McKinsey’s Global Banking Annual Review

December 9, 2020 | Report

Global Banking Annual Review 2020: A test of resilience

As the COVID-19 pandemic rolls on, banks must prepare for a long winter.

Ten months into the COVID-19 crisis, hopes are growing for vaccines and new therapeutics. But victory over the novel coronavirus still lies some nine to 12 months in the future. In the meantime, second and third waves of infection have arrived in many countries, and as people begin to crowd indoors in the months ahead, the infection rate may get worse. As a result, the potential for near-term economic recovery is uncertain. The question of the day is, “When will the economy return to its 2019 level and trajectory of growth?”

Welcome to the tenth edition of McKinsey’s Global Banking Annual Review, which provides a range of possible answers to that question for the global banking industry—some of which are perhaps surprisingly hopeful. Unlike many past shocks, the COVID-19 crisis is not a banking crisis; it is a crisis of the real economy. Banks will surely be affected, as credit losses cascade through the economy and as demand for banking services drops. But the problems are not self-made. Global banking entered the crisis well capitalized and is far more resilient than it was 12 years ago.

Our research finds that in the months and years to come, the pandemic will present a two-stage problem for banks (Exhibit 1). First will come severe credit losses, likely through late 2021; almost all banks and banking systems are expected to survive. Then, amid a muted global recovery, banks will face a profound challenge to ongoing operations that may persist beyond 2024. Depending on scenario, from $1.5 trillion to $4.7 trillion in cumulative revenue could be forgone between 2020 and 2024. In our base-case scenario, $3.7 trillion of revenue will be lost over five years—the equivalent of more than a half year of industry revenues that will never come back.

For banks, the difficult road ahead will have two stages.

For banks, the difficult road ahead will have two stages.

In the recession period from 2007 to 2009, global revenues were approximately flat at $3.4 trillion.

In scenario A1, two stages are shown.

Stage 1 is a recession period from 2020 to 2021.

  • The global revenues trend line would otherwise have risen from $5.5 trillion to $6 trillion.
  • Total crisis impact in this stage is $2.9 trillion: $1.0 trillion in forgone revenue and $1.9 trillion in loan-loss provisions.

Stage 2 is a recession period from 2022 to 2024.

  • The global revenues trend line would otherwise have risen from $6 trillion to $7.1 trillion.
  • Total crisis impact in this stage is $3.5 trillion: $2.7 trillion in forgone revenue and $0.8 trillion in loan-loss provisions.


Note: Chart shows year-end data.

Source: McKinsey Panorama Global Banking Pools

McKinsey & Company

In this brief excerpt from our new report, we look at the problems in credit losses and revenue and offer some of the insights that can help banks repair their short-term economics and ready themselves for the postpandemic world.

Credit losses: Bend but don’t break

To curb the spread of the virus, societies around the world have attempted the heretofore unimaginable: they have shut their economies, twice in some cases, throwing tens of millions of people out of work and closing millions of businesses. Those people and businesses are banks’ customers, and their inability to keep up with their obligations will sharply increase personal and corporate defaults. In anticipation, global banks have provisioned $1.15 trillion for loan losses through third quarter 2020, much more than they did through all of 2019 (Exhibit 2). Banks have not yet had to take substantial write-offs; their forbearance programs and significant government support have kept households and companies afloat. But few expect this state of suspended animation to last. We project that in the base-case scenario, loan-loss provisions (LLPs) in coming years will exceed those of the Great Recession.

Global loan-loss provisions: 1st 3 quarters of 2020 > all of 2019, could exceed global financial crisis by 2021 (charts)

Globally, loan-loss provisions in the first three quarters of 2020 surpassed those for all of 2019, and by 2021 they could exceed those of the global financial crisis.

Nominal provisions for loan losses, 2006–20E (fixed 2019), $ billion
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 actual through Q3 Full-year 2020 projection, A1 muted recovery
272 352 656 960 720 672 720 608 624 648 736 720 712 768 1104 1504
Provisions as a percentage of total loans, %. Actuals 2006–2019; projections by scenario 2020–2024.
Year Actual A3 faster recovery A1 muted recovery B2 stalled recovery
2006 0.48 N/A N/A N/A
2007 0.56 N/A N/A N/A
2008 recession 1 N/A N/A N/A
2009 recession 1.38 N/A N/A N/A
2010 1.02 N/A N/A N/A
2011 0.9 N/A N/A N/A
2012 0.94 N/A N/A N/A
2013 0.76 N/A N/A N/A
2014 0.75 N/A N/A N/A
2015 0.74 N/A N/A N/A
2016 0.82 N/A N/A N/A
2017 0.75 N/A N/A N/A
2018 0.7 N/A N/A N/A
2019 0.73 N/A N/A N/A
2020 recession N/A 1.1 1.34 1.34
2021 recession N/A 1.26 1.84 1.94
2022 N/A 0.82 1.36 1.46
2023 N/A 0.76 1 1.14
2024 N/A 0.72 0.8 0.9


Source: SNL Financial; McKinsey Panaroma Global Banking Pools

McKinsey & Company

The good news—at least for banks and the financial systems that societies rely on—is that the industry is sufficiently capitalized to withstand the coming shock. On average, globally, in the base-case scenario, common-equity tier-1 (CET1) ratios would decrease from 12.5 percent in 2019 to 12.1 percent in 2024, with a low of 10.9 percent expected in 2021. Regions would follow slightly different paths, but the overall system should be resilient enough. Even in an adverse scenario, we estimate that CET1 ratios would fall only an additional 35 to 85 basis points, depending on region.

Revenues: More than $3 trillion forgone

In the second phase, impact will shift from balance sheets to income statements. In some respects, the pandemic will only amplify and prolong preexisting trends, such as low interest rates. But it will also reduce demand in some segments and geographies. On the supply side, we expect banks to become more selective in their risk appetite. Of course, there will be offsetting positive effects for the industry, such as a need to refinance existing debt, and some regions and industry segments will still benefit from secular tailwinds. In addition, government support programs should continue to support activity in some places.

