became fearful of what investments the vehicles therefore had in them and what losses these vehicles might be exposed to in the short and medium term. The trigger for this fear was US sub-prime mortgage lending and the losses being made in the market. Many of the losses and exposures had been transferred around

the world through securitisations. The short-term lenders were not sure which vehicles were exposed to US sub prime (in reality very few outside the US) and also what other, as yet unidentified, risks and losses were ‘hidden’ in such vehicles.

In a declining worldwide economic environment would other exposures such as credit card securitisations or commercial property give rise to the same level of losses, say in Europe or Asia?

As liquidity dried up vehicles ceased to buy asset-backed investments, as did other investors (again in many cases out of fear), and originators such as mortgage companies found they could not issue traditional securitisations and in some cases could not ‘roll over’ funding on their warehouse structures. This gave rise to the failure in some cases of loan originators whose business model involved funding through the structured finance markets.

This led some to suggest that bankers needed to ‘get back to basics’ and lend purely out of retail deposits. Reliance on the structured finance markets was ‘foolhardy’.

This leads on to the question, does structured finance have a future, and if so, what lessons does it need to learn from this ‘credit crunch’?

The benefits of structured finance

If structured finance has a future it needs to demonstrate to the financial markets, regulators, politicians and the general public that it fulfils a positive role in the financial markets and benefits the public at large.

What many of those calling for a ‘back to basics’ banking environment fail to recognise is that a large part of peoples’ savings are not held in deposits with saving institutions but are held within pension funds. This is an increasing trend as pension fund inflows increased from £34 billion in 1995 to £75 billion in 2005. Figure 1 overleaf shows this trend for the period 1991-2002.

The implication of this is that if deposit takers waited until they could fund lending from deposits we would return to the situation pre 1980s, when queues and waiting lists for mortgages and other loans were not uncommon. It is also likely in this environment that credit would not be available to the less well off and a large part of the population would suffer exclusion from many financial products.

One of the most important roles structured finance plays in the overall financial markets is bringing the funding

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held in pension funds back into the banking markets. It does this through converting loan products into investment products, which are suitable to be held within a pension fund. It is not surprising therefore that pension funds and insurance companies are significant buyers of structured finance products (see Figure 2).

Structured finance has also been used to enable the risk of various financial products to be split between different market participants. This has allowed innovation in product design to take place and for retail customers to benefit through being able to access more attractive and suitable products. Examples of this in the mortgage area

range from fixed rate mortgage products through offset mortgages to equity release mortgages.

If structured finance is to have a future, those involved with it need to cut through the complexity and help educate stakeholders as to its benefits and workings.

Structured finance: Does it have a future? continued

Figure 1: Composition of the net wealth1 of the household sector

Source: Office for National Statistics

United Kingdom £ billion at

20022 prices

1991 1996 2000 2001 2002

Non-financial assets 1,897 1,651 2,463 2,586 3,078

Financial assets

Life assurance and pension funds 817 1,211 1,741 1,628 1,377

Securities and shares 340 498 780 584 451

Currency and deposits 511 556 665 701 743

Other assets 86 82 93 94 91

Total assets 3,651 3,998 5,742 5,594 5,740

Financial liabilities

Loans secured on dwellings 424 458 555 598 669

Other loans 114 106 153 170 186

Other liabilities 60 57 61 61 63

Total liabilities 597 621 768 830 919

Total net wealth 3,054 3,377 4,974 4,765 4,821

1 See Appendix, Part 5: Net wealth of the household sector.2 Adjusted to 2002 prices using the expenditure deflator for the household sector.

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Whilst structured finance is a world of complex jargon and structures it does not need to be, and in a period when it needs to regain support and confidence it needs to help investors, arrangers, regulators and the markets understand what it achieves as well as the risks within the structures.

Transparency

A way to enhance this confidence and remove the ‘fear factor’ is to improve transparency through better and more robust reporting both of financial performance and operational effectiveness.

Whilst this article concentrates on transparency by structured finance vehicles it would also be appropriate for investors such as pension funds, insurance companies and investment funds themselves to provide more information on their holdings of asset-backed securities. This will, in part, be helped by IFRS 7 and, for some, Pillar 3 of Basel II, but for all investors it may well be benefical to provide more information about their investments and risk management techniques such as monitoring and assessment of underlying assets and portfolios.

Investors in structured finance vehicles unlike many other types of investors gain little if any comfort from the financial statements of the vehicle. The comfort they require is that the assets in the vehicle are performing as expected or within acceptable parameters, that cash flows have been allocated and distributed correctly, that assets are being administered in a professional manner and that triggers and other mechanisms in the structure have been complied with.

In our opinion this requires regular reporting both on the assets within a structure and on the operation of the vehicle.

At present there are various reporting templates recommended by trade bodies such as the European Securitisation Forum and Commercial Mortgage Securities Association that cover what information should be reported on a regular basis. These templates, however, tend to concentrate on traditional securitisations and do not cover all assets classes. The templates are also not mandatory.

This means that reporting varies both in timing and quality from deal to deal and structure to structure. Very little information tends to be reported on conduit structures, whilst much more is provided on CDOs. Mortgage

Mortgageleaders

CDO

BBB

AA

AAA

AAA

AAACDO of CDOs Funds

SIVs etc.

Insurancecompanies,

pension fundsand banks

RMBS issuer

Figure 2: The spreading of risk across the financial markets

Source: PricewaterhouseCoopers


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Structured finance: Does it have a future? continued

securitisations tend to provide some data but it may not be consistent due to different definitions of things like arrears.

In many countries reports are only available to investors through password-protected websites and potential investors and other interested parties cannot easily obtain access to the data. This does not help build confidence in the market.

Often the reporting is not reviewed in any way by any independent third party, and in the last few years there have been some high-profile examples of information being wrong and needing to be restated.

‘ One of the key current issues in the European servicing arena is the quality of investor reporting. This issue came into focus in the spring of 2006 when reporting errors in UK RMBS transactions captured headlines. In addition to the obvious importance of accuracy, quantity of data, and timing of delivery, the degree to which reports are user-friendly is critical, as investor reports are key surveillance tools.’

– S&P Industry Report Card: European Loan Servicers 31 January 2007

In addition to regular reporting on the asset portfolio, investor confidence would be enhanced by regular reporting on the correct operating of the structure.

This type of reporting is now required in the US for SEC-registered deals in accordance with Regulation AB (‘Reg AB’).

Under Reg AB all those involved in undertaking servicing roles in a securitisation are required to attest to their compliance with the servicing standards of the structure (with Reg AB setting minimum standards) and independent accountants are also required to report on compliance with those standards.

We believe that the structured finance market would be enhanced by the introduction of similar regimes in all jurisdictions, covering all types of structured finance vehicles.

Governance

Structured finance vehicles are usually Special Purpose Entities (‘SPEs’) with pre-determined operations. They have no employees, and directors are provided by specialist SPE managers. Trustees are appointed to protect the investors’ interests. Rating agencies provide ongoing ‘comfort’ through the rating process.

Many of these vehicles are in territories where audits are not mandatory.

Greater confidence going forward would be obtained if SPE directors, trustees and rating agencies undertook a more active role in the vehicles and the transactions.

SPE directors need to play a more active ongoing role so that they protect all stakeholders. This would require them to receive more regular information and to have a mechanism for asking questions and probing issues.

Directors might like to ask the following questions:

Do we understand the transaction, • the commercial logic and ongoing operating requirements?

