In our 2016 review of Asia–Pacific banking, we warned that a storm was brewing because of slowing macroeconomic growth, attackers, and weakening balance sheets. Three years later, these forces continue to exert pressure on the region’s banks, and forward-looking indicators suggest that many banks will struggle as the storm worsens. We believe that the combination of low growth, thinning margins, possible higher risk costs, and the need for scale efficiencies point to potential consolidation.
Growth is tapering in the world’s largest regional-banking market
There are two ways to look at Asia–Pacific banking. On the one hand, it appears to be strong and growing. In 2018, Asia–Pacific banking generated revenues of approximately $1.6 trillion. The region’s profits (before taxes) topped $700 billion in 2018, representing 37 percent of global banking profit pools, according to McKinsey’s Panorama Global Banking Pools. Revenue and profit pools continue to grow, average returns on equity (ROEs) stand comfortably above the cost of capital, and total shareholder returns for Asia–Pacific banking exceed those for global banking by 51 percentage points.1
On the other hand, closer scrutiny reveals a sobering situation. Multiple trends show clearly that the days of a free lunch and fast growth, especially for banks in emerging markets, are behind us. Asia–Pacific banks are facing challenges typical of mature markets—including slowing growth, thinning margins, and higher capital requirements—and, in many cases, will need to build scale to strengthen their competitive position.
Tapering growth is the most obvious sign of a weakening environment for Asia–Pacific banking. The region’s banks enjoyed double-digit annual growth from 2010 to 2014. But from 2014 to 2018, annual revenue growth slowed to 5 percent, and growth in profit pools slowed to 3 percent. While there was a slight recovery in banking profit pools in certain markets from 2017 to 2018, the longer trend of slowing GDP growth in China and India, the Asia–Pacific region’s two largest emerging economies, has weakened economic expansion for the entire region and dampened demand for banking services. Over the same period, banks in Europe and North America have rebounded from the 2008–09 crisis, meaning that the Asia–Pacific share of global banking profit pools is shrinking (Exhibit 1).
Nonperforming loans are still rising
Several signals indicate that weakening industry performance is not simply a reflection of the slowing macroeconomic cycle but is also a result of noteworthy changes in the market. The average risk-cost provision for the Asia–Pacific market was approximately 0.30 percent in 2018. This is the highest level of loan losses for the region since 2002, when the average risk-cost provision for emerging and developed Asia–Pacific markets hit approximately 0.31 percent.
For emerging markets, the average risk-cost provision spiked from 0.43 percent in 2015 to 0.49 percent in 2018, according to McKinsey’s Panorama. Nonperforming-loan (NPL) ratios in Indonesia, Thailand, and Vietnam are especially high but pale in comparison with the crisis in India (concentrated in wholesale lending by public-sector banks), where NPLs accounted for 11.7 percent of loans in 2018.2
Decline in returns on equity continues
Over the past decade, the story has been the rebalancing from West to East, as growth in the Asia–Pacific region has driven global economic growth and generated robust returns. Now the combination of slower growth with rising risk and capital costs in emerging economies is creating a new equilibrium, as seen in the convergence of Asia–Pacific banking returns with global averages. The average ROE for Asia–Pacific banking decreased from 12.4 percent in 2010 to 10.1 percent in 2018. The average ROE for global banking was 9.5 percent in 2018 (Exhibit 2).
If rising risk costs have eroded banking ROEs significantly in emerging markets, thinning margins on fee and interest income have cut deeply into returns across developed and emerging markets alike, as banks face increasingly fierce competition from both peer banks and digital attackers. Rising capital costs (because of a combination of stricter regulatory requirements and inefficient capital management) are also significant drags on returns.
Improvements in cost efficiency help, but banks can do better
While many banks have improved efficiency through infrastructure improvements and extensive digitization, among other measures, these actions have not been sufficient to reverse the general decline in ROE. In some markets, including China and Japan, the biggest factor behind stronger cost-to-asset ratios has been the expansion of lending volumes.3 As volume growth slows, however, it will become increasingly important to leverage state-of-the-art capabilities in areas such as digitization, robotics, and machine learning to boost productivity across diverse functions, from account opening and know-your-customer reviews to loan processing, customer service, and other areas.
Not only has volume growth driven the improvement in productivity measures in several markets, it is also the main source of growth in bank profits throughout all Asia–Pacific markets. Profits from net interest margins and fee margins are declining, making the growth in loan and deposit volumes the last remaining stronghold for profit growth. This should give industry leaders pause. Nimble digital-platform providers (armed with data-centric business models that entail relatively low capital and operating expenditures) are positioning themselves to challenge incumbent banks with increasing force. And depending on regulators’ postures toward innovation, these attackers may extend their deposit-taking and lending activities, cutting further into the market share of incumbent banks. In China, for example, Yu’e Bao, Ant Financial Service’s digital savings vehicle, has grown from managing fewer than 200 billion renminbi4 (approximately $30 billion at today’s exchange rates) in 2013 to surpassing 1.1 trillion renminbi (approximately $160 billion) in assets under management in 2018.5 In South Korea, messaging service KakaoTalk launched KakaoBank of Korea in 2017, and it grew to approximately eight million users and 12.1 trillion Korean won (approximately $10.4 billion) within 18 months.