On balance, however, the outlook is challenging. In the base-case scenario, we expect that globally, revenues could fall by about 14 percent from their precrisis trajectory by 2024 (Exhibit 3). On an absolute basis, compared with precrisis growth projections, the COVID-19 crisis may cost the industry $3.7 trillion.


A test of resilience: Restoring short-term economics

People in northern climates know that winter tests our endurance, skills, and patience. Banks will be similarly stretched in the years to come. Some will need to rebuild capital to fortify themselves for the next crisis, in a far-more challenging environment than the decade just past. Zero percent interest rates are here to stay and will reduce net interest margins, pushing incumbents to rethink their risk-intermediation-based business models. The trade-off between rebuilding capital and paying dividends will be stark, and deteriorating ratings of borrowers will lead to inflation of risk-weighted assets, which will tighten the squeeze.

Solutions are available for each of these problems. Banks responded extraordinarily well to the first phases of the crisis, keeping workers and customers safe and keeping the financial system operating well. Now they need equal determination to deal with what comes next by preserving capital and rebuilding profits. We see opportunities on both the numerator and denominator of ROE: banks can use new ideas to improve productivity significantly and can simultaneously improve capital accuracy.

In our view, banks can use six moves to wring more productivity out of their operations. Here we consider just one of those six: speeding up the shift to digital banking that many customers are already making and reconfiguring the branch network, where demand has softened. In the past year, the use of cash and checks—core transactions for branches—has eased; in most markets, about 20 to 40 percent of consumers report using significantly less cash. In the meantime, customer interest in digital banking has jumped in many markets, although this trend varies widely. In the United Kingdom and the United States, only 10 to 15 percent of consumers are more interested in digital banking than they were before the crisis (and 5 to 10 percent are less interested). In Greece, Indonesia, Mexico, and Singapore, the “more interested” share ranges from 30 to 40 percent.

To make the new digital behaviors stick, banks can start with consumer education about their attractive value propositions, combined with nudging to make the behaviors easier. Even before the crisis, leading banks in developed markets had achieved 25 percent less branch use per customer than their peers by migrating payments, transfers, and cash transactions to self-service and digital channels. In addition to those who were already digital-only customers previously, another 10 to 15 percent of customers will be unlikely to use a branch after the crisis, further increasing the need to act.

Customers won’t abandon the branch, of course, but lower demand creates an opportunity to redesign the bank’s footprint. Branch networks have expanded and shrunk over the years, but the COVID-19 crisis demands that banks move beyond the heuristics that have prompted shifts in recent years. Leading banks are using machine learning to study every node of the network, with particular attention to demographics, ATM proximity, and nearby competitors. One bank developed an algorithm that considered the ways branch customers accessed seven core products. It found that 15 percent of branches could be closed while still maintaining a high bar on serving all customers, retaining 97 percent of network revenue, and raising annual profits by $150 million.

As part of this work, banks will need to retrain some branch bankers, in part by conceiving flexible roles that mix on-site and remote work, such as the customer-experience officer. Rules-based workers can be redeployed in different roles, based on assessed skill adjacencies. Branch bankers can perform their traditional teller tasks with some portion of their time. With the remainder, they can get trained on new skills to become contact-center agents. Over time, some people can acquire a full set of skills and become “universal” bankers, able to work well in a variety of roles.

How banks can thrive: Positioning for the longer term

Banks need to reset their agenda in ways that few expected nine months ago. We see three imperatives that will position banks well against the trends now taking shape. They must embed newfound speed and agility, identifying the best parts of their response to the crisis and finding ways to preserve them; they must fundamentally reinvent their business models to sustain a long winter of zero percent interest rates and economic challenges, while also adopting the best new ideas from digital challengers; and they must bring purpose to the fore, especially environmental, social, and governance (ESG) issues, and collaborate with the communities they serve to recast their contract with society.

Consider the last imperative, and one aspect in particular: climate change. No matter what they do, banks will feel the impact. The pressure to act is real and should not be discounted. On current trends, banks will be forced to move sooner or later. Furthermore, recent studies have established that a strong ESG proposition correlates with higher equity returns. ESG leaders are doing more than responding to the pressures: they are building solid business cases that support the new behaviors.

One way that banks are doing that is by building a climate-finance business to provide capital to companies to either strengthen their resilience to long-term climate hazards or decarbonize their activities. It’s crucial for banks to play a role in climate finance—it’s the logical outcome of their commitments to the Paris Agreement, and it fulfills a critical part of their contract with society. Building a climate-finance business requires four steps:

  • Think beyond first-level impact. Banks need to consider the whole ecosystem in which they interact, including measuring and accounting for the climate impact of their clients, as their actions can and should help clients on their journey to reduce impact.
  • Shift lending from brown to green. Banks will need to understand the effects of the energy transition in each sector that they serve. That includes emerging technologies, such as “green” hydrogen, that can help incumbent companies decarbonize their activities and competing propositions that could replace legacy approaches, potentially dealing a blow to banks’ borrowers. Banks then need to map these technologies to the products they can provide: equity and debt offerings, trading, supply-chain finance, and others.
  • Tweak the operating model. Banks need to build some new capabilities to ensure that expertise in this space is scalable and accessible. Increasingly, leading banks have a climate or sustainability center of excellence (COE), with concentrated expertise and resources across risk and ESG.
  • Measure and correct. Banks should develop an agreed-upon methodology, regularly evaluate the carbon intensity of their portfolio, and track alignment to goals (for example, Paris Agreement commitments).

Banks can be fast followers in many areas, but ESG is not one of them. It is a societal force that compels banks to get ahead of the curve. For banks that can, it will offer a substantial competitive advantage and a source of new business or defense of an existing one.

