To counter stiff competition, banks in the developing world are working hard to get their costs down. Those capable of using mergers and acquisitions to capture economies of scale from their staff, IT, and back-office functions usually do so, much like their Western counterparts. But banks in small emerging markets and in markets with limited M&A possibilities can’t lower unit costs by these means.

Scale isn’t the only route to cost efficiency in banking, however, and some smaller institutions in Western countries have used more efficient processes to match or even beat much bigger competitors. Can banks in other parts of the world copy these state-of-the-art skills? Gross domestic product per head in emerging markets is much lower, so average customers generate substantially less income for their banks and are proportionately more costly to serve. In addition, most banks in emerging markets still process many transactions (mainly payments) by hand—an expensive undertaking.

Yet Chilean commercial banks have proved that world-class cost efficiency is indeed possible in emerging markets. With only 15 million inhabitants, Chile is one of Latin America’s least populous countries, but in 2001 its five biggest banks boasted an average cost-to-income ratio of 59 percent, far better than the five biggest in Brazil and better even than much larger banks in the United States (exhibit). Chile’s largest private institutions—Banco Santander and Banco Santiago (which merged in 2002 and are owned by Spain’s Santander Central Hispano) and Banco de Chile—have made remarkable gains: they cut their average cost-to-income ratio from the moderate level of 65.1 percent in 1995 to a world-class 54.1 percent in 2002, largely by reducing their costs.

Chilean banks are doggedly pursuing cost efficiency through innovative branch formats, extensive outsourcing, and lean operating processes. These three levers are by no means unique, but banks in Chile have shown how to adapt them to serve the low-income segments of emerging markets. To suit local realities, the banks have radically transformed their traditional branch networks; the new formats include specialized no-frills offices where they extend high-interest credit to the lower-income market. For basic transactions, they use Servipag—a bill-payment network that came into existence partly as a response to a Chilean law obliging banks to provide clients and nonclients alike with services such as utility-bill payments, tax collection, and check cashing.1 By delegating these payments to a specialist network with spartan kiosks and basement offices staffed by clerks who lack full banking qualifications, financial institutions have reduced their personnel and infrastructure costs. More than 20 percent of all monetary transactions that were once handled by branch tellers now go through this external channel, at half the previous expense.

Outsourcing has also proved a powerful solution in dealing with another daunting local challenge—check processing. Time-consuming and bounce-prone checks, still common in Latin America as a result of high credit card fees and interest rates, are a nightmare for back offices. Chilean banks have a major scale disadvantage: they process only some 25 million checks a month as compared, for example, with Brazil’s banks, which process 440 million a month. But by using two check-processing specialists with highly standardized systems, banks in Chile are moving toward the scale advantage of their Brazilian counterparts: unit costs have fallen drastically because an outsourcer can handle three to six times the capacity of any one Chilean bank. Some institutions have outsourced almost half of their operations, including purchasing, credit card processing, money transport, data-center management, and software development and maintenance.

The experience of Chile’s banks offers encouragement for small banks in other emerging markets, where deregulation is inviting increased foreign competition while economic stability, with its lower interest rates, forces down lending and deposit margins. Because Chile has been maturing in this fashion for 20 years, its banks as a group have made more progress controlling their costs than have banks elsewhere in Latin America and in other emerging markets; in Brazil, for example, double-digit interest rates have allowed the leading institutions to thrive without having to follow the Chilean example. But as M&A opportunities dry up in these countries, their big banks will no longer be able to rely solely on increasing scale to reduce their unit costs. Such banks may soon have to cut their operational expenses.