McKinsey’s Global Banking Annual Review archive: 2014 to 2022

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Banks will need to become more resilient and reinvent their business models to ride out the current volatile period and achieve long-term growth and profitability.

By Miklos Dietz, Attila Kincses, Archana Seshadrinathan, and Dee Yang

First the pandemic, and now inflation, war, rising interest rates, supply chain disruption, and more: for banks globally, the combination of macroeconomic volatility and geopolitical disruption in 2022 overturned many assumptions and ended more than a decade of relative stability. One thing didn’t change, however: valuations. Banks overall continue to trade at a steep discount to other sectors, a reflection of the fact—confirmed once again in 2022—that more than half of the world’s banks earn less than their cost of equity.

In this year’s Global Banking Annual Review, we take a closer look at the roller-coaster ride banks have been on over the past months, the growing divergence between banks with different profiles in different countries, and the factors that make the best performers stand out.

At a time of growing corporate and government commitments to reduce greenhouse-gas emissions, we also shine a spotlight on sustainable finance, a much-discussed theme in banking. Despite lingering skepticism and concerns about greenwashing, we find strong evidence suggesting that climate-related financing is entering a “next era,” as the initial surge of funding for renewable energies gives way to a deeper engagement with banking clients across all sectors.

For banks, 2022 has been a tumultuous year of shocks and growing uncertainty

Banks rebounded from the pandemic with strong revenue growth, but the context has changed dramatically. Now a series of interrelated shocks—some geopolitical and others lingering economic and social effects of the pandemic—are exacerbating fragilities.

Bank profitability reached a 14-year high in 2022, with expected return on equity between 11.5 and 12.5 percent (Exhibit 1). Revenue globally grew by $345 billion. This growth was propelled by a sharp increase in net margins, as interest rates rose after languishing for years on their cyclical floors. For now, the banking system globally is sitting comfortably on Tier 1 capital ratios between 14 and 15 percent—the highest ever.

The improvement in margins accounted for 60 percent of the revenue gains (Exhibit 2). Almost all segments of banking have seen improvements—capital markets and investment banking being the exception.

Nonetheless, more than half the world’s banks in 2022 continue to have a return on equity that is below the cost of equity. For the second half of 2022, our analysis suggests that margin increases delivered returns above the cost of equity for just 35 percent of banks globally. And less than 15 percent of banks are earning more than 4 percent of their respective cost of equity.

Lingering effects of COVID-19 and geopolitical tensions are roiling the financial sector

The longtail effects of the COVID-19 pandemic are still being felt, and the Russian invasion of Ukraine in February 2022 and heightened tensions over Taiwan marked the rude return of geopolitics as a disruptive force. Five resulting shocks are affecting banks globally:

• Macroeconomic shock. Soaring inflation and the likelihood of recession are sorely testing central banks, even as they seek to rein in their quantitative-easing policies.
• Asset value shock. These include steep declines in the Chinese property market and the sharp devaluation of fintechs and cryptocurrencies, including the bankruptcy of some high-profile crypto organizations.
• Energy and food supply shock. Disruptions to the energy and food supply, related to the war in Ukraine, are contributing to inflation and putting millions of livelihoods at risk.
• Supply chain shock. The disruption of supply chains that began during the first pandemic lockdowns continues to affect global markets.
• Talent shock. Employment underwent major shifts during COVID-19 as people changed jobs, began working remotely, or left the workforce altogether to join the “great attrition”—shifts with no sign of easing.

The consequences differ across and within regions, notably in emerging markets

One of the striking characteristics of this period is that some banks in some geographies are growing robustly and posting buoyant and rising profits and revenues. This far more upbeat picture is to be found in select markets—many regional banks in the United States and top five banks in Canada, for example. In emerging economies such as India, Indonesia, Mexico, and South Africa, the largest banks by market capitalization are performing very well.

This is not the old story about emerging markets versus advanced economies. Indeed, this year it’s possible to make the case that, in banking at least, the whole notion of “emerging markets” is dead (Exhibit 3). The group of countries to which it refers is no longer monolithic: some of the best-performing and high-growth banks are to be found in Asia, as are some of the worst-performing and lowest-growth ones.

As the economy slows, the divergence between banks will widen further

The current uncertain macroeconomic outlook will affect banks in two ways, albeit to different degrees. First, there is likely to be a continuing boost to profitability from higher margins as interest rates increase—but this may prove transitory. Second, banks face a long-term growth slowdown. The result of these pressures will be an increase in the “great divergence” trend among banks that we noted last year, with outcomes varying considerably, depending on funding profile, geography, and operating model.