Banks, like other sectors of the economy, may face a cold winter ahead, but there is the promise of a thaw. The moment is right for banks to affirm their dual role as sources of stability against the pandemic’s upheaval and as beacons to the societies and communities they serve in a post-COVID-19 world. They must act because they have a crucial role to play in the work to restore and sustain livelihoods in their communities.

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This article was edited by Mark Staples, an executive editor in McKinsey’s New York office.

October 21, 2019 | Report

Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves

As growth slows, banks across the globe need to urgently consider a suite of radical organic or inorganic moves before we hit a downturn.

A decade on from the global financial crisis, signs that the banking industry has entered the late phase of the economic cycle are clear: growth in volumes and top-line revenues is slowing, with loan growth of just 4 percent in 2018—the lowest in the past five years and a good 150 basis points (bps) below nominal GDP growth (Exhibit 1). Yield curves are also flattening. And, although valuations fluctuate, investor confidence in banks is weakening once again.

The rate of global lending growth has moderated, lagging behind nominal GDP growth in recent years.

Industry veterans have been through a few of these cycles before. But, notwithstanding the academic literature, this one seems different. Global return on tangible equity (ROTE) has flatlined at 10.5 percent, despite a small rise in rates in 2018 (Exhibit 2). Emerging-market banks have seen ROTEs decline steeply, from 20.0 percent in 2013 to 14.1 percent in 2018, largely due to digital disruption that continues unabated. Banks in developed markets have strengthened productivity and managed risk costs, lifting ROTE from 6.8 percent to 8.9 percent. But on balance, the global industry approaches the end of the cycle in less than ideal health, with nearly 60 percent of banks printing returns below the cost of equity. A prolonged economic slowdown with low or even negative interest rates could wreak further havoc.

Global return on tangible equity (ROTE) has flatlined at 10.5 percent since 2013, despite a pickup in yields.

What explains the difference between the 40 percent of banks that create value and the 60 percent that destroy it? In short, geography, scale, differentiation, and business model. On the first, we find that the domicile of a bank explains nearly 70 percent of underlying valuations. Consider the United States, where banks earn nearly ten percentage points more in returns than European banks do, implying starkly different environments. Then comes scale. Our research confirms that scale in banking, as in most industries, is generally correlated with stronger returns. Be it scale across a country, a region, or a client segment. Having said that, there are still small banks with niche propositions out there generating strong returns, but these are more the exception than the rule. Underlying constraints of a business model also have a significant role to play. Take the case of broker dealers in the securities industry, where margins and volumes have been down sharply in this cycle. A scale leader in the right geography as a broker dealer still doesn’t earn the cost of capital.

Domicile is mostly out of a bank’s control. Scale can be built, although it takes time; attractive acquisitions and partnerships are currently available for most banks. But on their individual performance irrespective of scale or business model, banks can take immediate steps to reinvent themselves and change their destiny, inside the short window of a late cycle. Three universal organic performance levers that all banks should consider are risk management, productivity, and revenue growth. All while building the talent and the advanced data-analytics infrastructure required to compete.

Worldwide, risk costs are at an all-time low, with developed-market impairments at just 12 bps. But just as counter-cyclicality has gained prominence on regulators’ agendas, banks also need to renew their focus on risk management, especially the new risks of an increasingly digital world. Advanced analytics and artificial intelligence are already producing new and highly effective risk tools; banks should adopt them and build new ones. On productivity, marginal cost-reduction programs have started to lose steam. The need of the hour is to industrialize tasks that don’t convey a competitive advantage and transfer them to multitenant utilities. Industrializing regulatory and compliance activities alone could lift ROTE by 60 to 100 bps. Finally, on generating elusive revenue growth, now is the time to pick a few areas—client segments or products—and rapidly reallocate top customer-experience talent to attack the most valuable areas of growth and take share as competitors withdraw and customer churn increases late in the cycle.

What’s the right next step?

The right moves for the right bank

Each bank is unique. The degrees of strategic freedom it enjoys depend on its business model, assets, and capabilities relative to peers, as well as on the stability of the market in which it operates. Considering these factors, we narrow the set of levers that bank leaders should consider, to boldly yet practically take achievable moves to materially improve—or protect—returns within the short period of time afforded by a late cycle. To that end, we classify each bank into one of four archetypes, each with a set of levers that management should consider. In combination with the universal levers discussed in the full report, these archetypal levers form a full picture of the degrees of freedom available to a bank.

The four archetypes are defined by two dimensions: the bank’s strength relative to peers and the market stability of the domain within which the bank operates (Exhibit 3):

There are four bank archetypes, based on enterprise strength and market stability.
  • Market leaders are top-performing financial institutions in attractive markets. They have had the best run economically in this cycle, growing returns faster than the market and earning well above their cost of equity. Their critical challenge is to sustain performance and maintain their leadership position into the next cycle.
  • Resilients tend to be top-performing operators that generate economic profit despite challenging market and business conditions. Their strategic priority is to sustain returns in a low-growth, low-interest-rate, and highly disruptive environment. For resilient leaders in challenged business models such as broker dealers, reinvention of the traditional operating model itself is the imperative.
  • Followers tend to be midtier organizations that continue to generate acceptable returns, largely due to the favorable conditions of the markets in which they operate, but whose overall enterprise strength relative to peers is weak. The key priority for followers is to rapidly improve operating performance to offset market deterioration as the cycle turns, by scaling, differentiating, or radically cutting costs.
  • Challenged banks generate low returns in unattractive markets and, if public, trade at significant discounts to book value. Their strategic priority is to find scale through inorganic options if full reinvention of their business model is not feasible.

To identify the degrees of freedom relevant for each bank archetype, we assessed who they are, or a description of how banks in each archetype have performed economically in recent years (Exhibit 4), and where they live, or the underlying health of the markets in which they operate (Exhibit 5). These factors point to what they should prioritize, that is, the critical moves banks in each archetype should prioritize during the late cycle.

