Boost bank ROE by integrating innovation initiatives

July 29, 2019Over the past decade, banks have faced increasing pressure to lower costs, improve regulatory compliance and compete with aggressive fintechs. At the same time, their customers have come to expect seamless, intuitive, and convenient interactions on par with the digital experiences elsewhere in their lives, such as on Google and Amazon. A handful of leading banks including BBVA, Citi, Lloyds, Sberbank, DBS, and ING responded quickly with increased investment in various forms of innovation, most notably in digitization (for example, journey redesigns in current accounts and mortgages, digital marketing and sales), agile ways of working, partnering with fintechs, and launching new ecosystem strategies to create growth opportunities beyond banking.

Since these “early responders” invested in innovation, most other global banks have joined in. While each bank is organized slightly differently to deliver innovation, roughly 50 percent of the top 100 global banks by assets have corporate venture capital (CVC) arms, about 80 percent have at least one fintech partnership, and about 25 percent have launched digital attacker banks, such as Marcus from Goldman Sachs and digibank from DBS. A significant number have internal innovation units, and many of the largest banks are doing all of the above.

However, it has proven difficult for banks to innovate in ways that deliver “at scale” impact. By “at scale,” we mean delivering significant growth in the form of new processes, products, services, experiences, and business models. According to McKinsey research, currently 56 percent of banks globally are not generating their cost of equity (COE), with global banking ROE at 10.5 percent in 2018, hovering around its long-term average. For European banks to generate their COE they would need to lift revenue by 15 percent or reduce costs by 20 to 25 percent. So despite all of the activity noted above, very few banks are effectively using innovation to elevate their performance.

Part of the reason banks are struggling to deliver meaningful impact from innovation is that very few clearly connect their innovation investments to a clear and cohesive strategy, with distinct goals for innovation. They can begin to make this connection by explicitly answering three questions:

1. What ROI and total contribution to revenue and profits do we need from innovation and how quickly do we need it?
2. What portfolio of innovation initiatives can plausibly attain this ROI and fulfill our strategy?
3. How do we organize to bring the bank’s full resources to these efforts—so our scale becomes an advantage instead of a hindrance to innovating?

Through our research and conversations with industry leaders, we have identified three steps that banks can take to answer these questions.

The first step is to conduct a review of all innovation initiatives enterprise-wide to understand how much is being invested across the organization and where. This review should be overseen by a senior leader or a cross-functional/cross-business-unit group of leaders who are empowered and held responsible for managing the entire portfolio. Ensuring this coherence and balance across business lines (for example, so retail and corporate do not lose sight of the small and medium size business opportunity) as well as non-client facing functions like IT and risk management is critical.

A crucial component of this first step is for leadership to set goals for the return on innovation (we call this the “green box,” see Exhibit), define metrics to measure progress (for example, revenue after risk cost, new client acquisition, NPS, or operating expense reduction), and set timeframes to achieve these goals. All these aspirations must be “wired” into annual plans. This will help the leader measure ROI, understand what initiatives to continue and discontinue, and create accountability. In our work across industries, we’ve found that 65 percent of leading innovators set their aspirations in this manner compared to only 20 percent of all other companies. Interestingly, this gap has widened over the past five years.

Exhibit

For example, a US bank used this first step to mobilize and integrate previously dispersed resources into a new innovation unit. It had an ambitious goal of tripling its revenue over the next seven years, which meant the bank needed to expand beyond its core business. By assessing the momentum of the core business and the competitive and disruptive threats that existed and could accelerate, the bank determined how much growth needed to come from innovation. Concurrently, the bank developed four innovation-focus areas that responded to the threats facing its core businesses and targeted new growth sources worth about $1 billion. They also created targets for the business units.

The second step is to manage the organization’s innovation efforts and investments as an integrated “innovation portfolio” instead of treating the incubator, CVC, BU innovation teams, and so on, as stand-alone units with individual (and often competing) budgets and objectives—which is the common approach today. Bank leaders should gather potential innovation initiatives from a wide array of sources: top-down strategic bets, bottom-up ideas from BUs, proposals from external partners, and so on. And they should prioritize these initiatives based on how well they address strategic priorities, their risk profiles, and time to impact.