Two economic scenarios: How bad (or good) might it be for banks?

We modeled the effects on banks of two possible macroeconomic scenarios: inflationary growth and stagflation. In either scenario, we expect the initial stage to be positive for banks. Rising interest rates will lift net interest as short-term lending products such as consumer finance are repriced faster than liabilities. Global banking revenues are likely to see an increase of 5 to 6 percent in 2022.

In this phase, both scenarios forecast that costs and risks remain under control. Global banking return on equity would rise to approximately 12 percent in 2022, two percentage points more than in 2021.

The big question is what will happen during a transition phase when economic growth deteriorates, followed by a phase when the full effects of the scenario kick in. Banks could see three effects—a slowdown in volume growth, higher costs, and greater delinquencies—which, depending on the scenario, could be small or large.

The divergence story will continue to play out through these scenarios. Banks in Asia–Pacific may gain from a stronger macroeconomic outlook, whereas European banks may see the full effects of the scenario sooner and with more detrimental impact. In the event of a long recession, we estimate that return on equity globally could fall to 7 percent by 2026—and below 6 percent for European banks.

The net impact will likely be a further concentration of growth in emerging Asia, China, Latin America, and the United States. We expect that these regions will account for about 80 percent of the estimated $1.3 trillion in global banking revenue growth between 2021 and 2025.

What hasn’t changed: Banks trading at a growing discount to other sectors

Banking as a sector is valued substantially below other industries, a reflection of the stark legacy challenges that traditional banks face. About half of all banks are net destroyers of value, and many of the others are weighed down by prospects of slow growth and low expectations for profitability.

Total global market capitalization peaked in 2021 at $16 trillion and dropped back to $14.5 trillion by May 2022. Half of this valuation is represented by traditional banking institutions, while specialists and fintechs represent the other half—up from a 30 percent share five years ago.

The gap in valuation between traditional banks and fintechs remains large, even if the 2022 downturn in crypto and buy now, pay later brought fintechs down from their highs.

Between banking and other sectors, only about half of the valuation gap is a reflection of the banking industry’s low profitability (Exhibit 4). The other half reflects the expected lack of future growth, demonstrated by banks’ low price-to-earnings ratios (P/Es). Banks have P/Es of about 13, compared with an average of 20 for other sectors.

Within this overall gloomy picture are brighter spots. Globally, about 15 percent of banks qualify as “North Stars.” They have high P/Es, implying high expectations for long-term growth, and high price-to-book ratios (P/Bs) that reflect risk-adjusted short-term profitability. Their valuations are two to five times higher than those of other banks. Most of these banks are specialists with a focused business model. They are more geographically diverse, with concentrations for certain sectors; for example, North American payments providers and consumer finance and other specialists from emerging Asia demonstrate both high growth and high profitability.

In our banking review last year, we identified about half of banks as value destroyers. This year, by looking not just at profitability but also at growth, we find that in addition to this 50 percent, which are destroying value now and are expected to continue doing so in the future, another 35 percent are currently creating value but are not able to grow sufficiently to ensure they will continue doing so. These are banks with high P/Bs but low P/Es. In other words, they are profitable now, but the longer-term expectations for future growth are not bright.

Banks’ performance varies by geography, specialization, customer segmentation, and scale

To understand why and how banks end up where they do, we looked at them across four dimensions: geography, specialization, customer segmentation, and scale.

Geography is a key factor. We analyzed the deviation in banks’ P/Bs across the last decade, using a standard regression model to estimate the key drivers behind variation in P/B. Geography emerges as one of the key factors in a bank’s valuation. Overall, we find that a bank’s primary business location accounts for 68 percent of its valuation, a share that has been rising consistently since 2014.

Last year, many banks in Europe were already unprofitable; only 25 percent of the 300 largest European banks were valued above book in 2021. In the months ahead, they face intensified pressure from a potential recession. By contrast, about 25 percent of emerging Asia banks are valued at 1.5 times their book value or above, in part because of fast-growing economies and their innovative practices. P/B and return on equity are also strong in the Middle East, Latin America, and North America.

Specializing can be profitable. Well-valued specialist players and fintechs are—not surprisingly—active in banking products that generate profits, including deposits, payments, and consumer finance. The result is a two-speed system in which traditional banks are left behind (Exhibit 5). Overall, the banking system destroyed about $120 billion in economic value in 2021, with a return on equity that failed to match its cost of capital. But the divergences were very large across areas of banking specialization.