Future outlook
The Asia–Pacific region has entered a new phase in which growth will be much slower than in recent memory, and the potential for protracted slow growth in China could weaken the region’s growth even further.6 In addition to macroeconomic headwinds, banks also face increased competition with the gradual adoption of open-banking standards, and they will likely continue to struggle with declining returns. Investors have already registered their pessimistic outlook for the industry, and price-to-book multiples for Asia–Pacific banking have declined from 1.1 in 2011 to 0.7 in 2018,7 trailing the global average for the fourth consecutive year (Exhibit 3). Nearly two-thirds of Asia–Pacific banks have price-to-book ratios of fewer than 1.0 and could become acquisition targets for stronger banks seeking to build scale.
Growth is slower in China
Given the weakening macroeconomic environment, banks will need to plan their investments carefully and reach a new level of efficiency in order to grow faster than the broader economy. Asia–Pacific economies continue to grow, and in many markets, the growth of GDP will remain comparatively strong. However, growth is slowing across most Asia–Pacific markets.8
The Asia–Pacific area has a large and complex regional economy, with some markets heavily focused on manufacturing and others more dependent on services. What many Asia–Pacific markets have in common, however, is significant dependence on trade with China. This trade accounts for 7 percent of South Korea’s economic output, 14 percent of Malaysia’s GDP, and 35 percent of Vietnam’s GDP. As the market generating half of banking revenues in the Asia–Pacific region—and 78 percent of growth in the region’s banking profit pools—between 2010 and 2018, the tapering of China’s real GDP growth, from 7.9 percent in 2012 to 6.7 percent in 2018, will contribute to weakening the demand for banking services across the region.
Trade friction between China and the United States could potentially weaken the pace of growth in the Asia–Pacific markets that are strongly linked to China’s economy. However, a stronger emphasis on domestic trade within China could mitigate the negative impact of trade tariffs on the country’s growth, and some markets in the region may benefit as US companies seek alternative trading partners.
The rapid expansion of China’s real-estate sector is another source of concern, as a collapse in real-estate prices could threaten the stability of the Chinese banking system and ripple across the region.9 The Chinese government’s efforts to reduce the role of shadow banking are expected to yield systemic benefits over the long term. In the short term, however, effects may include restriction of the growth of private companies, which contribute significantly to both job creation and China’s economic expansion.10
Trend is toward open banking
Aiming to speed up innovation and modernization through competition, regulators across the Asia–Pacific region are gradually opening up banking systems to broader participation.11 India now allows nonbank payment-services providers to connect directly to its new infrastructure, the United Payments Interface, and Australia has also mandated that its four largest banks adopt open-banking standards for a broad range of transactions.12 Hong Kong and Singapore are both issuing virtual banking licenses in an effort to spur innovation and to create greater efficiencies and resiliency within the banking system.1314
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Whether regulatory efforts to encourage open banking lead to more direct competition or voluntary collaboration between banks and nonbanks, mounting competition between traditional banks and digital innovators will almost surely cut even deeper into bank margins in the coming years. New entrants will find avenues to introduce highly relevant services that have unprecedented levels of ease and convenience and low pricing. Some of these attackers may obtain banking licenses for start-ups; others may partner with a newly licensed digital bank or invest in an incumbent bank. In either case, disruption will continue to erode bank margins—it remains to be seen how fast the returns will decline.
Decline in returns on equity will continue unless banks or investors take action
We estimate that if regulators maintain a cautious posture toward nonbank innovators during a period of weak growth, Asia–Pacific banking ROE could decline to 9.8 percent by 2022. However, if low-cost, digital-first banks can build scale rapidly and take significant market share from incumbents, ROE could drop to 7.0 percent in 2022.
We also estimate that a rigorous, industry-wide effort to optimize operation, risk, and capital costs could reverse the decline in returns, potentially pushing industry ROE for the Asia–Pacific region up to 12.1 percent by 2022. More than 60 percent of Asia–Pacific banks have ROEs below the cost of equity. Banks that fail to improve productivity, optimize capital consumption, and revitalize revenue growth may see their ROEs drop below the cost of capital, leading, in turn, to efforts to restructure portfolios or seek a merger partner.
Wide variation in capital levels suggests inefficient allocation
On a brighter note, banks’ capital levels are generally adequate across the Asia–Pacific region. The average Tier 1 capital ratio for Asia–Pacific markets has risen from approximately 11.2 percent in 2010 to approximately 12.8 percent in 2018.15 The timing and level of Basel III implementation are still not clear for many markets16; however, we anticipate that most large banks in the Asia–Pacific region will be required to hold capital equivalent to 12.5 percent of risk-weighted assets (adding the regulator’s surcharge of 2 percent to the Basel III recommendation of 10.5 percent).