Revenue yield is the key differentiator across the four archetypes.

Archetypal levers comprise three critical moves—ecosystems, innovation, and zero-based budgeting (ZBB)—in two of the three dimensions discussed in Chapter 2 of the full report—that is, productivity and revenue growth. Combining the universal and archetypal levers results in the degrees of freedom available to each bank archetype. Unsurprisingly, market leaders and resilients should focus primarily on levers that will allow them to gain further scale and grow revenues through ecosystems and innovation, with productivity improvements limited to outsourcing nondifferentiated costs to third-party “utilities.” By contrast, followers and challenged banks both need to achieve productivity improvements through ZBB, and additional scale within their niche segments with inorganic options as the most credible choice.

Favorable markets are primarily in Asia and North America, while unfavorable markets are found in Europe and developed Asia.

Who you are, and what are your late-cycle priorities? Game board for the archetypes

Market leaders: Priorities to retain leadership into the next cycle

Who they are. Market leaders have benefited from favorable market dynamics as well as their (generally) large scale, both of which have allowed them to achieve the highest ROTEs of all bank archetypes—approximately 17 percent average ROTE over the previous three years. And they have achieved this leadership without having to focus too much on improving productivity, as reflected in their average cost-to-asset ratio (C/A) of approximately 220 bps. Unsurprisingly, most of the market leaders in developed markets are North American banks; however, it is also interesting to note that a significant proportion (approximately 46 percent) of market leaders consists of banks in emerging markets in Asia—mainly China—and the Middle East. These banks, even with declining ROTEs in the previous cycle, still have returns above the cost of capital.

Priorities for the late cycle. For this group, the need for action is clear as we head into the late cycle: these banks must understand their key differentiating assets and invest in innovation using their superior economics, especially when peers cut spending as the late cycle bites. As noted earlier, history shows us that approximately 43 percent of current leaders will cease to be at the top come the next cycle (Exhibit 6). The investments made now—whether organic or inorganic—will decide their place at the top table in the next cycle.

Leaders must be careful and laggards can be hopeful; archetypes move across cycles.

Given the scale advantages that leaders enjoy, banks in this group will be challenged to sustain revenue growth, especially as credit uptake typically slows in the late cycle. The focus now needs to shift toward increasing their share of wallet among current customers by extending their proposition beyond traditional banking products. This should be done through a classic ecosystem move, where they can generate capital-light fees by introducing other products into their platforms. This approach should allow them to expand revenues in a short period of time without spending significant amounts in development or acquisition costs. Meanwhile, improvements to the bank’s innovation capabilities as well as to capital commitments to innovation should remain in the forefront. Market leaders are also in a prime position to explore opportunities—to acquire smaller banks that have a customer base that is like their own, or a struggling fintech that has digital capabilities that can supplement the bank—and to pursue a programmatic M&A strategy across a select set of key technologies. In most cycles, a downturn creates the best opportunities, and now is the time to create the wish list. Fundamental to all these is the need to retain a strong capital and management buffer beyond regulatory capital requirements to capitalize on a broad range of opportunities that will likely arise.

Resilients: The challenge of managing returns in sluggish markets

Who they are. Resilients have been strong operators and risk managers that have made the most of their scale in what have been challenging markets, due to either macroeconomic conditions or to disruption. This has allowed them to generate returns just above the cost of equity, with an average ROTE of 10.7 percent over the previous three years, without taking on undue risk, as reflected in the lowest impairment rates of all archetypes (24 bps). Banks in this archetype have worked hard at costs even as they have struggled to maintain revenues, beating the C/A ratios of market leaders (their peers in buoyant markets) by nearly 50 bps. However, at 170 bps, there is still significant opportunity for productivity improvements when compared with best-in-class peers. Unsurprisingly, resilients are almost all in Western Europe and developed Asian markets such as Japan, which have been the toughest banking markets over the past three years. Leading broker dealers also feature in this group.

Priorities for the late cycle. Like market leaders, resilients must constantly seek a deeper understanding of which assets set them apart from the competition, and take advantage of their superior economics relative to peers to invest in innovation, especially when peers cut spending as the late cycle takes hold. However, unlike market leaders, given that they already operate in an unattractive market and barely earn their cost of capital, they have a higher sense of urgency in making their late-cycle moves.

The first item on their agenda, just like market leaders, should be to focus on increasing their share of wallet among their current customers through enhanced customer experience (CX) and by building a value proposition that extends beyond the traditional set of banking products. The most practical path is to expand their ecosystem activities and improve their ability to innovate. Second, those with a large infrastructure asset (for example, securities companies) should innovate by their platforms across noncompeting peers and other industry participants to find new ways of monetizing their assets. Furthermore, on the cost front, resilients need to pay closer attention to opportunities for improving productivity by exploring the bankwide appetite for ZBB. Where the resilients differ from market leaders is in inorganic levers. Due to their lower excess capital reserves, they should explore strategic partnerships to acquire scale or capabilities rather than material acquisitions. However, they should remain alert to the possibility of a compelling distressed asset becoming available.

Within resilients are banks that are less challenged by the macro conditions and more by the declining economics of their own underlying business models. For these, the playbook listed above definitely holds but they need to go beyond. As mentioned earlier in this report, there is an urgent need to find areas where they can actually add value and get rewarded as their core business economics fall. Identifying those areas and ramping up on those capabilities organically or inorganically will be the late cycle priority.

Followers: Preparing for tailwinds turning to headwinds

Who they are. Followers are primarily midsize banks that have been able to earn acceptable returns, largely due to favorable market dynamics. However, their returns (on average 9.6 percent ROTE) have been little more than half of those of market leaders, who have also operated with the same favorable market dynamics. The principal driver of their underperformance relative to market leaders is in revenue yields, where they are 100 bps lower. Finally, given their underperformance relative to other banks in similar markets, they have invested in productivity improvements and have C/A ratios 20 bps lower than market leaders but 70 bps higher than similarly underperforming peers in more challenged markets. Approximately 76 percent of followers are North American and Chinese banks.