Is this transaction being undertaken • for good commercial reasons?

How are we going to be kept • up to date with the transaction and underlying asset performance?

How do we ensure compliance with • the Market Abuse Directive?

Who is going to review the investor • reports and what approval will the directors need to give for their issuance?

What can we do if the transaction • begins to fail?

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Others also have a part to play in the governance process. Different trustees might be appointed to represent different classes of ‘investor’. Rating agencies may need to be more proactive in ongoing surveillance.

Conclusion

The above comments have hopefully shown that structured finance plays an important part in the financial markets. It should have a future.

However, to have a robust future the structured finance industry needs to work hard at educating the various stakeholders as to its benefits and equally the risks run by the various structures. Transparency needs to be enhanced and it may well be beneficial to have a regime similar to the US’s Reg AB in place across all geographies and types of structure. Governance needs also to be more active with directors having a responsibility to protect the interests of all stakeholders.

Without these improvements we may well see further periods when confidence is lost in the structured finance industry.


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by Richard Barfield, Stephen Anderson and Shyam Venkat

Chief Risk Officers are from Babylon, Chief Financial Officers are from Florence

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Shyam VenkatPartner, Advisory, Financial ServicesPricewaterhouseCoopers (US)


Stephen AndersonDirector, Advisory, Financial ServicesPricewaterhouseCoopers (UK)


Richard BarfieldDirector, Advisory, Financial ServicesPricewaterhouseCoopers (UK)


The urgent case for aligning risk and finance

Different histories and different strands of professional DNA mean that finance and risk have differing world views. Recent market events have raised serious concerns about the divide. These cover the spectrum from the front end (as firms decide which risks to take) to the back end (as results are communicated). Consequently, powerful external forces and internal drivers exist which mean that risk and finance must become better aligned. The benefits from doing so are likely to be significant – such as enhanced front-end risk management, better resource allocation, reduced costs and more effective reporting.

It is our point of view that significant gains can be achieved by aligning risk and finance. However, it is a mistake to integrate risk and finance – this would miss both the cultural nuances and the fundamental differences in their objectives. Aligning risk and finance can take these into account and capitalise on their complementary roles in the business.

Historical perspective

The Hammurabi Code of ancient Babylon consisted of a mere 282 laws to govern the vast Babylonian empire. Carved in stone around 2000 BC the code provides one of the earliest records of risk management.

The caravan trains that crossed the empire’s deserts required financing before merchandise was traded. This gave rise to default risk, which the Code recognised. As credit risk mitigation, the Hammurabi Code empowered a creditor to take a debtor’s family into employment for up to three years to work off an unpaid loan. Fortunately times have changed.

Some time later, medieval Florentine merchants marked the origins of modern finance through the use of double-entry bookkeeping. Records show that the earliest existing double-entry books are those of Amatino Manucci, a Florentine merchant, who lived at the beginning of the 14th century. A little later on, Luca Pacioli, a monk and collaborator of Leonardo da Vinci, then codified the system in his 1494 mathematics

textbook. From its early roots in Florentine mercantile trade, finance has evolved considerably.

Risk management and financial management have both come a long way from their historical beginnings, though they remain in many respects two quite distinct disciplines. Indeed one could say that their attitudes to the key business issue of uncertainty are diametrically opposed. The inherited characteristics of finance lead (stereotypically) to a preference for control, risk aversion and minimised uncertainty. Risk’s evolution leads to an appetite for uncertainty and a stereotypical desire to explore ranges of options and outcomes. This cultural diversity leads to different languages, ways of working, systems, data and processes.

Irresistible forces for change

External forces and internal drivers are demanding that some of the differences and distinctions be resolved. Figure 1 overleaf summarises these and the implications for risk and finance.

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Chief Risk Officers are from Babylon, Chief Financial Officers are from Florence continued

Figure 1: External forces and internal drivers


External forces Implications for risk and finance

Credit crunch •

Reputational damage –suffered by structured products

Litigation risk –

Demand from the markets for:

Greater confidence in risk management of financial institutions;•

Reported numbers that reflect the paradigm shift in valuation; and•

Greater transparency in the analysis and reporting of risk (especially from investors in • structured products).

Regulatory imperatives•

IFRS –

Basel II –

Solvency II –

IFRS 7, which affects most financial institutions, requires:

Public disclosures to allow shareholders to view financial instruments and risk management • activities ‘through the eyes of management’; and

Significantly enhanced disclosure of capital management strategy, as well as explanation of the • implications for regulatory capital.

Basel II and Solvency II are also catalysts for major change:

Pillar 2 requires firms to demonstrate to their regulators how they manage risk and capital together • (in far more detail than IFRS 7, albeit confidentially, through the Internal Capital Adequacy Assessment Process (ICAAP) submission); and

Pillar 3 requires detailed prescriptive risk disclosure of Pillar 1 risks and encourages firms to publicly • disclose other information that may be helpful to investors and other stakeholders.

Liquidity and capital • constraints

Tighter market conditions means that:

Management is forced to have a much sharper focus on capital and funding (and therefore • risk) management.

Resource allocation decisions are top of the agenda – both in terms of capital and liquidity.•

Disclosure of liquidity risk management to investors and other external stakeholders.•

Valuation of instruments, products and collateral in an illiquid market is a critical issue.•

CEO and Board insist on better decision support, management information and data consistency.•

Internal drivers Implications for risk and finance

Strategic choices require an • integrated assessment of risk perspectives

Risk needs to be integrated at the front end of strategy and business planning processes.•

Risk appetite needs to be formulated clearly, communicated and monitored. •

Economic capital and risk-adjusted performance measurement are no longer optional extras.•

Performance challenges • require improved operational efficiency

Increased appetite for simplified, integrated IT and data platforms.•

Finance and transactional activities increasingly standardised and offshore or outsourced.•

Assessment of opportunities to apply similar approaches to risk activities.•

Attracting and retaining talent• CROs and CFOs both seen as leaders with seats at the top table.•

Organisation models that provide challenging career paths across risk and finance.•

Well-defined, proactive commercial roles for risk and finance personnel, partnering with middle and • front office colleagues.

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Our point of view

Significant gains can be achieved by aligning risk and finance, but it is equally a mistake to integrate risk and finance – this misses the fundamental differences and complementary roles that both play in the business. Babylonians are somewhat different to Florentines!

The process of alignment means that the powerful challenges that risk and finance can give each other are sustained and that governance remains strong. Simultaneously, challenging career paths are offered to both risk and finance personnel meaning that the talent pool expands.

At one global investment bank, the CFO has recently switched functions and taken on the role of CRO: its becoming increasingly common for careers to be forged by moving between the functions in a series of planned steps. Firms recognise that combined sets of deep skills are required for senior roles in both risk and finance.

Leading institutions do, however, integrate risk and finance management with strategy and value creation. Figure 2

shows the evolution of approaches to risk from Babylonian exposure management through risk measurement to the

optimisation of risk-adjusted performance and from Florentine bookkeeping through

financial analysis to decision support.

