Tier 1 banks have an edge over smaller rivals: Their greater scale lends a near-unbeatable cost advantage. With the rules of the game stacked firmly against midsized banks, they must find a way to level the playing field. If costs can’t be cut further, then a way must be found to share them.

An uphill battle against flow monsters and category killers
In 2012, the five largest banks raked in $63 of every $100 of profits earned by the 15 largest banks, up 13% from 2006[1]. This is not surprising, if you consider that over these six years, the five largest banks have grown considerably larger than the rest, and for every additional $1 billion in assets, a bank’s annual operating costs decrease by $1–2 million[2].

These economies of scale can be traced to a change in Wall Street’s cost structure, with fixed costs becoming increasingly important. Ongoing regulatory reforms have driven up fixed costs from technology and operations. And, unlike their larger peers, midsized banks do not have the luxury of apportioning these higher fixed costs over a very large number of trades. As a result, midsized banks spend between $120 and $200 per trade on technology, while the larger players spend as little as $50 per trade. If midsized banks are to improve their profitability, they need to adjust their operating model and slash their trading costs at least 30% to 40%. If not, the banks have little choice but to boldly jettison their existing business model and move into niche, high-margin businesses.

Cost efficiency is necessary, but not sufficient
To become cost competitive with the large banks, midsized banks need a combination of cost efficiency and cost restructuring. Of the two, cost efficiency is better understood, and most banks are already implementing such measures. Using conventional cost-efficiency levers such as process optimization, outsourcing, and application simplification, however, will not be enough to be cost competitive.

Mutualizing costs to bridge the gap
To get there, midsized banks need to restructure their trading costs by sharing the cost of operations and using a common technology platform. Tier 1 banks have had the scale to build captive shared services operational centers. Midsized banks that lack the scale to form internal shared services centers can gain the cost and efficiencies achieved by Tier 1 banks by going a step further. That means joining forces in a true shared-services utility operated by a neutral non-bank partner.

This will help midsized banks not only slash their trading costs but also cope with the increased volatility in trading volumes. By linking the cost of services received to transaction volumes, these banks can convert fixed costs to variable costs. Such a utility would also apportion the cost of complying with regulatory requirements across a number of participants, further lowering trading costs for participating firms.

From no-win status quo to consensus
Post-trade services are textbook examples of commoditization, with banks competing mainly on the cost of providing these services, and not on the quality of the services delivered. Across post-trade functions such as reconciliations, trade processing, regulatory reporting, and brokerage commissions processing, little differentiation can be leveraged even by being the very best, but there is a lot to lose by executing poorly. Maintaining status quo is not an option. Tier 1 banks will continue to have a price advantage over midsized peers. It is no surprise, then, that consensus is developing on the need to run these functions as part of a shared service model.

Finding a common ground and reducing costs
Despite widespread consensus among North American and European stakeholders, no operational post-trade processing utility supports multiple banks. The primary reason is that no single player in the market has a winning hand, that is, the best operational metrics, the most streamlined process flows, and the most scalable technology platform. The best chance for midsized banks is to find common ground between leading platform providers, their peer banks, and service providers, and then come together with them to create an industry utility.

By 2016, midsized banks that act boldly to create such a utility can expect to be rewarded with cumulative annual sell-side savings of between $1 billion and $3 billion[3]. 

As for the midsized banks that decide to stand pat, they will pay a price dearer than any they have to date. Their future is one of being further and further marginalized by Tier 1 counterparts that boast a strength of scale that no go-it-alone midsized bank can ever hope to match.

[1] Wall Street Journal, May 20, 2013

[2] Federal Reserve Bank of New York, March, 2014

[3] Morgan Stanley – Oliver Wyman Wholesale & Investment Banking report, 2014