Priorities for the late cycle. There is a clear need for action with bold moves to ensure that returns do not deteriorate materially during a downturn. Furthermore, if they are to be among the 37 percent of follower banks that become leaders regardless of the market environment, now is the time to build the foundation, as they still have time to benefit from the excess capital that operating in a favorable market gives them.

Given their subscale operations and the fact that they are still in a favorable market, they should look for ways to grow scale and revenues within the core markets and customer sets that they serve. This includes both organic and inorganic options. On the latter, followers, which have underperformed their peers in buoyant markets, should also reevaluate their portfolios and dispose of nonstrategic assets before the market turns.

Organically, growth priorities for this group are best realized by achieving a high standard of CX and improving the bank’s innovation capabilities, with an emphasis on understanding ways to better serve the specific needs of their niche market rather than developing revolutionary new products. They should also explore strategic partnerships that allow them to offer new banking and nonbanking products to their core customers as a platform, thereby extending much needed capital-light, income-boosting returns.

Cost is also a significant lever for this group. With an average C/A ratio that is 70 bps higher than peers in more challenged markets (where challenged banks as a group have pulled the cost lever harder than other archetypes), followers have the potential to improve productivity significantly. For the portion of the cost base that cannot be outsourced to third parties, implementing ZBB is a highly effective way to transform the bank’s approach to costs.

The challenged: Final call for action

Who they are. Some 36 percent of banks globally have earned a mere average of 1.6 percent ROTE over the past three years. This is the lowest average return of all archetypes and well below the cost of equity of these banks, which we classify as “challenged banks.” With an average C/A ratio of 130 bps, they have the best cost performance. The problem, however, is in revenues, where they have the lowest revenue yields, at just 180 bps, as compared with an average revenue yield of 420 bps among market leaders. Further analysis of this category also points to the fact that most operate below scale and are “caught in the middle,” with neither high single-digit market share nor any niche propositions. Unsurprisingly, most of these banks are in Western Europe, where they contend with weak macro conditions (for example, slow loan growth and low interest rates).

Priorities for the late cycle. For challenged banks, the sense of urgency is particularly acute given their weak earnings and capital position; banks in this group need to radically rethink their business models. If they are to survive, they will need to gain scale quickly within the markets they currently serve.

To that end, exploring opportunities to merge with banks in a similar position would be the shortest path to achieving that goal. Potentially high-value mergers within this segment are of two kinds: first are mergers of organizations with completely overlapping franchises where more than 20 to 30 percent of combined costs can be taken out, and second are those where the parties combine complementary assets, for example, a superior customer franchise and a brand on one side and a strong technology platform on the other.

The only other lever at hand is costs, in which this group already leads other banks. However, there should still be further opportunities, including the outsourcing of nondifferentiated activities and the adoption of ZBB, both discussed earlier. With an average C/A ratio of 130 bps, challenged banks as a group still have a good 50 bps to cover before they produce the best-in-class cost bases we’ve seen from Nordic banks. In addition, costs (especially complexity costs) could creep up as the group chases higher revenue yields through product introductions. It is better to launch products off a leaner base and, should a bank seek an acquirer, a lower cost base would also help strengthen valuations.

While the jury is still out on whether the current market uncertainty will result in an imminent recession or a prolonged period of slow growth, the fact is that growth has slowed. As growth is unlikely to quicken in the medium term, we have, without question, entered the late cycle. Compounding this situation is the continued threat posed by fintechs and big technology companies, as they take stakes in banking businesses. The call to action is urgent: whether a bank is a leader and seeks to “protect” returns or is one of the underperformers looking to turn the business around and push returns above the cost of equity, the time for bold and critical moves is now.

Download Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves, the full report on which this article is based (PDF—2MB).

November 6, 2018 | Report

Global Banking Annual Review 2018: Banks in the changing world of financial intermediation

Banks sit at the center of a vast, complex system that intermediates more than $250 trillion in global funds. What happens when the system itself is significantly streamlined and reshaped?

A decade after a financial crisis that shook the world, the global banking industry and financial regulators have worked in tandem to move the financial system from the brink of chaos to a solid ground with a higher level of safety. In numerical terms, the global Tier 1 capital ratio—one measure of banking-system safety—increased from 9.8 percent in 2007 to 13.2 percent in 2017. Other measures of risk have improved as well; for example, the ratio of tangible equity to tangible assets has increased from 4.6 percent in 2010 to 6.2 percent in 2017.

Performance has been stable, particularly in the last five years or so, and when the above-mentioned increases in capital are figured in (Exhibit 1), but not spectacular. Global banking return on equity (ROE) has hovered in a narrow range between 8 and 9 percent since 2012 (Exhibit 2). Global industry market capitalization increased from $5.8 trillion in 2010 to $8.5 trillion in 2017. A decade after the crisis, these accomplishments speak to the resiliency of the industry.

But growth for the banking industry continues to be muted—industry revenues grew at 2 percent per year over the last five years, significantly below banking’s historical annual growth of 5 to 6 percent.

Compared to other industries, the ROE of the banking sector places it squarely in the middle of the pack. However, from an investor’s point of view, a jarring displacement exists. Banking valuations have traded at a discount to nonbanks since the 2008–09 financial crisis. In 2015, that discount stood at 53 percent; by 2017, despite steady performance by the banking sector, it had only seen minor improvements at 45 percent (Exhibit 3).

What do investors know, or think they know, about the future prospects for the banking industry? In part, low valuation multiples for the banking industry stem from investor concerns about banks’ ability to break out of the fixed orbit of stable but unexciting performance. Lack of growth and an increase in nonperforming loans in some markets may also be dampening expectations. Our view, however, is that the lack of investor faith in the future of banking is tied in part to doubts about whether banks can maintain their historical leadership of the financial-intermediation system.

