The 'new normal' environment of durably low interest rates is challenging the model of banking intermediation. While effects have not yet fully played out, the flattening of the yield curve puts banks' profitability under pressure. To mitigate the impact, banks need to develop a strategic response including measures such as review of their business portfolio, development of asset distribution, cost reduction… In this paper, we focus on two important levers of adaptation: banks need to adapt their pricing schemes, looking at the entire balance-sheet, as well as enhance their ROE forecasting capabilities at product level.

1. 1 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
ADAPTING BANKS TO A
NEW NORMAL ENVIRONMENT
OF LOW INTEREST RATES
Vincent Bastid
Chief Executive Officer
Axel Reinaud
Senior Partner and
Managing Director
The ‘new normal’ environment of durably low interest rates is challenging the
model of banking intermediation. While effects have not yet fully played out, the
flattening of the yield curve puts banks’ profitability under pressure. To mitigate
the impact, banks need to develop a strategic response including measures
such as review of their business portfolio, development of asset distribution, cost
reduction… In this paper, we focus on two important levers of adaptation: banks
need to adapt their pricing schemes, look at the entire balance-sheet, as well as
enhance their ROE forecasting capabilities at product level.
Micro-
segmentation to
segment client on
willingness to pay and
value to the bank

2. 2 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
Flattening yield curves put banks’ profitability
under pressure
While central banks have lowered short-term rates since the financial crisis, the
last years have seen a fall in long-term yields in all major advanced economies,
resulting in a dramatic drop in the spread between short-term and long-term rates
(‘flattening of the yield curve’), as illustrated in figure 1 below.
Figure 1
This flattening is the result of several factors. First, central banks have made
massive bonds purchases, in application of the quantitative easing policies.
According to the IMF, the Bank of Japan, the Fed, the Bank of England and the
ECB respectively hold 79%, 21%, 13% and 9% of their domestic bond stock.
These purchases significantly lowered the yield of long-term bonds. In addition,
new financial regulations (e.g. Basel 3 liquidity ratios, Solvency 2 in Europe,
margin requirements from Dodd Frank Act and EMIR) increased the demand of
financial institutions for government bonds, adding to the impact on prices.
While central banks have recently expressed concerns about the impact of low
long-term rates and a willingness to steepen the yield curve, some structural
demographic and economic changes will durably exert a downward pressure
on long term rates. Some factors increase the global supply of savings. Aging
populations across the world have a need for higher savings to prepare for
retirement. Growing income inequality also creates social groups with a higher
propensity to save. Simultaneously, other factors reduce the demand for investment.
Slower population growth in advanced economies means that young generations
do not generate the same investment needs. New business models (e.g. digital)
also tend to be less capital-intensive. A higher appetite for savings and a lower
demand for investment can only be matched at lower interest rate (figure 2). In
such a context, higher interest rates would stifle investment and growth.
1
IMF, Global Financial Stability Report, October 2016
Raising prices on
components where
perceived value
and price where
less aligned or less
important

3. 3 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
2
BCG Center for Macroeconomics
Figure 2
All else equal, a flatter yield curve reduces the profit of maturity transformation
(borrowing short-term to lend long-term) for banks, pressuring net interest
margins (NIM). In practice, the magnitude but also the timing of the impact
of a flatter curve on NIM will vary depending on the composition of a bank’s
balance-sheet. Some banks have adapted so far by increasing the maturity of
new loans as well as increasing the proportion of short-term deposits in their
funding mix.
Conversely, the impact could be accelerated where banks have difficulties to
lower the rate paid on deposits. While savings rates have already been cut
in some countries (eg UK), banks have been reluctant to charge retail clients
for deposits (sometimes for regulatory reasons) where central banks rates are
negative.
As the low rate environment persists, banks will face increasing pressure to
compensate the fall in the net interest margin.
Actions banks need to take to drive income
growth
We focus here on two specific levers to mitigate the profitability impact: pricing,
and balance sheet management. As low rates create an overall profitability
challenge, banks should of course consider all actions to improve profit,
including cost cutting and strategic moves such as expanding their service range
or M&A.
The commercial margin component: moving
towards value-based pricing?
Pricing is a powerful, but often still underutilized mean for banks to generate
top and bottom-line growth and consequently mitigate the pressure on profits.
Depending on the pricing maturity of individual banks, we discriminate four
pricing levers. The first two are biased toward extracting more income from the
existing (balance sheet) business, the others are focused on growing the share
Good-better-best
type of line-up