While Asia–Pacific banking may have a strong reserve of capital as an industry, many banks are not putting it to good use. The average return on risk-weighted assets (RORWA) across the region was 1.5 percent in 2018, but profitability varied widely. For example, banks in Australia, Hong Kong, and Indonesia earned more than 2.5 percent RORWA in 2018. Earning 1.6 percent RORWA in 2018, Chinese banks performed slightly above the overall Asia–Pacific average.17
If bank capitalization in Asia–Pacific markets is sufficient, on average, to satisfy regulatory requirements, the region’s banks maintain significantly lower Tier 1 capital ratios than do banks in Africa, Eastern Europe, and the Middle East (14.6 percent in 2018) and in Western Europe (15.6 percent in 2018). The lower capitalization of Asia–Pacific banks combined with the fact that capital levels vary quite widely from bank to bank within a market point to the opportunity for consolidation. More specifically, the wide dispersion of capital ratios signals two things. The first point is that poorly capitalized banks may become acquisition targets. The second point is that banks significantly above the market average are not deploying capital efficiently and, consequently, could potentially either acquire another bank (because they are awash in cash) or be acquired (because of their extraordinary inefficiency). Put more simply, capital will ultimately flow toward the organizations offering optimal returns.
Scale matters more than ever
Asia–Pacific banks with greater scale have typically generated higher returns. Across select Asia–Pacific markets, there is a wide difference in the ROEs of the largest and smallest banks, ranging from 140 basis points to 700 basis points. The wide dispersion in ROE shows that scale really does matter. For example, in Australia, the four largest banks handle practically all mortgage lending, which not only represents a large share of total bank assets in the country but also has become even more profitable with the adoption of high-powered credit-underwriting models.
But how far can a bank go by adding scale? Historically there has been a limit to how big an operation could become and still reap scale efficiencies. This has changed however. Recent technological innovations in machine learning, artificial intelligence, and robotics have lifted this limit, launching a new wave in productivity. Scale is back on the agenda, even for the largest, most efficient organizations.
Winning in a world of ecosystems
In certain Asia–Pacific markets, new regulations that aim for higher efficiency, stronger risk management, better choices for customers, and capital controls have an indirect impact on consolidation, as the new regulations pose special challenges for smaller, less-efficient banks.18 Without drastic measures to cut the fat, build muscle, and develop a superior offering, these banks will likely disappear as larger, highly efficient banks seek greater scale to ride the new wave of productivity. As well-capitalized banks with strong market valuations explore their options for improving productivity, many will likely seek to acquire less efficient and poorly capitalized banks. Several banks in the region have already completed multiple transactions, but we have yet to see the emergence of a strategic and programmatic approach to M&A.
Consolidation on the horizon
The combination of slowing growth, increasing competition, and potential further increase in risk costs creates a perfect storm in which Asia–Pacific banks will be severely challenged to reverse the decline in ROE. A number of developments, such as a distressed bank seeking a merger and a trend of bank failures because of a sharp rise in loan losses, could push the industry toward a new investment structure. We expect, however, that the most likely move toward consolidation will come from well-capitalized banks seeking synergies in areas such as market growth, technology, and talent.
Compared to the US market and various European markets, some Asia–Pacific banking markets are already consolidated to a certain degree. Even in highly consolidated markets, however, there is room for efficient and well-capitalized organizations to strengthen market leadership through M&A. In addition, as previously noted, the disparity between banks priced at multiples that reflect capital strength and those that display weakness is currently at its peak, suggesting fertile ground for M&A.
As capital shifts toward organizations that generate higher returns, banks that achieve market-leading productivity will compete aggressively with both regional and global banks—as well as digital giants. While the biggest banks will increase their market share, there will always be a role for smaller institutions that offer, for example, high-touch banking and investment for high-net-worth individuals and small and medium-size businesses or a highly efficient everyday banking proposition for underserved market segments. We expect that the imperative to create value will result in clearer choices for customers. Unprofitable, subscale banks that are poorly capitalized will disappear.
The situation will be different across markets, with some markets moving faster toward consolidation, depending on the number of competitors, the degree of variation in performance, the level of loan losses, capital requirements, regulatory changes, and other factors. There is considerably less room for consolidation in Australia, Hong Kong, and Singapore, but some banks, nonetheless, may seek synergies through M&A. In markets with a moderate level of consolidation, the largest banks may target smaller organizations. Most M&A activity will occur within markets, but cross-border deals could increase as banks seek to enter new markets or exit markets where they cannot compete.
The Asia–Pacific region is a tough environment for banks, and it is going to get tougher, as slowing growth, rising NPLs, and eroding margins continue pushing ROEs downward. Asia–Pacific banking is on the brink of consolidation, and banks urgently need to redouble their efforts to boost productivity, optimize capital, and pursue strategic growth. Bracing for consolidation will get banks in shape to forge ahead through the storm.
Download Asia-Pacific Banking Review 2019, the full report on which this article is based (PDF–2.5MB).