Strategicalignment/capital

allocation

Risk vs. returnoptimisation

Businessdecision support

Riskmanagement

Financialanalysis

Riskmeasurement

Managementreporting

Compliancemonitoring

Recordkeeping

Value creation

High

Proactive

Risk

Riskcontrol

Financialcontrol

Finance

Low

Link to strategy

Passive/reactivePassive/reactive

Figure 2: Evolution of risk and finance



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The main priorities

At the heart of aligning risk and finance is embedding risk management processes and disciplines as effectively as finance disciplines in the systems of the firm. This requires (amongst other factors):

CEO-sponsored and Board-approved • articulation of strategic risk appetite, which is supported by a handful of key risk measures and targets to steer the business;

A new perspective on business • planning where ranges of outcomes become the currency rather than point estimates. Risk inputs are used to consider the upside potential of planning options as well as the more limited traditional ‘risk as downside’ perspective;

In budgeting and forecasting, • stress testing the material risks becomes an integral part of the process, led by the risk team and supported by finance. Pillar 2 of Basel II has stimulated many firms to do this with appreciable and tangible benefits;

Linking enhanced front-end risk • management through to enhanced management reporting;

The enhancement of • performance management through better-aligned decision support information and tools; and

Risk and finance teams are • embedded in the business. Risk-adjusted performance measurement means that risk become an integral part of managing the business – it affects bonuses.

The market turbulence caused by the reappraisal of structured products has created some sharp lessons for finance – the implications of which we have discussed in Figure 1.

Institutions will wish to avoid the experience of one CFO at the height of last summer’s turmoil. The CFO requested separate reports from his finance, credit risk and market risk teams to understand potential exposures in the fixed income portfolio. Each report had different figures for profit and loss, balance sheet allocation and exposure levels.

Similarly firms are much more appreciative of the need to monitor the flow of transactions and to assess the downside risk and potential balance sheet and capital implications of the flow slowing (or stopping).

Another important area where we expect to see a change is in terms of external reporting and the provision of prospectuses for complex products in response to investor demands. This is likely to be accompanied by a parallel shift in the detail and coherence of internal reporting.

The benefits

We believe that significant benefits can be delivered from aligning risk and finance more effectively:

Greater application of • risk disciplines in key business processes such as strategy, planning and valuation. One example is the valuable insights gained from deploying economic capital and enhancing capital allocation mechanisms;

More robust financial plans and • projections: through challenging management to consider ranges of upside and downside outcomes it requires management to define its appetite for earnings volatility;

A more • coherent and consistent view of the business from risk and finance. For many risk functions this means escaping from the regulatory compliance emphasis of Basel II to a more productive, commercial focus.

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Reduced costs• – both direct and indirect. Alignment of risk and finance reduces internal friction and avoidable inefficiency and duplication;

Better, faster and more robust • decisions based on common data. The truth may be a shade of grey rather than black or white but a better aligned view of management information resolves ‘my numbers are better than yours’ debates and recognises the value of both in supporting decision-making; and

Improved reporting and • communication – internally and externally.

Combined, these benefits lead to increased value creation through better decisions, greater resource efficiency and the improved reporting to investors and other stakeholders. Realisation of these benefits may in many cases require a new business model.

Towards a new business model

For many financial institutions internal organisational models, systems, data, processes and controls have grown as a result of historical events and

not proactive management design. Multi-layered complexity proliferates due to the accommodation of, for example, regulatory requirements, new product development needs, differing demands for management information, acquisitions, partnerships and separate functional agendas. The sheer scale of the challenge involved in transforming the model means that many firms have been unwilling or unable to address it. While fundamental change from the ground up may remain a distant dream it is now essential to address the level of alignment between risk and finance.

PricewaterhouseCoopers has worked across the sector in developing appropriate risk and finance operating models to support our clients’ strategies. Legacy operating models for our clients’ finance and risk functions vary, from those where there is clear structural separation to others where both functions report to a CFO responsible for independent risk and finance teams. The challenge is to determine how these models can be more closely aligned to realise the undoubted benefits discussed above.

We believe that aligning strategy, risk and capital can no longer be left to good ‘teamwork’ between functions. Innovative

institutions are aligning risk and finance activities supported by a common infrastructure and data architecture.

Figure 3 overleaf summarises the general direction in which we see risk and finance models heading. Clearly, the level of alignment needs to be appropriate to the bank’s strategy, culture and the limits of its infrastructure. In our view, however, a more aggressive alignment agenda is justified in the majority of cases.

Better alignment rests on standardisation and simplification of the reporting, control, modelling, transactional and data elements of risk and finance alongside efficiency through extended combined shared services and outsourcing. Risk functions are increasingly using shared service and outsourced or off-shored models to reduce costs and focus on retaining the skills which confer competitive advantage. In management terms, better decisions are facilitated by combined, virtual teams embedded within the businesses for close day- to-day support. Distributed centres of excellence provide deeper, more specialised insights (for example into

particular risk types).


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‘Typical’ risk and finance structure

*Credit, market, liquidity and operational risk

Financialreporting

andcontrol

Taxplanning

andcompliance

Investorrelations

TreasuryandALM

Financialstrategyplanning,budgeting

andanalysis

Riskreporting

andcontrol

Riskcommittees

Oversight,policyand

modeldevelopment

Risk monitoringand escalation

in the business*

Bus A

Bus C

Bus B

Finance partners in

the business

Bus A

Bus C

Bus B

CFO CRO

Finance transaction, data and systems – shared services, offshored or outsourced run on tailored ERP

Risk transaction, data and systems –in-house developed tools and teams

Non-aligned

• External reporting incomplete/hard to digest

• Risk-adjusted performance as secondary

• Resource allocation decisions sub-optimal

• Strategy lack risk dimension

• Multiple multi-function business touch points

• Multiple data sources for reporting

• Unnecessary duplication of effort

• Narrow silo career opportunities

Aligned

• Greater transparency and coherence in reporting

• Risk-based capital management embedded

• Risk-reward profile managed to maximise value

• Front-end decisions explicitly address risk

• Limited high value cross-function business touch points

• Single chart of accounts for financial and risk reporting

• Teams aligned and activities harmonised

• Rich career paths structured across functions

Risk and financepartners in the business*

Bus A

Bus C

Bus B

Risk governance and policycentres of excellence e.g.

Market risk

Operational risk/control

Credit risk

Aligned risk and finance structure

Financial andcapital strategy

planningand

analysis

Taxplanning

andcompliance

Aligned teams

External relations

Riskcommittees

Financial and risk transaction, data and systems – Consistent data with supporting change of accounts across financial, risk and regulatory reporting, supporting data dictionary, shared services, offshored or outsourced run on tailored service orientated architecture between existing systems.

Changemanagement

M&A

Capital strategy, allocation and planning

Integrated financial andrisk reporting and control

Treasury andbalance sheetmanagement

Oversight,policy and

modeldevelopment

CFO CRO

Figure 3: The aligned model


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Conclusion

Each institution starts from a different place and the first step is to identify the issues. If you found the issues raised in this article relevant to some of the challenges that you are facing, ask yourself three key questions:

How satisfied are you with the • alignment of risk and finance in your organisation?

Where are the greatest benefits likely • to be generated?

What would you like to change?•

For many institutions the case for change is compelling from the perspectives of improved reliability of reporting, sharper business insights, faster business support, better resource allocation and greater operational efficiency. Full integration of risk and finance may be a fool’s errand but alignment to achieve common goals in a hostile market environment is fast becoming a business imperative.


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by Bruce Weatherill, Natasha McMillan and Justin Ong

Watch the wealth management gap: Are you in danger of falling behind?

