The past two years have been the best for banking since before the global financial crisis (GFC) of 2007–09, with healthy profitability, capital, and liquidity. But even though banking is the single largest profit-generating sector in the world, the market is skeptical of long-term value creation and ranks banking dead last among sectors on price-to-book multiples.
In addition to a mix of macroeconomic factors, there are also some industry-specific ones:
- Labor productivity growth in banking has been mixed, even though banks spend the highest proportion of revenues across sectors on tech.
- Regulatory changes around the world continue to require investment.
- The more profitable pools in banking are witnessing competition from focused attackers (including private credit, payments, and wealth management).
- The recent lift in performance has largely been buoyed by rising interest rates.
- Despite the recent value creation, over the past decade, the sector has eroded economic value when measured against cost of capital.
So will the liftoff in overall industry results achieved in 2023 give way to the gravitational pull of the industry’s recent history, as questions about banking fundamentals persist?
Looking at banks that outperformed over the past five to ten years could hold the answer to how banks might achieve escape velocity. Banks that win use a combination of smart moves on three structural dimensions (selecting segments carefully, finding scale where it can matter, and strategically locating themselves, whether geographically or in the value chain) and rigorous operational execution across a range of capabilities (for example, analytics, marketing effectiveness, operating model, and tech).
The good news for the rest of the industry is that things can be improved. Indeed, about 10 percent of the industry improved as much as five deciles of return on tangible equity over the past five years (though conversely, roughly two-thirds of the industry stayed within two deciles of their prior performance). For banking to recover its multiple, management teams will need to conjure the dynamism of these winners. We believe this “management quotient” will be what makes the real difference in the remaining years of the 2020s.
The industry
There’s some solace in the witticism about it not being the end if it’s not fine. But recently, things have been fine indeed for banking, so what does that say about the endgame? In fact, the past two years have been the best for banking since before the Great Recession. Globally, banks generated $7 trillion in revenue (Exhibit 1) and $1.1 trillion in net income, with return on tangible equity (ROTE) reaching 11.7 percent. Banks have returned to healthy levels of capital (12.8 percent common equity tier one capital divided by risk-weighted assets) and liquidity (77.2 percent), which both improved over 2022. In fact, banking generated more total profit than any other sector around the world.
So why the foreboding? Simply, global banking is valued at a price-to-book ratio of 0.9—the lowest of all industries—which suggests the market is expecting the industry will erode economic value as a whole (Exhibit 2). And this challenge exists across most markets. There are many potential reasons for it:
- The improvement in returns could be fleeting. Looking back, while the industry has reduced costs and kept credit quality high, the improvement in returns since 2021 appears to be largely owed to rising interest rates (Exhibit 3). Modeling, while imperfect, suggests that without rate support, industry ROTE in many geographies would have been around 8 percent, or below cost of capital. If one believes that rates will be lower than they are today, some of our scenarios suggest the industry’s ROTE could revert to near its cost of equity over the next two years.
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- The wide variations in the industry across subsectors and geographies may skew how certain institutions are viewed relative to others. Structure and mix could significantly influence how individual banks fare as conditions change. In some countries, including the United States, the United Kingdom, India, Germany, and Nigeria, performance improved in 2023 versus the 2010–22 period, while other countries, like Brazil, Canada, China, Japan, and Australia, saw lower ROTEs.
- Banks may not be able to count on raising productivity or harnessing scale. These continue to be conundrums for banks in many regions of the world. AI hasn’t yet proved a panacea (though quite recently, some leading banks that have been first movers have publicly announced efficiencies from AI—for some of them in the billions of dollars, already worth as much as a point of efficiency ratio). Despite a global total of approximately $600 billion being spent by banks on tech that should be boosting productivity, labor productivity in some major markets (for example, the United States) is declining.1 AI could change that, but at most banks, generative AI is currently in pilot mode. And with it comes more spending and more regulatory requirements, so many banks have adopted a cautious posture.
- Improvement in margins may not be able to come from more cost cutting. To maintain current ROTE in the face of some macro-driven scenarios, the industry would need to reduce its cost per asset by 5 percent per annum, or five times the industry’s historic performance of 1 percent reduction per annum (Exhibit 4).
- Attackers continue to pressure incumbents. As we described in last year’s Global Banking Annual Review, about two-thirds of financial asset value growth was in off-balance-sheet assets (for example, mutual funds and alternatives).2 Nontraditional competitors (for example, nondepository companies and private capital) and well-funded neobanks peck at the largest profit pools.
Macro uncertainties and industry-level issues also pose challenges:
- The cost of funds for banks could increase, driven by continued quantitative tightening that reduces total deposit volumes (–6 percent CAGR since 2021 in the United States and –10 percent at European Central Bank) and increased competition with money market flows in some markets.
- Loan originations face the dual challenge of declining consumer and corporate demand. For example, US commercial real estate (CRE) originations are down 55 percent from their pandemic peak and 25 percent below their ten-year average. At the same time, existing assets face potential devaluations—some of which are yet to be fully realized. For example, CRE price index was down 9 percent in the fourth quarter of 2023 in the United States and the euro area. A reduction in interest rates may help to smooth some of these effects.
