Management Effeciency in Banking explained

Effective management entails properly finding and capitalizing on acceptable profit possibilities while also controlling risk. Compliance with rules and regulations is critical for all sorts of businesses.

It is also vital to have a solid governance structure with an impartial board that precludes excessive remuneration or self-dealing. Internal controls, transparency in management communication, and the quality of financial reporting are all indications of management effectiveness. Overall performance is ultimately the most accurate indication of management success across all organizations.

A particularly essential component of managerial competence for financial institutions is the ability to recognize and control risk, which includes credit risk, market risk, operating risk, legal risk, and other hazards. Bank directors determine overall risk exposure levels and suitable implementation strategies, as well as offer oversight of bank administration.

Senior management at banks must design and execute effective risk measurement and monitoring methods that are consistent with guidelines.

Sustainability Heatmap (Non-Interest Income vs CTI).

Figure: Few banks in the blue ocean

The cost-to-income ratio, which calculates operating expenses as a proportion of operating income, is used by banks to assess efficiency and productivity. Lower ratios typically imply better efficiency, although a variety of factors, including a bank’s business strategy and size, can influence the ratio.  CTI excluded costs due to impairment of loans.   Winning banks focus on operational effectiveness through a digital agenda by automating manual processes to increase turnaround time and throughput in service delivery. A high-cost structure is strategically sustainable, especially during dynamic times like these where revenue forecasts are unstable.  High costs eat up revenue and make it difficult for the bank to post a profit.

In Uganda, most banks bundle their costs under categories like “Operating Expenses”, “Operating and Administration Expenses”, it is difficult to drill down to the key cost drivers. Commercial banks must focus on growing interest income, as part of their primary mandate to support entrepreneurs with the much-needed capital.   Of most interest, is the non-funded income share of the interest income component, as such income is the best indicator of a sustainable business model focused on delivering customer convenience and innovative products and services.  Although banks continue to change their business models in response to the market challenges, brought about by the pandemic in part, and increasing sophistication of customers due to the availability of alternatives, banks are yet to fully optimize incomes from “convenient banking and innovations.” Many banks instead are increasingly investing capabilities in secondary market investments which are at the expense of private-sector lending.  To win, commercial banks must aspire to generate at least 30% non-interest income from non-funded sources. interest income from funded sources like bank charges, loan interest fees and charges, cheque leaf charges, etc represent a charge for inefficiency and is not sustainable.

With several Ugandan banks having reported results for the fiscal year ending December 31, 2020, Summit Business Intelligence examined cost-to-income ratios to get a bird’s-eye view of bank efficiency throughout Uganda.

Figure: Industry average of cost to income

General industrial cost to income dropped from 61.51 per cent to 59.87 per cent meaning banks were much more efficiently managed in 2020 despite the drop in business in key client sectors. The cost management efficiency was imperative for survival.

With much more convenient banking with banks offsetting branches for agency banking and other technologies, the cost to income has managed to be reduced and will further drop in 2021 as banks continue to adopt more convenient technologies to reach their clientele.

Equity Bank, Bank of Baroda, EFC and Citibank had cost to income within the aspiration zone. Equity bank had a cost to income of just 12.1 per cent dropping by 78.8 per cent following the sustained focus on convenience banking. Equity had dropped in-branch presence and an increased focus on agency banking which has much more penetration at a much lower cost.

Top Finance bank reported the worst cost to income in a row wiping out every shilling of its operating income with rising costs as it continues to embattle the struggle to recover from previous failures and acquire an effective business model. The management team remains one of the most strained in the economy. Brac followed closely with the highest cost to income growth rising by 91.7 per cent year on year, a year that saw the institution struggle as it was shaken by the COVID-19 shock. Orient Bank and Exim also reported heavy figures of cost to income as they continue to sustain loss generating business models.

Another element of sustainability is the saturation of non-interest income to total revenue. Non-interest income (NII) is earned by banks and creditors largely through fees such as deposit and transaction fees, insufficient funds costs, yearly fees, monthly account service charges, inactivity fees, check and deposit slip fees, and so on. Fees that produce non-interest income are charged by institutions to enhance revenue and provide liquidity in the case of higher default rates. Because the fundamental objective of a bank’s business model is to lend money, interest is its primary source of income, and cash is its principal asset. However, when interest rates are low, banks rely largely on non-interest revenue. When interest rates are high, non-interest revenue sources might be reduced to persuade consumers to select one bank over another. The capacity of a bank to grow non-interest revenue to protect or even improve profit margins in good times is a plus. The more income drivers a financial institution has, the better it can weather bad economic situations. However, some banks have prioritized non-interest revenue over their primary role as commercial banks.

In NII, the aspiration threshold is 40% and must not be below 30%. A large non-interest income threatens to drive clients away from the bank if it is driven by charges and transaction fees, whereas a little one exposes the bank to significant credit risk. Banks that grow their interest income over 40% risk losing their concentration as commercial banks and become increasingly involved in investment banking. Outliers, however, grow non-interest incomes from innovative offerings like wealth management, fin-tech incomes driven through enabling payments and the attendant commission shares with the ecosystem partners. These “customer convenience” commission income, if properly optimized transform the bank into a sustainable powerhouse for unprecedented future success.

There has been a general reduction in contribution on non-interest income to total revenue since 2017.  Year on year it dropped from 27.69 per cent to 25.87 per cent. Banks need to widen this space not through zero-sum games such as increased transaction costs but through increased service options enhanced through digital optimisation and services that ease the way consumers work and in turn enhance consumer loyalty such as digital personal assistants, ability to trade on mobile platforms without the need for physical presence at the banking counters and so on. The more convenient a bank is, the more it will be able to generate non-interest revenues that are not averse to its performance.

FINCA has the best saturation of non-interest income to total revenue at 39.19 per cent followed closely by Top Finance bank at 38 per cent and Pride at 37.9 per cent.

While UBA had the highest saturation of non-interest income at 54.82 per cent, this is beyond the aspiration zone and undermines its commercial banking practice. High concentration on securitised products exposes the financial system in the medium term a replica of what happened in the financial crisis of 2007 which led to the Dodd-Frank Act that forced American commercial banks to stop doing both commercial and investment banking.

Although it seems sustainable, it exposes consumer deposits to the banks’ ‘personal’ business and can cause them to flee from the bank citing increased costs. Orient bank with over 88 per cent of its non-interest income to total revenue is a high-risk mechanism as it continues to struggle with bad loans. This soaring number is not sustainable as consumers continue to cite high fees and transaction charges. Non-Interest income especially trading income is extremely volatile and over-dependence might cause a systemic catastrophe. As a result, a higher share of net interest and service revenue is usually more sustainable than trading income.

Strategic insights

  1. For non-interest income, the aspiration threshold is 40% and must not be below 30%. A large non-interest income threatens to drive clients away from the bank if it is driven by charges and transaction fees, whereas a little one exposes the bank to significant credit risk.
  2. Banks that grow their interest income over 40% risk losing their concentration as commercial banks and become increasingly involved in investment banking.
  • Winning banks, however, grow non-interest incomes from innovative offerings like wealth management, fin-tech incomes driven through enabling payments and the attendant commission shares with the ecosystem partners. These “customer convenience” commission income, if properly optimized transform the bank into a sustainable powerhouse for unprecedented future success.
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