18



Justin OngPartner, Private Banking/Wealth ManagementPricewaterhouseCoopers (Singapore)

Tel: 65 6236 [email protected]

Natasha McMillanSenior Manager, Private Banking/Wealth ManagementPricewaterhouseCoopers (UK)

Tel: 44 20 7804 7655natasha.mcmillan.uk.pwc.com

Bruce WeatherillGlobal Leader, Private Banking/Wealth Management PricewaterhouseCoopers (UK)


Despite the recent volatility in the markets, and the impact of the credit crisis, this remains a very positive time for wealth managers. The rapid growth of personal wealth is fuelling fast expansion in assets under management (AUM) and profits for wealth managers.

It is also clear that tomorrow’s leading wealth managers will need to continue to evolve and that their success will come from a single-minded focus on delivering excellent client service. This will not necessarily be easy as it will require major strategic shifts and investment, as well as operational and cultural changes. However, those that do succeed will reap the rewards offered by the marked growth in personal wealth.

Our 2007 Global Private Banking/Wealth Management Survey1 revealed that Chief Executives (CEOs) were predicting on average a staggering 30% annual growth in AUM for their own businesses – the highest seen in the survey’s 14-year history. At the same time, the challenges of managing this growth surfaced again and again. Whilst the effect of the credit crisis has dented these forecasts, many have still achieved this growth (see Figure 1).

The survey highlighted the changing shape of wealth management. The participation in the survey of 265 organisations across 43 countries is evidence of the global explosion of wealth management. Participants came not only from the established markets of the Americas and Western Europe, but also in large numbers from Eastern Europe, the Middle East, South America and Asia, including India and Singapore.

Overall, the number of private clients is increasing as a result of the accelerating economies of these new nations, as well as sustained growth in established markets. New wealth management clients are dominated by entrepreneurs who have built private businesses, representing a fundamental shift from traditional, inherited wealth to self-made

wealth. Today’s clients understand business, know what they want and expect to get professional service at competitive, institutional costs. Wealth managers that can meet these demands will become tomorrow’s market leaders.

1. Delivering excellence

‘ Clients are getting wealthier, shrewder and less tolerant of poor service. They are setting the agenda. Wealth managers best able to meet and exceed the needs of clients will win market share.’

Whilst survey participants agreed that delivering excellence was the key to servicing the new client, there was less clarity around the understanding as to what this really meant. Given that wealth management is built on client trust and that the primary means of gaining new clients is through referrals, it is critical that wealth managers focus on delivering quality service and advice to existing clients.

But are client relationship managers (CRMs) truly regarded by their clients as ‘trusted advisors’? More than 80% of CRMs believe they have achieved this status, yet the weight of evidence is stacked against them.

1 ‘Executive Summary – Global Private Banking/Wealth Management Survey 2007’, PricewaterhouseCoopers – 06.2007.

Figure 1: Average predicted annual growth in AUM


Global 30%

Asia Pacific 34%

EMEA* 28%

The Americas 30%

* Europe, the Middle East and Africa

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Existing share of wallet2 is low, with only 14% of wealth managers holding over 60% of a client’s wealth (see Figure 2). Less than a third of CRMs’ time is spent with existing clients. Additionally, there is a self-confessed lack of understanding of clients’ personal circumstances. In particular, nearly 50% of CRMs regard their knowledge of extended family considerations as ‘moderate’ at best. In our view there is significant scope for improvement before most wealth managers can claim trusted advisor status.

Those that do achieve the elusive trusted advisor status will be in the best position to deliver on their stated strategic aim of increasing share of wallet, which in turn will secure future revenue growth and success. It may also further ‘institutionalise’ the client within the organisation, making it harder for the CRM to take clients with them if they were to leave the organisation.

Excellence cannot be delivered if wealth managers do not better understand what their clients value. While 78% of wealth managers do undertake some type of segmentation analysis, techniques are still very crude and do not contribute to a greater understanding of client needs. The focus is more designed to benefit the wealth manager, and there needs to be a shift towards what the client wants. More

meaningful analysis of clients’ needs is necessary, including lifestyle, wider family considerations and risk appetite if wealth managers are to deliver on clients expectations.

Not only do wealth managers not understand client needs adequately, the majority do not appropriately assess satisfaction with their service. The main method of measuring client satisfaction, the monitoring of complaints, is too little, too late. The fact that 50% of wealth managers do not have a defined retention process to monitor and maintain valued existing clients is completely at odds with their claims to have a client-centric business model. If wealth managers do

not actively monitor client satisfaction, capture direct independent feedback from clients and act upon it, how can they ensure they are delivering quality client service?

Throughout the survey, the growing power of the client is one of the strongest messages to emerge. Wealth managers need to take a serious look at themselves and ask whether their organisations are really delivering excellent client service whilst at the same time addressing the changing needs of today’s clients. If not, then they should not be surprised when clients leave and move to competitors.

Watch the wealth management gap: Are you in danger of falling behind? continued

2 Share of wallet is a term used in wealth management in reference to the percentage of a client’s investable wealth held by the wealth manager.

Investable wealth

1-20% 121

4321

3137

932

59

%

21-40%

41-60%

61-80%

81-100%

Now

3 years

0 10 20 30 40 50

Figure 2: The percentage of existing clients’ investable wealth that wealth managers hold


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2. Rising to the people challenge

‘ People are emerging as the key capacity constraint to growth. Quite simply, there are not enough CRMs to deliver the forecasted growth, let alone with the ability to offer excellent client advice and service. The best wealth managers will find new ways to recruit CRMs, and make the most of their existing CRM pool by developing talent, rewarding excellent client service and improving training.’

It is said that a picture is worth a thousand words. If so, Figure 3 highlighting the most pressing business issues currently facing CEOs shows just how important the ‘people’ issue has become.

Globally, CRM numbers are expected to expand by almost a third over the next two years. The fastest growth is taking

place in Asia Pacific, where CRM numbers are anticipated, in our view unrealistically, to expand by 57%, reflecting the economic boom and rising personal wealth within the region (see Figure 4).

Few wealth managers are showing signs of properly addressing this issue. Poaching from competitors is still the principal method used to recruit CRMs, evidenced by 90% of CRMs claiming they have been approached by a competing organisation in the last year. With such significant demand for CRMs, such a strategy only drives up salaries and costs, and, in the long term, is not sustainable.

Wealth managers who focus on developing their existing and future talent pool will be successful. Our work with wealth managers suggests that only a few of the largest players have begun to

tackle this through more innovative recruitment, better talent management, leadership development and training.

Whilst there is clear doubt about the ability of wealth managers to achieve their forecast numbers, there is also an issue about the quality of CRMs. Lack of training in softer skills is still a key weakness. While almost 80% of CRMs believe relationship management skills are essential for their success in servicing and retaining clients, they also state that this is the area where they are most in need of further training. Currently, training still tends to focus on product training or mandatory areas such as Anti-Money Laundering and Know Your Customer. Our experience with wealth managers in this area shows that those who recognise the importance of softer skills, including relationship skills, and

257

199

130

100

105

Sum of weighted ranked responses

Building future leadership capability

Attracting appropriately skilled employees

Maintaining highly motivated employees

Retaining key employees

Building strong organisational culture values

0 50 100 150 200 250 300

Figure 3: The most significant people issues facing wealth managers today


Figure 4: Expected growth in demand for CRMs over the next two years


Global 32%

Asia Pacific 57%

EMEA 25%

The Americas 17%


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invest in training programmes to develop these skills, will be better able to deliver excellence to clients.

When it comes to remuneration, it appears that there is no specific reward for delivering high levels of client satisfaction. The primary influence on salary levels is still the achievement of revenue targets. By focusing on financial targets client service is potentially neglected. Client-centric performance measures, such as retention levels and referral rates, therefore need to be built into reward packages. By focusing on both client service and financial targets, both the client experience and share of wallet will improve – a ‘win-win’ situation for clients, CRMs and the wealth manager.

