The asset management and financial services industry operates in an environment of competing pressures. Amongst active managers, alpha generation is difficult and often unsustainable, and has been accompanied by a secular shift from active to passive strategies, further exacerbating the endemic fee and margin compression in the industry. Financial services firms, more broadly, are witnessing similar dynamics at work, ultimately eroding institutional and shareholder value. Against this backdrop are low-interest rates, ever-increasing regulatory burdens, and volatile geopolitical events. This is before one even considers the global impact of COVID-19.

Today, perhaps more than ever before, firms must embrace a strategic view of their end-to-end technology and operations capabilities across all manufacturing, servicing and distribution functions. At its core, we believe this to be increasingly existential, rather than merely incremental. Technology can no longer be viewed simply as a necessary cost-center intended to drive down operational costs and prop up legacy operating models. Firms must move far more aggressively towards digital business transformation. In some cases, this is purely a parity play for survival; in others, new digital capabilities can truly be marketplace differentiators. Regardless of the scenario, however, this must be a business imperative driven by leadership.

In this context, there are three terms that business leaders must understand from a strategic perspective: Digitization, Digitalization and Digital Business Transformation (the “3Ds”).  Although the 3Ds have been around for a while, their distinct definitions have often been blurred and their strategic value marginalized.

“Digitization” is the process of changing from analog to digital form. An early example of digitization can be seen in the financial services world with the move from physical delivery of securities, residing in bank vaults, to widespread book-entry delivery through depositories. Even the transfer of physical hand-written notes or records to digital office applications, including word processors and spreadsheets, represents digitization. This is an accepted baseline for most firms, today.

“Digitalization” is the use of digital technologies to change or enhance a business model from which to derive value, whether in the form of cost savings, revenue generation, risk mitigation or other business dimensions. According to the report, Digitalization and the American Workforce, by Mark Muro, “Digitalization is the process of employing digital technologies and information to transform business operations.”

While digitalization is clearly more robust than digitization, the financial industry has used both to increase scalability, efficiency and profitability. In many cases, digital technologies have been used to simplify, or automate people’s jobs. One only has to look at the way in which a bank accountant’s role has changed over time to see an example of digitalization. The interplay between digitization and digitalization can be seen in the following example: at one-point, bank accountants used bound general ledger books (not software) to record client transactions, and physically deposited interest and dividend checks into client accounts. Through the application of digitization and digitalization, accountants now use computers, and funds move through electronic payment platforms. ATM networks, too, introduced digitalization into retail and commercial banking, ultimately streamlining transactions and displacing tellers.

To understand the power of digitalization at its core, you need only to look at the evolution of the financial industry over the last 30 years. Interestingly, most people believe digitalization is defined by automation; but they are only half right. As we will highlight, digitalization is just a part of this journey.

Digital Business Transformation (“DBT”) is a strategic concept that goes well beyond isolated digitalization projects, or even enterprise-wide technology projects. Instead, DBT needs to be seen through a strategic lens that focuses on client experience, new go-to-market paradigms and a refactoring of legacy business and operating models. DBT cuts across all dimensions of a firm’s entire organizational structure, and its full application of digital capabilities. Equally important, DBT enables more data-driven business decisions, blurs functional boundaries and permeates the entire organization, rather than creating fragmented silos of digital enablement.

Some executives may confuse Digital Business Transformation with digitalization. This leads to reducing the journey to the introduction of another system, or another tool in the toolbox – from this perspective, digital is little more than a technology project, or even a series of technology projects, rather than a key element of a strategic business plan. Often, the thought process is further bound by the constraints of the existing corporate environment and organizational structures. The perpetuation of these boundaries, however, results in a more myopic view and can be a critical mistake, since it limits innovation and invites organizational bias that often prohibits meaningful change. As a result, many executives fail to realize the true power and impact of their current digitalization projects and never actually achieve full-out Digital Business Transformation.

In a recent McKinsey survey of Asset Managers, for example, DBT leaders in the marketplace outperform their peers, significantly and consistently (Chart 1). In fact, DBT leaders outperform the laggards in all key business metrics: operating and technology costs, assets under management (AUM) and profit margins. In one dimension, the industry leaders’ move to embrace DBT is seen in their organizational realignment of IT and operations.

Chart 1 – McKinsey & Company Survey Data

To highlight the difficult times ahead for the investment management industry, consider the following. In 2014, the average cost of regulatory, technology and office space accounted for only 26 percent of an asset management firm’s total budget. Today, that number is roughly a third, according to Casey Quirk and compensation analytics experts at McLagan. Sadly, the relative increase in budget allocation to these areas isn’t due to greater investment – in fact, they’ve all dropped by 1-2 percent, on average, in the same period. Instead, it’s largely due to a precipitous drop in fees and margin that has eroded the overall denominator!

According to a recent article in Institutional Investor, “Increases in non-compensation cost came as fees fell 20 percent during the same period. As a result, the revenue growth that came as the industry gained assets under management didn’t result in growing margins. Assets grew to $71.8 trillion in 2018, from $68.3 trillion the previous year – but margins fell to 32 percent in 2018 from 34 percent the year before.”

To address the impact of market events and an environment of rising costs, investment managers and financial services firms need to embrace DBT by leveraging Intelligent Automation (IA), and having a strategic plan to re-engineer their organizations. Arguably, the relatively flat-to-down cost of technology and operations, on an absolute basis, belies the fact that the deployment of capital has largely been to BAU, incremental enhancements, non-discretionary capabilities and support activities, rather than towards driving meaningful, and transformative digital capabilities. Even the investment in large-scale projects is often aligned with the support of legacy business models and processes. So, we would therefore suggest – and this comes from first-hand experience – that capital is often deployed inefficiently.

Ultimately, a holistic business strategy is needed when applying new technology solutions that incorporates the reorganization and re-engineering of how business groups are both structured, and function. Conservatively, we estimate that there is up to a 15 percent savings to be mined by refactoring organizations and applying sufficient digitalization, but within the context of a broader Digital Business Transformation strategy. Pursuing such a wholesale strategy requires firms to reimagine their product offerings and product delivery, thereby driving not only greater operational efficiencies and cost savings, but also top-line growth by contributing to a better client experience, investment performance, scalable solutions and new go-to-market opportunities. Business leaders must also realize that the biggest obstacles to achieving the benefits of DBT are often cultural impediments, inter-company bureaucracy, and a failure to think “outside of the box” and challenge legacy structures.

Current market conditions, pressure to lower fees and external regulatory pressures demand a change in industry business models that leaders ignore at their peril. The failure to do so is to accept the risk of becoming irrelevant. In contrast, the successful leaders of tomorrow understand that small “d” digitization and digitalization are just tools in a toolbox, leveraging technology for incremental improvements and automation; while capital “D” Digital Business Transformation, at its core, is a strategic endeavor that enhances the client experience, enables new go-to-market paradigms, drives top-line growth and achieves higher operating efficiency. By leveraging and embracing advances in technology with strategically re-engineered businesses, tomorrow’s successful leader will realize the true power of Digital Business Transformation!