Based on this prioritization, leaders can construct a portfolio of innovation initiatives that can plausibly deliver on their strategic goals, assign initiatives to the right BUs, and then allocate resources. As the innovation initiatives progress, leaders should look for opportunities to re-allocate resources, doubling down on initiatives that are succeeding and quickly killing those that are struggling by using metered funding, agile governance, and other mechanisms. This effectively brings zero-based budgeting to the innovation effort and is critical for maximizing ROI.

By managing these innovation vehicles and investments as a single portfolio, the bank can coordinate activities and share resources when possible for greater efficiencies and cost savings. As part of this second step, leaders can also manage the balance between short-term initiatives that will generate revenue or cost savings relatively quickly, with longer-term bets. Designed correctly, this development strategy can make initiatives essentially self-funding. Our research shows that 47 percent of leading innovators have strong innovation portfolio management and resource allocation systems, compared to 12 percent of other companies.

The third step involves implementing a robust operating model that integrates critical choices across seven elements: governance, funding, metrics, development processes, organizational structure, talent, and distinct capabilities and assets needed to support initiatives. While there is no one-size-fits-all configuration, an effective operating model must support:

• A committed, sustained allocation of resources to innovation initiatives
• A steady stream of opportunities and ideas from multiple sources
• Streamlined governance that moves as quickly as innovation teams and focuses on de-risking and accelerating initiatives
• Multiple (or at least flexible) innovation development and delivery pathways tailored to the different needs of incremental versus disruptive initiatives
• Go-to-market channels for innovations, and in-market feedback mechanisms for continuous learning
• Cultivation and retention of talent to drive and support innovation (for example, digital, design, business model specialists)
• Secure IT environments so teams can access enterprise data, CRM systems, and so on

For a real-life example of how these three steps can work in practice, consider the following case. After two years, and despite having 100 people dedicated to building new digital businesses, a large European bank found itself far behind schedule and generally disappointed with its innovation initiatives. Leadership realized they lacked an overarching vision and the right capabilities to meet their strategic objectives. So they re-set a clear aspiration for their innovation strategy, reprioritized projects, and adjusted resources and talent to operate at full speed. This new tack allowed them to manage their portfolio versus being overly focused on the success of individual projects. They also enhanced their operating model by setting up a VC-style governance committee to help prioritize initiatives in the pipeline, and to create a talent pool they could tap for new priorities and reallocate across initiatives. They also centralized, empowered, and incentivized a team of executives from across core corporate functions (for example, accounting, risk, procurement, compliance) to keep innovation teams working quickly and efficiently toward their goals.

Banks need to act now to ensure impact from their innovation investments

The pressure to innovate for long-term competitiveness is significant, but innovation within banks is not a trivial undertaking. Indeed, banking industry characteristics can work strongly against innovation. For one, economic payoff is usually slow. The balance-sheet driven, vintage-based economics of the banking business means new growth innovations don’t fall to the bottom line in a visible way for three to five years. Meanwhile, regulatory and investor demands often force banks to focus more on immediate risk, compliance, and cost issues than on long-term growth opportunities. Finally, there is also an inherent tension within banks between a risk-averse culture that wants 100 percent predictability and accepting the reality that not all innovations will succeed.

Even under the best of circumstances, three to five years is a long time to keep the faith, and in the past some banks have been inconsistent with their commitment to initiatives. Sometimes this might be due to a change in leadership and priorities. Sometimes it might be a turn in economic fortunes. But banks must resist stopping and starting funding for innovation. Technology is moving too quickly, customers are too demanding, and fintech competitors are too effective at finding ways to innovate across the value chain. Leaders need to act now to ensure innovation becomes a core element of their bank’s strategy in a way that continuously delivers “at-scale” returns.