The CRM model needs to be re-engineered if wealth managers are to be able to improve CRM quality, change behaviours and deliver quality client service. Those that fail to do this will become severely challenged in attracting and retaining high-quality staff.

3. Time for a step change in efficiency

‘ A significant investment is needed to upgrade systems and processes to transform the effectiveness of wealth managers. Wealth managers are investing heavily in this area and it is rapidly becoming an area of differentiation.’

Although almost 60% of wealth managers have executed major upgrades of their core business systems over the last two years, nearly a third of Chief Operating Officers (COOs) say systems are still not ‘fit for purpose’. In a number of territories, particularly in Europe, business volumes are expected to significantly outstrip current capacity levels. Without continued investment, legacy systems are in danger of not only impeding growth, but also putting the whole wealth management business model at risk.

Our work with clients also indicates that there is significant room for improvement to current systems and processes, with 60% of wealth managers stating that inefficiencies exist. It is remarkable that ‘people’ interaction, not IT systems, remain the primary method of communicating between the front, middle and back offices and other support functions. Additionally, CRMs spend on average more than one day per week on

administration and error resolution, which is not an effective use of their time. This business model is not scaleable. If wealth managers are to make better use of people – their scarcest resource – they need to embrace IT as an enabler of business support and administration.

With CRM resource constraints well documented, particular emphasis needs to be placed on tools that support the relationship management process (see Figure 5).

The availability of technology tools, including easier access to account information, providing enhanced performance tracking and aggregated account statements, will improve the efficiency of CRMs, as well as enhancing client service. While many wealth managers plan to introduce aggregated client statement reporting, the majority (60%) indicate that they will need to upgrade systems in order to do so. Furthermore, the success of such initiatives lies in the ability of wealth managers to provide adequate training to CRMs to use such tools, as currently only 5% of CRMs are considered by COOs as highly IT competent.

Our work shows that a gap is emerging between the largest players who are able to invest heavily in systems and use the efficiency gained to put pressure on the

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mid-tier players. Success will depend not necessarily on huge-scale investment but rather targeted investment to support the client proposition. Aligning IT strategies to business objectives will become a key differentiator for wealth managers in achieving a competitive advantage.

4. Setting the right course

‘ The success of a wealth management organisation, whatever its size, will be dependent on its ability to know its strengths and weaknesses, and to develop the best client-centric solutions available.’

Brand is still considered as the top differentiator for their businesses by CEOs. With a successful brand

comes a strong reputation which is attractive to new and existing clients as well as staff. Aspirations to build stronger brands continue, with 74% of participants aiming to have recognised and established brands in three years’ time. However, as 50% plan to spend less than US$500,000 per year on branding and marketing, this seems largely unattainable. There are, however, a few wealth managers who are currently investing substantially in their brands, and using brand as an important competitive tool. It appears that a noticeable gulf is being created between the brand position of these wealth managers and that of other players in the industry, which will prove very hard to close.

The quest for differentiation continues and after brand, the depth of personal relationships and quality of professional advice are also seen as the key differentiators for wealth managers. (see Figure 6).

This emphasis on advice and the client, rather than simply the product, represents a significant change in the whole wealth management model. It is a shift that has been taking place, albeit gradually, since the end of the 1990s equity bull market, when investment performance was a much more important differentiator.

Management information needs to support this strategy to deliver on the client-centric proposition. It is debatable whether CEOs receive sufficient and timely information to adequately support such decisions and strategies. Furthermore, our work with wealth managers shows that there remains a substantial amount of client information held by individual CRMs, which is still not being shared with senior management. CEOs need holistic profiles of their client base to support their strategic decisions. Development of management information with appropriate Key Performance Indicators (KPIs) is critical to ensure that CEOs are well informed and making appropriate strategic decisions that will deliver the client proposition.

62

62

47

46

39

33

30

%

Improving performance tracking metrics

Reviewing/improving client relationship management systems

Improving client reporting systems

Increasing straight-through processing for trade execution and booking

Adopting e-platforms to allow clients to service themselves

Reviewing IT architecture and aligning IT strategy to business plans

Reviewing core banking systems or specific product modules

0 10 20 30 40 50 60 70 80

Figure 5: COOs’ current IT priorities



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The survey findings indicate that it has never been more important to set the right strategy. At a time of increased change in the industry, there are both opportunities to be taken and dangers to face. We see evidence that the mid-tier wealth managers will face the greatest challenges, as they seek to compete without either having adequate critical mass to deliver cost-efficient service or a differentiated service proposition. A clear strategy will assist successful navigation of the hurdles and obstacles that lie ahead.

5. Embedding the client proposition

‘ A consistent client-centric approach needs to be cascaded throughout the organisation, and to the client. Being intensely client-centric across the whole organisation will be the most important differentiator for tomorrow’s leaders.’

In order to effect change, the entire organisation has to be focused on delivering the client-centric proposition. It is revealing that while salaries and wages make up more than 50% of the cost base, and one of the main constraints on growth is described as the shortage of CRMs, 74% of wealth managers do not

have a ‘people’ representative on the board. Furthermore, CRMs state that the main reason for leaving a wealth manager is not agreeing with the corporate strategy. Success will depend on responsiveness to change, and ensuring that all key stakeholders buy into the organisation’s strategy.

Creating the right culture is an important attribute to the success of a wealth manager. We know that these intangible aspects of an organisation play an important role in whether CRMs choose to stay with or leave a wealth manager. Some 53% cite corporate culture and ethos, and 83% say good relations with management or colleagues are key reasons for staying with their organisations (see Figure 7).

A successful culture can take significant time to establish, yet it can easily be diluted by actions such as frequent management changes or significant acquisitions. Indeed the wealth management industry is currently experiencing continued change within Executive Boardrooms. Such frequent changes in management can put the business strategy at risk. Furthermore, as consolidation continues in the market, the challenge of maintaining the culture and DNA of the wealth manager remains fundamental to the success of the chosen business strategy.

186

180

180

146

83

74

Sum of weighted ranked responses

Provision of comprehensive, integrated wealth management planning approach

Brand value

Quality of professional advice

Best in class products

Personal relationships

Knowledge of local markets

0 50 100 150 200

Figure 6: Areas in which CEOs believe their organisation is currently differentiated


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As part of the culture of the wealth manager, effective risk management becomes not just a regulatory requirement, but a business imperative to protect and enhance the reputation and value of the wealth manager. Failure to minimise risks through not complying with new rules and legislation, failing to treat customers fairly or inappropriate client service, will result in the unwanted attention of regulators, media and other stakeholders. This can adversely impact brand and reputation, including the trust of clients which, once damaged, is very hard to restore.

Spurred on by new regulatory requirements, wealth managers are becoming more sophisticated in their approach to risk. More than a third of wealth managers have introduced a new

risk management framework in the past two years, and nearly 80% are currently upgrading their frameworks. However, given the embryonic state of wealth managers’ existing risk frameworks, there remains much to do. Not upgrading and embedding the risk management framework will lead to wealth managers falling behind market best practice and increasing their risk of reputational damage.

The long-term commitment of a stable senior management team and a value-enhancing risk management framework will be critical if the client-centric proposition is to be embedded throughout the business. It is our opinion that being successfully client-centric throughout the whole organisation will be critical for tomorrow’s leading wealth managers.