- Unrealized losses for held-to-maturity securities are predictably burning off and will shrink, with revaluations at lower rates, potentially opening the aperture for M&A. But large-scale M&A hasn’t been a certain path to success.
- Our projections for the original Basel III endgame impact on ROE were material. It remains to be seen what the recently released revised proposal will result in, but that could have a further moderating effect on ROTEs.
Add these challenges to the geopolitical uncertainties of the world today, and one can contextualize the impact on ROTE that the markets are foreseeing.
Attaining escape velocity
We believe that banks wanting to attain escape velocity will need to operate very differently from today to “avoid gravity.” To understand how they could do this, we looked at the track record of performance by some leaders, hoping to find clues to their longer-term health.
As we say this, it’s also important to note that banks are by nature fragile entities that first and foremost need to prioritize safety and soundness. Poor structural bets, like a lack of diversification by concentrating on one segment or over-rotating on a portfolio, can destroy banks through liquidity or credit quality. Some of the leading banks in the United States by the measure of ROE (and often, growth) from a few years ago were consumed by the regional banking disruption of 2023. Further back, prior to the GFC, the leaders were subprime originators. So when we look at winners, we’re cautious, looking at what they do through the lens of whether they are achieving their leadership prudently and sustainably.
With that in mind, we identified potential winners from around the world (see sidebar “About our analysis”).
The winners
Perhaps heeding the baseball sage’s advice, banking winners have achieved their position through a combination of both structural and execution moves. Neither strategy confers enduring advantages, but the combined effect puts banks in a position that’s market leading. Here’s what we observed:
There’s a path to escape velocity
A total of 14 percent of banks are expected to create value and perform at a high level based on their current price-to-book multiple (more than one) and price-to-earnings multiple (more than 13), demonstrating that there’s a path to “escape gravity” in the industry. By comparison, about 62 percent of publicly traded companies outside of banking achieve this same threshold.
The path is more common now
In good news, higher performance is becoming more distributed across the industry (perhaps aided by the regulated nature of different markets). Today, 14 percent of banks account for 80 percent of the economic profit in the industry, up from 11 percent in 2013. The figure is almost five times the average of all other industries, where performance is far more concentrated in a few players.
The outperformance can be large
Our analysis of TSR outperformers (in the United States) shows that there’s a wide dispersion in performance: 14 points between the top and bottom deciles across 90 top US banks between 2013 and 2023. Four operational metrics, along with avoiding risk, largely explain most of the outperformance of TSR: revenue growth (34 percent); better net interest margin management (34 percent) from lower cost deposit-gathering strategies or better distribution and credit risk management; growing fee income (16 percent) from expansion in advisory services, wealth management, and other fee-heavy businesses; and cost efficiency (5 percent).
Where you operate matters
About one-third of these institutions are in attractive banking markets (for example, Australia, Canada, and India) that demonstrate high margins and strong fundamentals (for example, demand for credit, demographics, and economic growth) (Exhibit 5).
Performance also matters
Endowment or structure—or where you operate—isn’t the only thing that matters. Institutions have achieved and sustained high levels of performance through deliberate strategic choices around structure and bold moves around execution.
What do these banks look like? Since comparing widely varying geographies is pointless, we normalized some features to common benchmarks. The outperformers’ revenue growth is 1.5 times their local GDP growth, their fee-to-revenue ratio is typically 40 percent or higher, their efficiency ratio is lower than 50 percent, and their risk costs are generally well-managed enough through the cycle to be significantly below their reference industry’s costs.
Where to compete (structure)
Winners have at least one of three structural markers that drive their performance:
- Picking and decisively committing to the right segments for growth while avoiding the trap of over-rotating into them. Investing in growth by client segment or product type but not tipping to a point of concentrating exposure is crucial. Some winners have grown their commercial portfolios that inherently carry lower expense ratios, thereby lowering the institutions’ overall expenses. Others have leveraged their platforms in sectors like wealth and payments.
- Finding scale where it matters to drive productivity and acquisition. While in some countries, finding economies of scale is elusive at the overall industry level, scale does exist in pockets, and finding out how to harness it can thus have a significant effect. Some winners have found those pockets and doubled down on their position to create more margin by moving up the scale curve.
- Optimizing location—either geographically or in the customer value chain. Positioning is clearly important, and some banks have chosen to shape their footprint either transnationally in countries or domestically in states and provinces that show higher-than-average economic prospects. Other banks have occupied strategic positions along the value chain.
How to win (execution)
Execution excellence also provides an edge. For many institutions, there are limits to what can be done structurally (for example, shifting geographies and entering more attractive lines of business). More disciplined focus can be on targeting specific profit pools, more granular pricing capabilities, and better tailored customer segments for growth, among other approaches.
