We are pleased to provide you with the fifth anniversary edition of the Cass-Capco Institute Paper Series on Risk. As with previous issues, we have had contributions from an exceptional group of world-renowned academics and practitioners who focus on the major risks facing our industry and the possible solutions that could help overcome them.
We are particularly excited about the two papers we have in our “Ideas at Work” section which deal with IT complexity. Part of the financial services world, complexity can create both risks and costs. Dr. Peter Leukert and Capco have done groundbreaking work on this topic and we now encourage the industry to participate, as institutions work to improve their abilities to measure and manage complexity. In this field there are many similarities with the evolution of market, credit and operational risk measures. Because of this we understand that the journey is long. However, more data and industry contributions can significantly accelerate the timeline.
In hindsight, we were correct in starting the paper series in conjunction with Cass Business School when we did five years ago. Unprecedented in modern finance, these years have certainly not been kind to our industry. We have had numerous reputation-damaging events, a generational economic crisis, a never-ending stream of new regulations to bring the industry in check, and an ongoing crisis of confidence.
When we first thought of establishing the paper series we could certainly not foresee the dramatic events of the past few years and we were not fully aware that our industry was operating on a tightrope. Now, a simple back-of-the-envelope calculation suggests that to return to historical return on equity (RoE) levels, the industry needed to shed around U.S.$500 billion of costs. A staggering number. We have assumed that RoEs need to increase by approximately 3% and that 12% is an acceptable threshold for shareholders. The benchmark cost/income ratio for financial institutions is currently around 56%, so a 20% fall in costs overall is required to deliver acceptable RoE. Given the current total cost of U.S.$2.5 trillion, a reduction of 20% is around U.S.$500 billion.
In the past the industry has waited for the rebound when new products and recovering margins would eventually fix the RoE. This time the industry not only has to deal with the regulatory cost overhang, but also the potentially disruptive forces of smart devices, social media and new banking entrants. In addition, many of the quick outsourcing cost fixes have been locked in. However, along with this challenging backdrop, I am confident that the financial services industry is not shy when it comes to innovation and both the new structural and technology revolution provide a great platform for that renovation.
During the past five years of this paper series we have tried, with the help of the many world-renowned experts who have contributed to these five editions, to highlight the numerous risks that our industry faces, and worked hard to overcome them by developing solutions to help our clients and the industry as a whole. Many challenges of course remain.
We will not shirk from our responsibilities to help the industry meet these challenges head on and will, as always, remain committed to helping Form the Future of Finance.