Invest for the future

To summarise, at a time of rapid growth it is all too easy to delay tackling the challenges revealed by our survey. However, we believe this to be a critical time in the development of the wealth management industry. For an industry that is seeking to become more client-centric, many wealth managers will need to change their business models in response to clients’ changing demands. There is the necessity to be able to manage the exceptional growth whilst at the same time delivering an excellent client experience.

It is evident, through our work with wealth managers, that already a gap is emerging between those wealth managers taking actions to prepare for this new world, and those not doing so. If wealth managers fail to change and adapt, there is a real danger that they will fall behind and be relegated to the sector’s second division. However, those that are serious about wealth management, and prepared to invest for the long term, will emerge as one of ‘Tomorrow’s Leading Wealth Managers.’

83

53

43

41

24

20

%

Remuneration

Good relations with management

Corporate ethos and culture

Uncertainty that clients would follow your move

Career path

Personal reasons

0 20 40 60 80 100

Figure 7: Reasons why CRMs stay at their current organisation


Sections of this article have been reproduced from the ‘Executive Summary’, June 2007 and further analysis ‘Wealth managers driving for success: Becoming tomorrow’s elite’, PricewaterhouseCoopers November 2007. For further information or to download these publications visit www.pwc.com/wealth.


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by Christopher Box, Brian Furness and Jonathan Shepherd

Transforming the finance function: So much more than numbers

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Brian FurnessPartner, Financial Services, AdvisoryPricewaterhouseCoopers (UK)


Jonathan ShepherdDirector, Banking and Capital MarketsPricewaterhouseCoopers (Australia)

Tel: 61 (3) 8603 2713 [email protected]

Christopher BoxDirector, Financial Services, Human Resource ServicesPricewaterhouseCoopers (UK)


Growing business and regulatory complexity over the past decade has forced the finance function to rethink the way in which it operates. The implications mean that it must move away from the traditional scorekeeper role, towards that of a proactive and equal business partner.

Nowhere is this change more evident than in the financial services sector, where the accounting, risk management, pricing and capital implications of new businesses and products must be considered on an ongoing basis. Add to this the constant pressure to reduce costs and the increasing expectation on firms to speed up the time to close books and report to the market, and it is clear that chief financial officers (CFOs) need to focus on adapting skill-sets and behaviours to ensure that they have a finance function which is able to meet the challenges of the future.

One of the biggest hurdles is trying to galvanise a workforce to develop new ways of working and possibly new environments. Research suggests that the vast majority of organisations respond to change by developing the right solution, but projects fail to deliver

lasting benefits because of poor implementation and lack of focus on people issues. All of which means it’s never been more important to think about the people in the finance function and how they can lead this transformation.

Where do you start?

Setting out with the main objective of cutting costs in a business transformation project will almost certainly lead to failure. Additionally, transformations which focus purely on IT and process change may not deliver the benefits you seek if they don’t also look at the effect these changes will have on the workforce.

In our experience, a better approach is to think about how your finance function currently operates, your aspirations for the future and what needs to change. You can then focus on specifics about the skill-sets you need, the people you have and how they might need to develop to drive this transformation.

In many ways, undertaking an audit of the skills you currently have in your resource pool and comparing this to what you need is fairly straightforward; the

difficult bit comes when you have to address how the behavioural change can take place so that your team continues to consist of motivated, and proactive, ‘business people’.

Here we talk you through how you can have greater confidence that you have covered these issues so that your finance function transformation is successful.

Thinking about where you are now

When we work with CFOs to find out how their finance functions are operating, for example, during a business transformation project, we investigate the function by looking at three key areas; insight, compliance & control and efficiency as shown in Figure 1.

Some of the questions we ask are listed below; the answers to them should highlight key information about the current role the finance function is fulfilling and the skills its people possess. They can also give an indication of the likely return on the planned human capital investment:

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InsightWhat is the role of finance (vis-à-vis • operations, internal audit, risk management, etc.) and how does it contribute to value creation within the business?

What is a business partner and has • this role been articulated to the wider organisation?

Does finance provide the appropriate • management information to the business (group and divisions) to support its strategic objectives?

Is there a consistent and reliable • model for managing the internal and external relationships?

Do people have the appropriate skills • to make the journey to becoming better business partners?

Compliance and control Do people have a clear understanding • of end-to-end processes, ownership, accountability and definition of roles/responsibilities?

How are the relationships between • differing groups within finance (e.g. chief financial officers, shared service centre employees, outsourcing partners) managed to maximise value to the business?

How are outsourced processes • managed? Are there appropriate service level agreements in place with third parties to ensure that the organisation gets what it pays for, the level of risk involved is appropriate and the measurement and monitoring of these risks is adequate?

How are the controls measured, • are they are sufficient to protect the function and the business?

EfficiencyIs this an appropriate and cost • effective resourcing model for finance? How is cost effectiveness being measured?

How are people encouraged to • continually strive to improve process efficiency and effectiveness?

How do the standards of efficiency • applied to the finance function compare to best in class?

Is effective use made of the available • technology, in particular in automating those processes and employing tactical spreadsheet solutions that do not require human intervention?

What mechanisms are in place • to share and benefit from learning across the organisation and with other organisations?

Transforming the finance function: so much more than numbers continued

Insight

Org

anis

atio

n

Technology

People

Compliance and control Efficiency

Figure 1: Considering insight, efficiency, compliance and control in a finance function business transformation scenario


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Understanding the people issues

In many ways, uncovering what you are dealing with and what needs to change is the easy part. The difficulty comes in trying to mobilise and motivate people to change the way they work. As part of a finance function transformation, the roles of individuals will change. This can cause anxiety and confusion over what their role is and what impact this has on their future career.

Changes can be geographic/locational (offshoring or centralisation projects) or may be role-specific (some roles may be

combined and some will be created). People may be placed in roles that do not immediately play to their strengths or their personal development plans. In addition, roles may be unclear to the individuals and reporting lines may change, causing uncertainty and worry for the individuals involved.

The key is to provide support both for those who are leading the change and for those going through it. Some points to think about in the people arena are summarised in Figure 2.

Each of the areas in Figure 2 present some common issues in a transformation scenario. Resolving them in the right way can be pivotal to the success of your finance function transformation.

Considering each of them in turn, the following are some of the key points an organisation needs to factor into its finance transformation project.

Vision and strategy

Culture and values

Role definition

and development

Leadership

Skills development

Reward and incentivisation

Talent management

and succession

planning

Finance function

transformation

Communication

Figure 2: Areas for consideration in finance function transformation scenarios


Role of the business partner

Key to this is the role of the business partner, they act as the liaison between the finance function and the business. This role has evolved in response to criticism from the business that finance doesn’t understand the commercial realities it faces, so the role is one of a go-between, someone who knows finance and understands business realities, who challenges decisions and, in many ways, acts as a business consultant.


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Vision and strategy

Get people to buy into the strategy by involving them in developing it

It’s crucial to articulate what you want to do and how it’s going to happen: a good vision and strategy should be developed with the wider finance team so that employees buy into it and to ensure it is appropriate and relevant to them.

Leadership

Do they have the skills and confidence to lead through a period of change?

Because transformational change can be painful, it can be difficult for leaders to fully support it if they believe it is going to be hard for their employees, even if they know it is the best move for the business. Coaching is an excellent way to instil leaders with the skills they need to help transform the business. It also gives them the opportunity to vent their own frustrations and anxieties so that they are not passed on to their staff.