The following are some execution-based approaches we observed among the winners across the globe:
- Deepening relationships (one customer-centric bank and ecosystems). This is particularly a factor in the corporate space. Delivering the right mix of mutually reinforcing businesses across balance-sheet-intensive and fee-generating activities spreads the cost of acquisition of an expensive customer across more of the bank.
- Achieving retail or small and medium-size business (SMB) customer primacy through a personalized funnel. A North American leader has retooled itself to create a more personalized experience for its customers, focusing on products like wealth and home equity to create rapid cycle propositions (as many as four marketing campaigns a month). It has attached that to a segmentation that drives who answers the phone, the script used, and ultimately what kinds of ongoing servicing support the customer experiences.
- Leveraging granular pricing and risk selection. A leader that had long prided itself on both customer access and speed of decision making realized a few years ago that these two edges were being competed away by the ubiquity of digital offers and the inevitable compression of decision-making time. Indeed, in its market today, the vast majority of approvals are achieved in a matter of hours.
- Building world-class lead generation in wealth management. A wealth manager with a large team of financial advisers decided to fundamentally shift its approach to lead generation and economics. The institution recognized that there were three outsize drivers of capturing “money in motion”: the right offer, the right time, and delivery through the right channel. Getting these three things right is delivering a propensity to convert that’s almost 20 times higher than peers.
- Achieving retail or SMB customer primacy through mobile-orchestrated distribution. A winner that operates in a digitally forward nation has invested heavily in making the shift from thinking about an omnichannel distribution strategy to using one that’s truly mobile orchestrated. It has elevated mobile as the orchestrator of all customer journeys; standardized all other channel operations; moved many services that require specialized expertise into a remote advisory model; and invested in orchestration across the customer relationship management, funnel management, and customer value management systems.
- Using strategic talent management to win with clients and unlock productivity. Some winners are focusing on their return from talent and using their people to differentiate their client value proposition. They have created a strategic HR capability to recruit candidates in days instead of months, compensate at the top quartile, maintain employee satisfaction scores, and inspire their workforces to go above and beyond to serve their customers.
- Picking the right spots in wholesale banking to win. A regional wholesale bank recognized that it would never reach the scale to win. Instead, it built vertically integrated sector offerings to become the destination institution for companies in those sectors. It invested deliberately in talent, footprint, marketing, and thought leadership to build its brand in these areas.
- Building an AI-enabled bank. While intelligence that’s truly artificial is still emerging, there are a few leading institutions that have leaned very heavily into using advanced analytics, which include machine learning, deep learning, and more recently, generative AI and other approaches. They have built this into their cultural fabric and operating models.
- Using proven operating models to unleash speed at scale, safely. Several winners have built (and branded) their operating models. These are variations of “digital factories,” “product and platform,” or more aggressively, “independent mini-companies” that are able to operate under the same umbrella with more independence while automating a large portion of common services.
‘Management quotient’ as a differentiator
About 10 percent of global banks have been successful at raising their performance by as much as five or more deciles of the industry’s ROTE distribution, showing that breakout performance is indeed possible in this sector (Exhibit 6). But overall, our analysis shows that there doesn’t seem to be a lot of relative positional movement in the industry. Only 5 percent of banks dropped their performance by five or more deciles, about half the industry remained within one decile of its starting position, and roughly two-thirds of the industry remained within two deciles of its starting position.
These figures speak to how hard improving performance is. The industry is rife with examples of well-intentioned ideas and initiatives that didn’t anticipate second-order effects that weren’t sustained over time (for example, cost-cutting programs that lasted two years only to see costs “walk back in the door”) or that ran at cross purposes (for example, poorly designed mobile apps that led to increases in call center volumes instead of the reductions planned in the business case).
Given the market’s current view of banking and the gravitational forces at work, management teams can seize the moment to separate from the pack and create real dynamism by answering five core questions:
- The hand you have been dealt. Given market structure matters (fragmented versus concentrated, public versus private, and global versus national versus regional versus community focused), what’s your thesis about how the fundamental economics in your specific market will play out? What are the empirical drivers of your and your competitors’ market values that could realistically be influenced to drive relative competitive advantage?
- The hand you play. Once you have isolated and accounted for market-structure-oriented drivers of enterprise value, how much of the residual value gap to your competitors can be closed by further harnessing endowments your bank enjoys (for example, brand and community loyalty)? How much would need to rely on execution factors (for example, moves you make and businesses you grow into)?
- Tilting the scales. Where are the points of disproportionate structural leverage (for example, via scale, portfolio mix, and relationship depth)? Where are the points of disproportionate executional leverage (for example, from better risk selection, talent selection, pricing, and marketing)? How much of this leverage is organically capturable?
- Friction or frictionless. Is your operating model set up to translate ideas to actions fluidly, or does it sometimes feel like you’re wading in mud when trying to get things done internally? What exactly is getting in your way? What can be learned and adapted from more nimble executors?
- Improvidus, apto, quod victum.3 How fast do you tack to changing trends and competitors’ moves? Who are the “beacons” you have set yourself and your management team to emulate, so you can leap ahead?
