Banks are in an end-of-cycle slowdown from which a third of them may not emerge unless they revamp their models for a digital world – and emerging markets aren’t immune.
This is the sobering conclusion of a new report from McKinsey & Co today, October 22.
“Nearly 35% of banks globally are both sub-scale and suffer from operating in unfavourable markets,” the report says. “Their business models are flawed, and the sense of urgency is acute. To survive a downturn, merging with similar banks may be the only option if a full reinvention is not feasible.”
The report finds that nearly 60% of banks are making returns below their cost of equity – a perilous position if a prolonged economic slowdown takes hold. Globally, loan growth stood at just 4% in 2017/18, the lowest level in the last five years, and 150 basis points below nominal GDP growth.
“While banks have worked hard at reinventing themselves, at this point the outlook is less optimistic than in the past,” Joydeep Sengupta, senior partner at McKinsey in Singapore and co-author of the report, tells Euromoney. “It becomes really challenging at this stage. The bottom quadrant of these banks has to think really hard about what is their future, what is the way in which they will survive?”
One striking element of the report is that emerging market returns are converging with those in the developed world. Global return on tangible equity (ROTE) stands at 10.5%, and it has been around that level since 2013. But emerging market banks have seen their ROTE drop from 20% in 2013 to 14.1% in 2018, at the same time that developed market banks – which have worked on productivity and costs – have lifted from 6.8% to 8.9%.
The main reason emerging markets, and in particular Asia, have seen this reversion to the mean and the mire is because of their particular exposure to disruption and fintechs.
“As we are seeing the penetration of digital going up, we are also seeing margins coming down,” says Sengupta, asked about the impact of increasing digital access in Asia. “That’s on the negative side. On the positive, it allows for greater penetration into areas that banks in the past couldn’t get into, such as consumer finance and micro-SME lending. But the short-term pressure on margins is quite significant.”
Though this trend is playing out globally, “in Asia the extent and the pace has been much faster,” Sengupta says, citing the size of platforms in the digital space in China and India. “Margin pressure will continue. We don’t see that abating in the near term.”
As we are seeing the penetration of digital going up, we are also seeing margins coming down
– Joydeep Sengupta, McKinsey
Globally, the report analyzes the difference between “the 40% of banks that create value and the 60% that destroy it”, and finds the answer comes down to three things.
One is domicile, which explains nearly 70% of underlying valuation, with banks in the US earning nearly 10 percentage points more in returns than those in Europe. Another is scale, which in most cases correlates with stronger returns. The third is idiosyncratic performance, with some business segments almost unworkable.
“Take the case of broker dealers in the securities industry, where margins and volumes have been down sharply in this cycle,” the report says. “A scale leader in the right geography as a broker dealer still doesn’t earn cost of capital.”
Scope for growth
In Asia, there is still scope for decent business.
“We still have a lot of growth available in Asia,” Sengupta says.
Wealth management is a particularly strong area in the region, as is transaction services, and while digital initiatives are eroding margins, they also provide new sources of consumer and SME growth as they offer penetration into new markets.
Sengupta believes onshore wealth management will be one of the strongest areas of growth.
Globally, the report finds that 20% of banks globally capture almost 100% of the economic value added by the entire industry. The corollary, it says, is that a majority of banks globally may not be economically viable.
McKinsey is particularly disheartened to find so much mediocrity in an environment of very low risk.
“Risk costs are lower than ever, and yet 60% of banks destroy value,” the report says. “That’s a poor state of affairs in which to enter a downturn and it calls for bold actions.
“This is likely the last pit stop in this cycle for banks to rapidly reinvent business models and scale up inorganically. Imaginative institutions are likely to come out leaders in the next cycle. Others risk becoming footnotes to history.”
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