By our estimates, this financial-intermediation system stores, transfers, lends, invests, and manages risk for roughly $260 trillion in funds (Exhibit 4). The revenue pool associated with intermediation—the vast majority of which is captured by banks—was roughly $5 trillion in 2017, or approximately 190 basis points. (Note that as recently as 2011, the average was approximately 220 basis points.)

Banks’ position in this system is under threat. The dual forces of technological (and data) innovation and shifts in the regulatory and broader sociopolitical environment are opening great swaths of this financial-intermediation system to new entrants, including other large financial institutions, specialist-finance providers, and technology firms. This opening has not had a one-sided impact nor does it spell disaster for banks.

Where will these changes lead? Our view is that the current complex and interlocking system of financial intermediation will be streamlined by the forces of technology and regulation into a simpler system with three layers (Exhibit 5). In the way that water will always find the shortest route to its destination, global funds will flow through the intermediation layer that best fits their purpose.

The first layer would consist of everyday commerce and transactions (for example, deposits, payments, and consumer loans). Intermediation here would be virtually invisible and ultimately embedded into the routine digital lives of customers. The second and third layers would hinge on a barbell effect of technology and data, which, on one hand, enables more effective human interactions and, on the other, full automation. The second layer would also comprise products and services in which relationships and insights are the predominant differentiators (for example, M&A, derivatives structuring, wealth management, corporate lending). Leaders here will use artificial intelligence to radically enhance but not entirely replace human interaction. The third layer will largely be business to business, such as scale-driven sales and trading, standardized parts of wealth and asset management, and part of origination. In this layer, institutional intermediation would be heavily automated and provided by efficient technology infrastructures with low costs.

This condensed financial-intermediation system may seem like a distant vision, but there are parallel examples of significant structural change in industries other than banking. Consider the impact of online ticket booking and sharing platforms such as Airbnb on travel agencies and hotels or how technology-enabled disruptors such as Netflix upended film distribution.

Our view of a streamlined system of financial intermediation, it should be noted, is an “insider’s” perspective: we do not believe that customers or clients will really take note of this underlying structural change. The burning question, of course, is what these changes mean for banks. McKinsey’s view is that there will be four strategic options open to banks in the reshaped system:

  • the innovative, end-to-end ecosystem orchestrator
  • the low-cost “manufacturer”
  • the bank focused on specific business segments
  • the traditional but fully optimized and digitized bank

The right path for each bank will, of course, differ based on its current sources of competitive advantage and on which of the layers matches its profile—or the profile it intends to take in the future.

We believe the rewards will be disproportionate for those firms that are clear about their true competitive advantage and then make—and follow through on—definitive strategic choices. The result will be a financial sector that is more efficient and delivers value to customers and society at large. That is a future that should energize any forward-looking banking leader.

Download Global Banking Annual Review 2018: New rules for an old game: Banks in the changing world of financial intermediation, the full report on which this article is based (PDF—4MB).

October 25, 2017 | Report

Global Banking Annual Review 2017: Remaking the bank for an ecosystem world

By Miklós Dietz, Matthieu Lemerle, Asheet Mehta, Joydeep Sengupta, and Nicole Zhou

Global banking-industry performance has been lackluster. Now comes the hard part: the rise of nonbanking platform companies targeting the most profitable parts of the banking value chain.

The global banking industry shows many signs of renewed health. The recovery from the financial crisis is—at long last—complete, capital stocks have been replenished, and banks have taken an ax to costs. Yet profits remain elusive. For the seventh consecutive year, the industry’s return on equity (ROE) is stuck in a narrow range, between 8 percent and the 10 percent figure that most consider the industry’s cost of equity. At 8.6 percent for 2016, ROE was down a full percentage point from 2015. Further, banks’ shares are trading at low multiples, suggesting that investors have concerns about future profitability. Several regions and business lines have done better, and some institutions are outperforming due to strategic clarity and relentless execution on both their core businesses and their efforts to improve.

In short, the recovery from the crisis has been tepid, rather like the broader economy to which banking is closely tied. In fact, as our colleagues first mentioned in the 2015 edition of this report, the industry is bogged down in a flat and uninspiring performance rut. At the time, we called this a “new reality”; a few years later, with a string of lackluster performances under the industry’s belt, we have to conclude that the reality is here to stay.

Why is performance proving so hard to budge? Several factors are responsible, starting with a slowdown in revenue growth (Exhibit 1). While the trend line shows a nicely upward slant, the fact is that revenue growth has slowed dramatically: between 2015 and 2016 the rate was 3 percent, half that of the previous five years.

New digital entrants are also having an impact on bank performance, particularly by threatening the customer relationship and margin erosion across retail segments. We see new evidence of those trends—and they are happening faster than we expected. Margins continue to fall worldwide (Exhibit 2). In China, for example, they dropped 35 basis points in the past two years, shaving 6.7 percentage points off ROE. In North America, margins tightened by 46 basis points, lowering ROE by 4.1 percentage points. Banks are also losing share in some products, especially in emerging markets.

And there is a new heavyweight competitor in town. “Platform” companies such as Alibaba, Amazon, and Tencent—about which we’ll have more to say later—are staking a claim to banks’ customers and the revenues and profits they represent.