Take a fresh look at customer segments and demographics. Our analysis suggests that, in retail banking, disproportionate revenues tend to be locked in specific segments. One notable feature of this analysis is the gap between the demographic distribution of the population and the age at which they generate banking revenue. For example, in the United States, banking revenue peaks among people between the ages of 60 and 70, which is about 40 years after the demographic peak. In China, the trend is reversed: the revenue peak arrives 20 years before the demographic peak.

Scale matters. About 70 percent of market capitalization is held by banks that have a P/B of higher than 1 (which is about half of all banks)—even though they account for only 30 percent of assets. Only 10 percent of these banks are already at scale, and they represent a market share of at least 10 percent; the rest of these “value-creating” banks could benefit from M&A to increase their scale.

The dual challenge: Managing the present while preparing for the future

Over the next five to ten years, market pressures and shifts, including technological changes that disrupt traditional banking, will amount to fundamental structural breaks. Banks will need to improve their short-term resilience and invest in the long term to innovate and prepare the path for future profitability, increased growth, and higher valuations.

In the near term, four strategic objectives can help bolster resilience:

1. Financial resilience. The best-performing banks will have a net income structure with low sensitivity to interest rates and risk costs, and they should target a cost-to-income ratio of 35 to 40 percent.
2. Operational resilience. That means reducing or eliminating a presence in high-risk countries and building exceptional risk management practices.
3. Digital and technological resilience. Cyberattacks remain a serious risk, and the best banks have a well-protected and future-proof technology infrastructure, as well as superior data security.
4. Organizational resilience. Banks that perform best will have rapid reaction times and invest in attracting, reskilling, and retaining the best talent.

For the longer term, banks will need to move from traditional business models to more future-proof platforms, potentially decoupling business units such as everyday banking and complex financing or advisory services. Banks could consider several approaches. For example, they could foster highly differentiated customer relationships, with a strong focus on establishing a deep emotional connection. They also could develop proprietary data and insights on sets of customers, including with the use of advanced analytics. A third option would be to make substantial and clear bets when allocating resources and capital. Fourth, banks could create new customer access and revenue sources, such as subscription fees, payments fees, and distribution fees, that do not involve the balance sheet. And banks could focus on innovation, with the goal of instilling a truly entrepreneurial culture and attracting and retaining the talent needed to contribute within such a culture. Finally, as we describe in the next section, banks could develop a strategy for targeting environmental transformations.

Issuance of sustainable debt instruments, which was close to zero five years ago, has seen substantial year-on-year growth through 2021. The volume of sustainable bonds, including green bonds, sustainability bonds, social bonds, and sustainability-linked bonds, reached $965 billion, up by 80 percent from 2020. The volume of sustainable syndicated loans, including green loans and sustainability-linked loans, totaled $683 billion in 2021, up by more than 200 percent from 2020. Sustainable financing activities related to the capital markets—including M&A, equities, and carbon trading—have also expanded over the past few years.

The momentum slowed in 2022 amid the broader market declines, but sustainable debt capital markets and lending fared better than the debt market overall. Issuance of sustainable bonds currently accounts for about 12 percent of total bond market volume, while sustainability-related syndicated loans are about 13 percent of the volume for global syndicated loans.

As sustainable instruments gain acceptance, scrutiny of how they are labeled also increases. In particular, sustainability-linked loans and bonds need to establish their credibility. More broadly, there is a need to disaggregate ESG categories in order to distinguish climate finance and track it separately.

Green bonds initially dominated the sustainable debt market, but they have been overtaken by sustainability-linked loans. These are performance-based instruments that tie interest rates to the achievement of defined sustainability targets. Challenges remain in setting goals, including incentives for meeting the targets set and penalties for failing to do so.

Europe has historically led issuance of sustainable debt instruments. In 2018, it issued more than 80 percent of sustainable syndicated loans, but in the meantime, North America has gained an increasing share of the market (Exhibit 6).

Clean-energy finance reached record highs in 2021, then slowed

In 2021, the volume of clean-energy project finance rose to record highs of $164 billion, of which $77 billion came from solar projects alone. But in the first half of 2022, banks saw a 38 percent decline in the volume of clean-energy project finance, largely because of declines in solar and wind projects. However, sustained growth in clean-energy project finance is expected to close the gap between current renewable generation and the amount needed for the energy transition.

Financing for clean energy is also becoming more competitive as a diverse and well-capitalized set of players pile into the market. Private-equity firms invested $76 billion in renewable energy, sustainable mobility, and carbon technologies in 2021, more than doubling investments since 2017. Venture capital firms nearly quadrupled investments in the same technologies during the same period.

