How divestments are helping banks respond to industry shifts

Pressure on profitability and returns intensified by the pandemic causes banks to re-examine their portfolios.

Mergers and acquisitions (M&A) have boomed in the banking and capital markets (BCM) sector since August 2020. The flurry of activity reflects management teams’ heightened realization of how customers’ expectations have changed in recent years. The pandemic’s digital migration has supercharged this shift. 

Banks are taking matters into their own hands: in the 2021 EY Global Corporate Divestment Study, 85% of banks describe their most recent divestment as proactive, up from 64% pre-pandemic.

The EY Global Capital Confidence Barometer (CCB) highlights how this has emerged as a key pillar of banks’ strategies. More than three-quarters of banks expect technology and digitalization to drive increased M&A activity in the sector.

Recognizing digitalization as an increasingly important key driver, management should redouble efforts to achieve strategic clarity as a guiding principle to determine where capital can be freed up to fund technology transformation.

These dynamics can very clearly be seen at work in the recent transformation of a Fortune 500 diversified financial services company. It first divested its holding in an asset management firm before acquiring the US business of an international banking group to help fulfill its ambition of a digitally led effort to expand retail banking nationally. Besides its geographical footprint, the business’s advanced technology had made it an attractive target. 

Factoring in transaction certainty with TSAs

Increased M&A is boosting focus on transitional service agreements (TSAs) in the banking sector. The key issue here is product migrations if the bank’s core platforms are not within the deal perimeter. Developments such as current account switching, modularization of core banking platform technologies and moves away from legacy in-house technology to modern third-party vendor platforms have helped to accelerate these migrations.

Regulators’ push on banks’ resolvability since the global financial crisis also plays into this. This national and international focus has enhanced banks’ understanding of how they would carve out and divest subsidiaries and business lines in a recovery situation or resolution event. 

Banks’ TSAs are often very short compared with financial services peers in insurance and WAM. Of banks that employ TSAs, 42% set them at under six months and 68% set them at under a year.

Strategically, TSAs are highly relevant for the consideration of potential buyers as they support execution certainty and speed. This is particularly the case for the higher proportion of banks that emphasize transaction speed over value (28%, compared with 16% in insurance and 17% in WAM). 

Buyers that can demonstrate migration expertise and that have a target technology platform already in place with limited product gaps to address are particularly attractive. This includes PE bidders, who may be able to integrate the divested entity into an existing portfolio company. 

Exploring the potential of ecosystem alliances

As part of their ongoing portfolio review, which the pandemic has only accelerated, banks are focusing heavily on leveraging strategic alliances to improve their service in every area of banking.

More banks should now look to ecosystem approaches. These involve engaging with software companies, FinTechs and other collaborators to innovate and raise margins while reducing costs. These arrangements bring a host of benefits, including strategic clarity over enhancing the portfolio, as well as accelerated speed to market, access to innovative technologies and a level of scale that they could not achieve alone. 

The sector appears receptive to this kind of collaboration. The vast majority (86%) of EY CCB respondents report being open to forming alliances with competitors to create new ecosystem solutions. 

In the recent past, several banking groups have entered into alliances with technology players to co-innovate new products and services with startups and FinTechs or to jointly expand into the banking-as-a-service (BaaS) space. 

Further examples exist across a range of banking product areas and types of collaboration — from mortgage lending to wealth management.

Recommendations

• Tighten portfolio review criteria further to help identify potential divestments that could help lift cost-income ratios — particularly portfolio businesses that lack sustainable long-term cost transformation potential
• Explore ecosystem collaborations as an innovative route to improving service and increasing growth
• Treat TSAs as a powerful tool for managing the buyer pool 

Conclusion

Overall, the need for both strategically transforming costs and freeing up capital for digital and technology investments and the drive towards greater ecosystem collaborations are acting as powerful catalysts for BCM companies to revisit their portfolio review criteria. These drivers should lead to increased divestment activity in the sector over the next 12 months.