McKinsey’s latest research on the global banking industry leads to a number of additional key findings:

  • The variations in banks’ valuations continue to be substantial, but the reasons have shifted dramatically. In 2010, 74 percent of the difference in valuations was due to geography: banks with operations in hot markets were valued more highly. Geography, however, is no longer destiny. In 2017, the location of a banks’ operations accounts for just 39 percent of the difference (Exhibit 3). The rest—more than 60 percent—is due to the business model and its execution, strategy, well-aligned initiatives, and the other levers that banks command.
  • In the 2015 global banking annual review, we estimated the impact of the digital threat. Today, we update the estimate to account for a faster pace than anticipated. As interest rates recover and other tailwinds come into play, the banking industry’s ROE could reach 9.3 percent in 2025. But if retail and corporate customers switch their banking to digital companies at the same rate that people have adopted new technologies in the past, the industry’s ROE, absent any mitigating actions, could fall by roughly 4.0 points, to an unsustainable 5.2 percent by 2025 (Exhibit 4).
  • Banks cannot afford to wait any longer to extract the potential of digital to industrialize their operations. As an essential first step, those that have not yet fully digitized must explore the new tools at their disposal and build the skills in digital marketing and analytics that they need in order to compete effectively. If most of the industry were to do this, and not compete too much of it away, we estimate that banks would add about $350 billion to their collective bottom line. This gain from digitization would lift the average bank’s ROE by about 2.5 percentage points—not enough to fully offset the 4.1-point drop forecasted in our unmitigated scenario. But no bank can afford to forgo the benefits of digitization, and individual banks can do much better than the average. A full-scale digital transformation is essential, not only for the economic benefits but also because it will earn banks the right to participate in the next phase of digital banking.

The rise of platform companies

With most retail businesses (except investing) already fully explored, at least for now, fintechs are moving into commercial and corporate banking. McKinsey’s Panorama fintech database, which tracks more than 1,000 financial start-ups, shows that one of the fastest-growing segments is payments solutions for large companies. The spate of alliances and acquisitions between retail banks and fintechs has helped to solidify the notion that the land grab is over.

Now it is corporate banking’s turn, with collaborations between Standard Chartered and GlobalTrade, Royal Bank of Scotland and Taulia, and Barclays and Wave showing that when innovation meets scale, good things can happen. Fintechs are also making strides in capital markets and investment banking, especially advisory—although here, the emphasis is more on enabling traditional business processes, rather than disrupting them.

The idea of fintechs as a threat to retail banking might be receding. But the new strategies adopted by the aforementioned platform companies are even more challenging for incumbent banks. By creating a customer-centric, unified value proposition that extends beyond what users could previously obtain, digital pioneers are bridging the value chains of various industries to create “ecosystems” that reduce customers’ costs, increase convenience, provide them with new experiences, and whet their appetites for more. Not only do they have exceptional data that they exploit with remarkable effectiveness but also, more worrisome for banks, they are often more central in the customer journeys that include big financial decisions.

Consider Rakuten Ichiba, Japan’s single largest online retail marketplace. It provides loyalty points and e-money usable at hundreds of thousands of stores, virtual and real. It issues credit cards to tens of millions of members. It offers financial products and services that range from mortgages to securities brokerage. And the company runs one of Japan’s largest online travel portals—plus an instant-messaging app, Viber, which has some 800 million users worldwide. Likewise, Alibaba is not just an enormous e-commerce company; it is also a large asset manager, lender, payments company, B2B service, and ride-hailing provider. Tencent is making similar advances, from a chat-service base. And Amazon continues to confound rivals with moves into the cloud, logistics, media, consumer electronics, and even old-fashioned brick-and-mortar retailing—and lending and factoring for small and medium-size enterprises. Such companies are blurring traditional industry boundaries. With their superior customer experience, they can sell an ever-wider range of products to their loyal customers. The manufacturing end of many businesses is fading from view, as the platform companies increasingly dominate the distribution end of multiple businesses, providing a wide range of products and services from a single platform.

To put some hard numbers against what may seem like a distant threat to some banking leaders, we calculated the value at stake for global banking should platform companies successfully split banking in two (Exhibit 5). We found that “manufacturing”—the core businesses of financing and lending that pivot off the bank’s balance sheet—generated 53.0 percent of industry revenues, but only 35.0 percent of profits, with an ROE of 4.4 percent. “Distribution,” on the other hand—the origination and sales side of banking—produced 47 percent of revenues and 65 percent of profits, with an ROE of 20 percent. As platform companies extend their tentacles into banking, it is the rich returns of the distribution business they are targeting. And in many cases, they are better positioned for distribution than banks are.

Beat them? Or join them?

It is early days, but much of the global economy may eventually be reshaped by ecosystems. Naturally, mileage may vary: ecosystems will not spring up at the same pace, or to the same degree, in every market. But where they do, banks will be in the platform companies’ crosshairs.

This will place banks at the next strategic crossroads: As ecosystems emerge, should banks beat them or join them? The odds are seemingly against banks’ ability to get the jump on the world’s most advanced tech companies. But they have some things going for them. When it comes to customers’ decisions about where to place their money, research shows that banks enjoy greater trust than tech companies. And they have exclusive access—for now—to mountains of incredibly valuable customer data. Already we are seeing early success stories from around the world, as banks start to develop platform capabilities. It is not too far-fetched to imagine a day when banks will offer a range of services, reach a vastly larger customer base, and succeed at their digital rivals’ game.

To do so, banks will have to fully deploy the vast digital tool kit that is now available—something most have failed to do thus far. Harnessing the new powers of data-driven marketing, a digital workbench for sellers, robotic process automation, the cloud, application programming interfaces and apps, and all the other tools now available is an essential step for banks.

If the integrated economy begins to emerge in a bank’s market, it could be an opportunity for banks that have built these digital skills and rapid reflexes. Banks that successfully orchestrate a basic ecosystem strategy, by building partnerships and monetizing data, could raise their ROE to about 9 to 10 percent. Banks that can go further and create their own platforms might capture a small share of some nonbanking markets, which would elevate their ROE to about 14 percent—far above the current industry average.

The ecosystem strategy is not open to every bank; nor is it the only option. Banks could also find success, though less profit, with two other business models: a white-label balance-sheet operator, or a focused or specialized bank. But should the integrated economy develop in the way that many expect, a successful ecosystem strategy could be the key to a bright digital future for a number of banks.