4. 4 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
of fee income from (innovative) value-add services.
1. Doing the basics right:
The first and most immediate lever is to fix price realization on the existing business
and future production. In many markets and products, significant income leakage
is occurring because discounts are not optimally managed. An effort to reprice the
existing business, together with a change effort in the sales force to sustain future
price discipline is the first lever that banks can pull.
Price realization is for example a quick impact lever in Retail markets where
discounts occur (in investments, mortgages, loans), where revenue increases of
+5-15% are very typical.
2. Differentiate pricing:
While many banks differentiate prices based on cost and risk, a lot can be gained
by moving to price (and hence margin) differentiation based on sensitivity. This is
not only helpful to grow overall income and profit, but also to capture untapped
volume opportunities. The extent of differentiation is often dictated by market
circumstances. In the simplest approach, price grids or propositions can be
optimized based on differences in price elasticity. This is mostly appropriate for
retail products in transparent markets, such as mortgages (prices by risk, maturity)
or loans (prices by purpose, risk, size, etc)
For example, one North-European bank used historical price and volume data
to quantify the price elasticity curve for its mortgage products. Because they
understood how monthly volumes (and margins) would change in response to
a price change, they changed prices across their grid (based on Loan-to-value
and maturity) on a monthly basis to maximize overall profit. For some points on
the grid this meant pricing lower (where the lower margin was offset by more
volume), on other points this implied pricing higher. This logic was captured
in a simple price decision tool, which immediately increased overall profit on
mortgage production with +10 bps.
A more granular approach is to differentiate prices by customer segments, or
even down to the individual customer level. A segmented approach to price
differentiation is highly relevant for deposits in the current low rate environment;
some segments will be easier to charge for deposits (e.g. commercial clients),
whereas other segments will be more sensitive (e.g. mass retail). But also in
other products where individual price negotiations occur there is an opportunity
to differentiate individualized target prices (all products in commercial banking,
and retail products in some markets)
For example, one bank developed a client-specific price algorithm for its
consumer loans. It used micro-segmentation to segment client on willingness to
pay and value to the bank. Revenue on new production grew by +15% - without
any volume losses, which will in time materialize on the entire loan book.
3. Grow service-based income:
In all banks we see opportunities to grow fee income by charging for value-
added services. A very typical product is daily banking, which has many different
service components that are not optimally charged. Top of mind services are
Incentivizing
customers to shift
their excess money
from (unprofitable)
deposits into
investments

5. 5 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
account maintenance, cards, transactions, but there are also tens of less visible
components (paper statements, lost cards etc) that are often free or underpriced.
Reversely, some services may be overpriced in the eyes of the customer, which
leads to lower product attractiveness. The perceived value of all of these services
can be quantitatively measured and used to grow revenues while at the same time
improving customer satisfaction.
For example, one retail bank used qualitative and quantitative customer
research to measure the perceived value of all the product features and price
components in its Daily Banking offering. It then made smart adjustments to each
of these components, e.g. lowering the price for services that where perceived
expensive (such as the monthly fee) and compensating that by raising prices on
components where perceived value and price where less aligned (e.g. second
card) or less important (e.g. paper statements). As a result, the bank increased
revenues on its Daily Banking proposition by +15%, as well as its market share,
and decreased cost to serve.
In addition to those tactical moves, on a medium term time horizon, banks could
also think about growing service-based income by introducing a proposition
line-up. Many banks still offer a single one-size-fits-all daily banking proposition;
they may be segment specific (e.g. students, families, seniors, etc), but any given
customer within a segment is being offered the same bundle. An interesting
option would be to introduce a ‘good-better-best’ type of line-up, where
customers can self-select various components based on their needs. The same
approach also applies to other retail propositions, most prominently investments
and mortgages.
4. Change the price model:
The fourth lever banks should exploit is to change the value-capturing logic on
clients, predominantly on the liability side. This involves answering questions such
as: should we price deposits on the basis of an interest rate or a fee? And should
that be a flat fee, or dependent on the volume of deposits? How to capture the
value over the customer’s lifecycle: with interests paid over time or perhaps with
an upfront, fixed fee? Should deposit pricing be seen independently, or do you
take a customer, cross-product view?
Some interventions building on this concept are relatively simple, such as
incentivizing customers to shift their excess money from (unprofitable) deposits
into investments. This relieves the pressure on bank’s NIM and at the same time
generates fee income from advice, custody and asset management.
Others ideas may be more profound and innovative, requiring creativity and
sometimes even moving into uncharted territory. An idea could be to design
deposit ‘offset’ propositions, where interest is only paid on the net amount the
customer has with the bank, taking into account deposits, loans and investments.
Or perhaps make interest contingent on having an active payment account, or
permission for the bank to monetize transaction data.
Whatever route a bank chooses to explore, the development of these ideas
require not only a deep understanding of the customer’s value perceptions,
but also a cross-functional strategic involvement from sales, marketing, product
management, ALM and finance. Implementation of these ideas will need to
be timed tactically, taking into account potential competitive reactions, new
Effort in the sales
force to sustain future
price discipline