Role definition and development

Not sure if you have the right skills in the team?

Performing a gap analysis of the skills you require before you get to implementation stage is crucial to ensure a smooth transformation. If you end up relying heavily on contract or temporary staff, consider giving members of the existing team roles as champions to gain their buy-in and to help drive change forward. The critical thing is to get the right people in the right roles.

Skills development

People can’t change overnight

In a finance function transformation scenario, many people will need to develop new and different skills to complement their strong technical skills in order to become effective business partners. The role of business partners is varied and in many cases this means changes in skills and behaviours from the people involved. The key is to make sure you have the right people in place, with the appropriate training to ensure the transition really works.

Reward and incentivisation

Why should we do things differently?

A common issue is that employees can’t see why they should do something differently as it may make their work more difficult or take longer in the short term. How can you incentivise the right behaviours? One option is to balance short term (salary) and financial bonuses with specific transformational-related achievements, underpinned with additional non-financial rewards, such as leadership programmes, to ensure that individuals feel recognised for their efforts and achievements.

Talent management and succession planning

How can you recruit, identify, develop and retain future leaders?

A time of transformation can see many talented individuals leave organisations; to stop this happening, consider identifying from the outset the talent you need for the future of your finance function so that you can gain their buy-in from the beginning of the process. It may also be a pertinent time to think about how you recruit and retain employees and how this is linked to succession planning.

Transforming the finance function: so much more than numbers continued

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Culture and values

Offshoring – How can you ensure that cultural differences don’t stop you from succeeding?

Any change which involves outsourcing/ offshoring or shared service centres may create challenges as the geographical spread, institutional landscape and cultural mix of the finance function changes. If at the same time communication lines are also made more complex and time differences and distance are introduced, the potential for issues arising in the finance function will increase.

Communication

How do you ensure everyone understands what is happening and why?

Communication is key to ensure that all members of both finance and the wider business understand and believe in the need for change, the solutions and the vision of the future which management is trying to achieve.

Conclusion

An institution needs to address all of these areas if it is to be successful and achieve its goal of transformation change in the finance function. Driving and managing effective people change is something that all organisations need to become better at; for the finance function to change this means expanding on and honing the skills of the professionals in this field to ensure that they think about people and not just the numbers.


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by Nick Page, Mervyn Jacob and John Hawksworth

Banking 2050

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John Hawksworth Head of MacroeconomicsPricewaterhouseCoopers (UK)


Mervyn JacobFinancial Services LeaderPricewaterhouseCoopers (Hong Kong)

Tel: 852 2289 [email protected]

Nick PagePartner, Transaction ServicesPricewaterhouseCoopers (UK)


In the last few years the financial world’s vocabulary has expanded to include the acronyms BRIC1, TBTI2 and the date 2050 connected to the now increasingly widely accepted view that in less than half a century (in other words, during our children’s careers) the economic world order is likely to have changed very significantly from that around us today.

Macroeconomic analysis3 undertaken by PricewaterhouseCoopers indicates that what we call the ‘E7’ emerging

economies (China, India, Brazil, Russia, Mexico, Indonesia and Turkey) will, by 2050, be between 25% and 75% larger than the current G7 nations at the same date.4 In crude terms, this is all linked to relative rates of economic growth (see Figure 1), which in turn, is linked to a wide range of factors including population and demographics, education and wealth levels, industrial development and investment levels, and so the list goes on.

So what does this mean for the banking sector?

We recently extended our macroeconomic analysis to consider the possible consequences of this economic change on the banking sector. The principal conclusions from the analysis are that:

The banking sectors in the E7 will grow • significantly faster than in the G7, and total domestic credit in the E7 is likely to overtake total domestic credit in the G7 within the next 40 years;

Total domestic credit in China is likely • to overtake the UK and Germany by 2010, Japan by around 2020 and the US by 2045;

India is likely to emerge as the third • largest domestic banking market by 2040 and could grow faster than China in the long run;

Brazil, Indonesia, Mexico, Russia and • Turkey all have the potential to develop banking sectors of comparable scale to major European economies such as France and Italy before 2050; and

*Includes projected real exchange rate appreciation (shown in light blue bars)

Japan

Germany

*% real GDP growth p.a.

UK

US

Russia

Mexico

Brazil

Turkey

Indonesia

China

India

0 2 4 6 8

Domestic currency

US $ terms*

Figure 1: Projected average real GDP growth 2005-50


1 BRIC = Brazil, Russia, India and China, as featured in a series of research reports by Goldman Sachs in particular.2 TBTI = Too Big To Ignore, which tends to refer in particular to China and India.3 J. Hawksworth, ‘The World in 2050: How big will the major emerging economies get and how can the OECD compete?’, PricewaterhouseCoopers, March 2006.

This report is available to download from our website at www.pwc.com/world2050 .4 The E7 is projected to be around 25% larger than the G7 by 2050 measured at market exchange rates, or around 75% larger at purchasing power parities (PPPs).

The latter correct for the lower price levels typically observed in emerging economies to give an indication of the relative volume of output produced by different economies. In the present article, however, we generally use projected market exchange rates to compare the value of banking markets in different countries, but allowing for the tendency for the real exchange rates of fast-growing emerging economies to increase in the long run relative to the dollar and other G7 currencies.

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Profits from E7 banking markets could • reach half the level of profits from G7 banking markets by 2025, and could exceed G7 banking market profits by 2050; by 2050 profits in the E7 banking markets could be approaching USD 1 trillion per annum.5

Some of the key strategic implications

Entering the world’s largest and most populous markets such as China and India has been increasingly in vogue in the last few years. Established banks in these emerging markets, such as HSBC and Standard Chartered Bank, have been joined by large US and European banks, such as Bank of America and Royal Bank of Scotland, as large investors in E7 and other emerging market banking sectors. In all cases the arguments have centred on the growth agenda and the strategic logic of deploying expertise and know-how from established markets to one or more emerging markets. We consider that this trend is likely to continue for some considerable time, and that arguably the rate of investment will increase, which bodes well for the M&A markets in the financial services sector.

The limiting factor may not prove to be financial capital, but rather other factors such as human capital.

Hand in hand with investment flowing to emerging markets will be other trends such as:

Continued domestic consolidation in • the banking markets within the E7;

Restructuring of emerging market • economies (as they develop and transform) which may give rise to many more opportunities for private equity investors;

Emerging market banks taking stakes • in, or acquiring, banks in established markets to gain better access to capital markets and to secure further expertise and know-how;

Increased levels of innovation from • lower-cost operations based in emerging markets to compete with the incumbents in more established markets; and

Greater competition from E7 banks for • the best talent.

Relationship between domestic credit and GDP

It is a well-established fact that, as an economy develops, it moves first from specialising in agriculture to specialising in manufacturing, and then from manufacturing to services, including banking and other financial services. All of the G7 economies have been in this third stage of post-industrial development for at least the last 20-30 years, during which time there has been an underlying upward trend in their ratio of banking assets6 to GDP. The E7 economies have also seen a clear upward trend in this ratio, albeit from a much lower base and often with considerable short-term variations around this underlying trend (see Figure 2).

Current size of domestic credit and expected future trends

Despite the upward trend in the ratio of banking assets to GDP in the emerging markets, with the exception of China, the E7 banking (and other services) sectors are not yet that large, relative to the G7 countries. As the development of the E7 economies continues, however, in the long run we would expect their banking

Banking 2050 continued

5 Expressed in real terms at constant 2004 US dollars (i.e. excluding general price inflation).6 Banking assets are defined here as total domestic credit, using IMF data and definitions for consistency across countries and time.