Regardless of a bank’s views on the ecosystem economy, a comprehensive digital transformation is a clear “no regrets” move to prepare for a digital and data-driven world. As banks move from their traditional focus on products and sales to customer-centric marketing, they should reconfirm that their source of distinctiveness is still potent, design and deliver an extraordinary customer experience, and build the digital capabilities needed not just for the next few years but also for the longer term. With those assets in hand, banks will be ready when the ecosystem economy arrives.

Download Global Banking Annual Review 2017: The Phoenix Rises: Remaking the Bank for An Ecosystem World, the full report on which this article is based (PDF—1MB).

October 25, 2016 | Report

Global Banking Annual Review 2016: A brave new world for global banking

Denis Bugrov, Miklos Dietz, and Thomas Poppensieker

Our annual global banking review finds that a weak global economy, digitization, and regulation threaten the industry’s near-term profitability.

Three formidable forces—a weak global economy, digitization, and regulation—threaten to significantly lower profits for the global banking industry over the next three years. Developed-market banks are most affected, with $90 billion, or 25 percent, of profits at risk, but emerging-market banks are also vulnerable, especially to the credit cycle. Countering these forces will require most banks to undertake a fundamental transformation centered on resilience, reorientation, and renewal.

Our report, A brave new world for global banking: McKinsey global banking annual review 2016, finds that of the major developed markets, the United States banking industry seems to be best positioned to face these headwinds, and the outcome of the recent presidential election has raised industry hopes of a more benign regulatory environment. Japanese and US banks have between $1 billion and $45 billion in profits at risk by 2020, depending on the extent of digital disruption. Yet after mitigation, their profitability would drop by only one percentage point to 8 percent for US banks and 5 percent in Japan. Banks in Europe and the United Kingdom have $35 billion, or 31 percent, of profits at risk; more severe digital disruption could further cut their profits from $110 billion today to $50 billion in 2020, and slice returns on equity (ROEs) in half to 1 to 2 percent by 2020, even after some mitigation efforts (see exhibit for how digitization may reduce fees and margins across different businesses).

Emerging-market banks face a different challenge. They are structurally more profitable than their developed-market counterparts, with ROEs well above the 10 percent cost of capital in most cases but vulnerable to the credit cycle. Brazil, China, and Russia could have $50 billion in profits at risk, with China comprising $47 billion. A slower growth scenario could result in additional credit losses of up to $250 billion, of which $220 billion would be in China, our report finds, but with their current high profitability of $320 billion, Chinese banks should be able to withstand these losses.

Three formidable challenges

Banks must adapt to the reality of a macroeconomic environment that offers a number of risks and limited upside potential. Along with stagnating growth, banks face enormous challenges to digest the wave of postfinancial-crisis regulation, despite industry hopes of a more benign regulatory environment in the United States. Control costs in risk, finance, legal, and compliance have shot up in recent years. And additional proposals, termed “Basel IV,” are likely to include stricter capital requirements, more stress testing, and new guidelines for conduct and compliance risk.

Meanwhile the pressures of digitization, which boosts competition and compresses margins, are growing. Some emerging-market banks are managing well, offering innovative mobile services to customers. But our report finds that in the largest emerging markets, China and India, banks are losing ground to digital-commerce firms that have moved rapidly into banking.

In developed economies, digitization is impacting banks in three major ways. First, regulators, who were initially more conservative about the entry of nonbanks into financial services, are now gradually opening up. Over time, huge tech companies may be able to insert themselves between banks and their customers, capturing the vital customer relationship and presenting an existential threat. On the positive front, a number of banks are teaming up with fintech and digital firms, using big data and analytics to sharpen risk assessment and drive revenue growth. Lastly, many banks have been able to digitize processes and dramatically lower costs in their middle and back offices (although digitization can sometimes add costs).

A fundamental transformation

Countering the headwinds now gathering force means most banks will need to embark on a fundamental transformation that exceeds their previous efforts. Tinkering around the edges, as many banks have done for years, is not adequate to the scale of the task and will only exacerbate the sense of fatigue that comes from years of one-off restructurings.

This transformation is centered on three themes:

  • Resilience. Banks must ensure the short-term viability of their business through tactical measures to restore revenues, cut costs, and improve the health of the balance sheet. They need to protect revenues through repricing and greater intermediation, reduce short-term costs, manage capital and risk, and protect core business assets. Our report found that digitization is only the start of the answer on costs, with radical reductions in functional costs needed to fundamentally rebase the cost structure.
  • Reorientation. While the resilience agenda is defensive in nature, in reorientation, banks go on offense. They must reorient their business models to the customer and the new digital environment by establishing the bank as a platform for data and digital analytics and processes, and aggressively linking up with fintechs, platform providers, and other banks to share costs through industry utilities. They also need to streamline their operating models and IT structure and move toward a proactive regulatory strategy.
  • Renewal. The industry must move beyond traditional restructuring and renew the bank via new technological capabilities, as well as new organizational structures. Any new business model that banks design will likely require new technology and data skills, a different form of organization to support the frenetic pace of innovation, and shared vision and values across the organization to motivate, support, and enable this profound transformation.

Download Global Banking Annual Review 2016: A brave new world for global banking, the full report on which this article is based (PDF—2MB).

September 01, 2015 | Report

Global Banking Annual Review 2015: The fight for the customer

While the global banking industry has achieved a modicum of stability over the past several years, earning a record $1 trillion in 2014 and recording a 9.5% return on equity for the third consecutive year, banks now face rising competitive threats on all sides as new technology companies and others seek to poach their customers.

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December 01, 2014 | Report

Global Banking Annual Review 2014: The road back

The global banking industry continues to progress on the road back from the global financial crisis, improving return on equity 9.5% in 2013 and 9.9% in the first half of 2014. Most of the value creation is coming from banks that adhere to one of five distinctive strategies.

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