6. 6 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
processes, market communication, and sales steering. But when done well, it
may turn-around product profitability of almost the entire liability side of the
balance sheet.
The financial component of the PnL: fine-tuning
balance-sheet management
A significant part of banks’ revenues is related to their maturity transformation
function, which benefits from a steep yield curve. In a low/negative rate
environment, the sensitivity of that source of revenues to even minor changes
increases significantly. Therefore, it triggers the need for the bank to have a
more granular and precise estimation of NIM revenues, to review and enhance
models to account for the change in environment and assumptions and to review
governance accordingly.
1. Having the right model assumptions
The new rate environment represents an important change from the time
where most of the forecasting models currently used to manage the balance
sheets were developed. Assumptions about customers’ behaviors regarding
prepayments, use of credit lines, and deposit balances have been assessed
in a given set of circumstances, but can prove grossly wrong in a significantly
different market environment. This is one aspect of what is called “model risk”,
a major source of losses during the financial crisis: for instance, the evaluation
models on CDS developed before the crisis proved to be massively wrong under
a new paradigm and led to significant losses for the many ones who were late
recognizing the shift in market conditions.
Therefore, collecting and analyzing with a fresh eye granular and high quality
data to challenge current models and hypothesis can prove a life saver exercise
in the current market environment. As an example, a European bank reviewed
the prepayment assumptions used to forecast balances on its mortgage
portfolio. The review identified some products and client segments that exhibited
strong early repayment behavior and therefore an effective maturity shorter than
the contractual one. The bank partially reduced the maturity of the matching
funding, reducing cost of funding on a 7-year duration loan by as much as 30
basis points, significantly increasing competitiveness.
2. Forecasting and stress testing governance
Banks need to have a governance mechanism in place gathering all relevant
parties to select appropriate forecasting scenarios, assess the impacts of those
scenarios on the balance sheet at a granular level and analyze the results from
a business and market positioning perspective. This should enable the bank
to run quickly and efficiently an open dialogue to identify major weaknesses
in light of stress testing results and take swift remediation actions. This
capability is usually hampered by the lack of alignment on assumptions, proper
understanding of the business, analytical limitations, etc.
The selection of the right scenarios to be tested can’t happen in a laboratory
far from the businesses. It should be the result of a fruitful dialogue between
economists, businesses, finance and risk that would enable the bank to identify
scenarios both probable from a macroeconomic perspective but also meaningful
from a business perspective.

7. 7 BCG - EFMA POINT OF VIEW: ADAPTING BANKS TO A NEW NORMAL ENVIRONMENT OF LOW INTEREST RATES
OINT
IEW
F
P
V O
From our observation, scenarios are too often selected by economists and
finance teams, without the right level of business input. As a result, they can’t get
the buy-in of the businesses, and can hardly be seriously considered for decision
making. Furthermore, the mandate of Asset-Liability Management Committee
(ALCO) is often focused on the management of maturity gaps, more than on the
commercial impact of interest rates changes.
From our point of view, an effective governance structure comprises specific
forecasting and stress testing committees reuniting businesses, ALM and Risk
in order to align on assumptions on future composition of the portfolio, and its
sensitivity to economic scenarios.
A good practice, implemented by some US banks in the context of the CCAR
stress-testing exercises, is to develop forecast narratives by asset class, e.g.
Mortgages or Consumer loans: the results of the different stress tests models
for pre-provision net revenues, credit losses and capital requirements are
combined into ROE forecasts for the asset class for base and adverse scenarios.
These forecasts are reviewed and challenged by teams combining business
line management, Risk and Finance/ Treasury. The objective is to produce a
‘pressure-tested’ business plan, where sensitivities to economic factors and the
adequacy of management actions have been assessed.
3. Adjusted ALM policies
In parallel to the client price adjustment, banks should also adjust internal fund
transfer prices (FTP). We observe that some banks have not yet fully adjusted the
price of deposits charged to asset-originating businesses. For example, a bank’s
internal FTP incorporated a value of deposits that was now higher than current
market prices. As a result, the high cost of funding charged to lending business
lines made it hard for them to meet Return on Assets targets on operations that
would have been profitable at market conditions.
Some banks are also making structural changes to their Fund Transfer Pricing
structure to prepare for an environment where even small changes to the level
of interest rates could have a large impact on profit. Some banks’ Treasury
department have integrated a structural buffer in FTP to prevent credit pricing
from increasing too much if rates and/or liquidity spreads go up for a short
time.
* * *
An environment where maturity transformation does not provide sustainable
profits is an important challenge for banks. However, banks do have multiple
levers to adapt and defend profitability and growth. Of those, both pricing and
balance-sheet management are still underutilized levers that can deliver quick
benefits while enabling banks to make better strategic decisions.
The authors would like to thank their BCG colleagues for their valuable input and insights:
Muriel Dupas, Vincent Grataloup, Karen Lellouche, Martin Van Den Heuvel, Valerie Villafranca
and Ian Wachters.