34



sectors to grow, on average, more than proportionately with GDP; it has often been remarked that banks are a ‘leveraged bet on economic development’, and our analysis supports this view.

Projecting growth in domestic credit – rise of E7 markets

Our long-term projections also consider a number of other factors (as explained in more detail in our full report)7 including:

Underlying economic growth levels;•

The relationship between income • levels (GDP per capita) and banking penetration (domestic credit as a percentage of GDP);

Analysis to assess the likely upper • level for banking penetration (we set a maximum limit of 200% of GDP for domestic credit); and

Expert qualitative input concerning • convergence patterns over time in domestic credit to GDP ratios, in particular because China has a comparatively high level of banking penetration (140% of GDP) compared to other E7 banking markets (which are generally in the range of 20% to 60%).

7 ‘Banking in 2050: How big will the emerging markets get?’, June 2006. This report is available from our website at www.pwc.com/financialservices.

% of GDP

0

20

40

60

80

100

120

140 G7 average

E7 average

53 57 61 65 69 73 77 81 85 93 97 01 0589

Figure 2: Development of domestic credit to GDP ratio


Japan

Germany

$ billion

UK

US

Russia

Mexico

Brazil

Turkey

Indonesia

China

Spain

Italy

France

Australia

Canada

India

Korea

Domestic credit: (Net) claims on central government + claims on state and local governments + claims on non-financial public enterprises + claims on private sector + claims on non-bank financial institutions

0 2,000 4,000 8,0006,000 10,000 12,000

Figure 3: Current size of banking sectors



35



Figure 4 illustrates that although the E7 (as a portfolio) start some way behind the G7, the scope for their banking sectors to grow relative to the size of their economies is generally greater, which means that by 2050 near convergence will have been achieved in ratios of domestic credit to GDP.

In absolute terms, bearing in mind that E7 GDP is projected to be around 25% higher than G7 GDP by 2050 at market exchange rates, the banking assets of the E7 markets are expected to be greater than the banking assets in the G7 markets in our baseline scenario.8

Share of global banking – a shifting picture

As illustrated in Figure 6, the world order of banking markets will change considerably between now and 2050. That is not to say that the banking sectors in the developed markets won’t still be important, just that some of the players at the top table are likely to have changed. Not surprisingly China and India will have very large domestic credit markets and hence will be particularly important markets (ranked first and third in the world by 2050 according to our

Dom

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as %

GD

P

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Global average

2004 2009 2014 2019 2024 2029 2034 2039 2044 2049

Figure 4: Projections for domestic credit to GDP ratio: E7 vs G7 and global average


Dom

estic

cre

dit

($ 2

004

bn)

0

50,000

100,000

150,000

200,000

250,000 G7

E7

World

2004 2009 2014 2019 2024 2029 2034 2039 2044 2049

Figure 5: E7 vs G7 total domestic credit


8 We also consider alternative scenarios in our report, but the broad conclusion on the relatively much faster growth of the E7 banking markets as a portfolio compared to the G7 appears reasonably robust across alternative scenarios, even if individual country projections are subject to greater uncertainties.

36



projections). Somewhat smaller E7 markets such as Brazil, Indonesia, Mexico, Russia and Turkey are expected to grow dramatically and could be of broadly similar sizes to more established markets such as Canada, France, Germany, Italy and Spain.

The growth of E7 markets will be driven by many factors, but the rise in retail banking (mortgages, consumer credit and the like) is expected to be particularly important as household income and wealth levels, and so borrowing capacities, rise rapidly as the E7 economies develop. See Figure 7 for further details of our country projections and anticipated key trends in each of the E7 banking sectors.

Any individual country projections are subject to many political, social and economic uncertainties that could throw this projected strong growth off track for prolonged periods. But, as a portfolio, our analysis suggests that the E7 banking markets have strong potential that is robust to plausible alternative scenarios. It is for this reason we anticipate a continuation of investment by western institutions in the E7 markets and more generally across all emerging markets.

Japan

Germany

% of world total

UK

US

Russia

Mexico

Brazil

Turkey

Indonesia

China

Spain

Italy

France

Australia

Canada

India

Korea

0 5 10 15 20 25

2050 shares

2004 shares

Figure 6: Shifts in shares of global banking assets


Japan

Germany

Change in real GDP per capita (% pa)

Dom

estic

ban

k cr

edit

as %

GD

P

UK

Korea

Spain

Italy

Canada

Australia

France

US

RussiaMexicoBrazil Turkey

Indonesia

China

India

0 0.5-0.5 1.0-1.0 1.5-1.5 2.0 2.5 3.0 3.5 4.0%

9%

8

7

6

5

4

3

2

1

Figure 7: GDP growth and the banking sector



37


Profit pools – significant expansion in the E7

Projections of banking assets are all very well, but for potential new entrants or acquirers in the emerging markets, it is the size of the profits pools that matter most. To get some insight into how these might develop, we carried out an analysis of bank profitability using data from the Fitch database of all the banks on which they issue credit ratings. Focusing on the period since 2000 (or, in some cases, more recent data where this seemed more reliable)9 we found post-tax return on assets averaging around 1% globally but with variations by country; with the emerging markets being more profitable for the most part.

To forecast profitability we assumed gradual convergence (by 2030) of return on assets in all countries towards the global average of 1%, driven perhaps by cross-border capital flows tending to equalise returns across countries.

Figure 8 illustrates banking profit pool projections (for domestic credit assets only). It shows that the E7 rises to close to half the G7 level by 2025 and to more than G7 levels by 2050. The growth in profits available in the E7 markets is spectacular and comfortably outperforms that in the G7. This is not to say that the G7 will stand still. On the contrary. G7 banking profits are projected to rise by around 300-400% in real terms by 2050, broadly in line with projected G7

GDP growth over this period. But compared to the growth rate of the E7, this is relatively modest.

Strategic issues

There are wide-ranging strategic implications for banks from our analysis; amongst the many questions for business leaders to consider are:

Does our bank’s near-term strategy • encompass an adequate presence in the emerging markets?

If we are to enter the emerging • markets or expand an existing presence, what is the best way of doing this: green-field, joint venture or acquisition?

In which market other than our own, if • any, does, or could, our institution have a sustainable competitive advantage?

Which segments of the banking • market provide the highest growth prospects in the major emerging markets?

How do we manage a portfolio of • businesses in several E7 and other emerging markets?


0 200 400 600 800 1000Profits on domestic credit (constant 2004 $bn)

Baseline scenario with convergence

E7

G7

2005

2050

2025

Figure 8: Illustrative banking profits


9 BRIC = Brazil, Russia, India and China, as featured in a series of research reports by Goldman Sachs in particular.

38



How best do we compete with fast • growing, ambitious, low-cost local competitors?

Conclusion

While our projections to 2050 are inevitably subject to many uncertainties, the broad message from the analysis seems likely to be robust, namely that the emerging economies – and particularly China and India – are likely to have an ever-increasing weight in global banking markets over the coming decades. Western banks that do not respond effectively to this challenge seem likely, sooner or later, to become victims of the growth of their E7 rivals.

This article is based on our report ‘Banking 2050: How big will emerging markets get?’ which is available on our website at www.pwc.com/financialservices.

For further reading regarding our series of report on aspects of the world in 2050, please visit www.pwc.com/world2050.

Further information on our economics practice is provided at www.pwc.com/uk/economics.


39


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