As transition technologies like solar and wind mature, developers are refining how they bid to account for different risks and durations of contracts. Banks must change as a result: they are lending for shorter periods, aggregating project portfolios to increase ticket size, and playing a structuring role to earn incremental fees. Banks are also beginning to explore emerging technologies such as hydrogen and storage.

Entering a new era

In this next era of transition, we will see continued focus on capital deployment for sustained growth in low-emission power generation, along with many new aspects of the global energy transition being pushed as priorities that require financing. These new initiatives include growth in electrification, the build-out of energy transmission and distribution infrastructure (including grid-scale storage), emission reductions in high-emission and energy-intensive sectors such as steel and cement, and natural climate solutions.

Signs of this next era are already visible. Along with continued investments in power generation, they include increased funding for emerging technologies such as hydrogen and grid storage and bank innovations aimed at financing the low-carbon transition. Leading global banks and smaller local banks alike are developing new products, platforms, and in some cases, separate financing entities across sectors.

Growth has been fueled by policy shifts, new technologies, and growing corporate momentum. As a result, banks are maturing from a simple understanding of the baseline to exploring with clients the levers to finance reduced emissions in the real economy.

Policy shifts. Government subsidies, tax credits, and guarantees, among other interventions, are unlocking bankable value pools to enable the low-carbon transition. In the United States, for example, extensions of and changes to tax credit programs under the Inflation Reduction Act could almost double new solar and wind capacity by 2030.

Technological innovation is enabling lower costs and increased readiness. As an example, the costs of lithium-ion batteries have dropped by 97 percent since 1991, giving a boost to adoption of electric vehicles (EVs). EV loan volumes for banks have already quadrupled since 2017 and are expected to grow 24 percent annually to more than $800 billion through 2030, according to estimates from the McKinsey Center for Future Mobility.

Companies move from commitments to action to accelerate decarbonization. Some companies are funding pilots and projects initially through their own balance sheet, but many are looking to lenders and the capital markets to fund bigger operational and strategic initiatives. For example, the Swedish steel company H2 Green Steel recently announced support from European financial institutions for €3.5 billion of debt and equity financing for a sustained hydrogen-powered “green” steel plant in Sweden.

Regulators are focusing on climate and sustainability. Disclosure-focused regulations and standards will increase rigor and transparency for climate finance and create more potential for banks to identify financing opportunities. For example, in March 2022, the International Sustainability Standards Board (ISSB) circulated draft global climate-related and sustainability-related disclosure standards. The European Union and United Kingdom have also introduced new reporting requirements.

A large untapped value pool for banks

Funding needs for a net-zero transition could exceed $4.4 trillion annually through 2030, according to McKinsey estimates. Banks are on the front line to provide financing and advisory support for a wide range of opportunities. Clean-power investment, for example, will need to be at three times 2020 levels by 2030, while investment in the electrification of road mobility will need to increase to ten times 2020 levels by 2030.

Based on this McKinsey model, we estimate that commercial financial institutions have an annual direct financing opportunity of about $820 billion. Beyond that, banks could facilitate an additional $1.5 trillion of investments for corporates between 2021 and 2030.

The revenue potential for banks from debt investment in climate finance will average roughly $100 billion annually through 2030, we estimate. This represents approximately 5 percent of total global banking revenue pools (Exhibit 7).

Navigating climate finance’s next era

Banks interested in the potential of financing the transition to clean energy should be well informed about the challenges they must overcome. They also could study early successes to draw up a road map based on their own strengths and objectives.

Weighing the challenges

Several challenges will be significant in this next era:

• Project economics. Long payback periods for certain technologies may increase risk and diminish returns, while the front-loaded capital required for the transition across sectors may discourage lenders from committing capital.
• Market conditions. Margins have been contracting for some bankable technologies, including utility-scale solar.
• Credit risk. Many deals currently fall outside banks’ risk appetite, for reasons that include lack of historical performance data; uncertainty in future cash flows, caused by price uncertainty or regulatory reliance; longer-tenor, unconventional legal structures; and lending to newer or smaller companies.
• Scalability. Many green projects depend on permits, supporting infrastructure, and supply chains, all of which can delay scaling.
• Standardization and disclosure. For now, there are no established standards for sustainability-related financial products or performance metrics.
• Reputational risk. Brown-to-green financing may create reputational concerns, given the profiles of clients, including fossil-fuel companies.

Forging a path

Banks will need a nimble approach to assessing a rapidly changing market for sustainable finance. The experiences vary by type of institution.

Corporate and investment banks have made the most progress, but many opportunities remain. To build on the progress made in renewable energy over the past decade, banks could scale financing capabilities to close the gap for solar, wind, and hydro while simultaneously developing capabilities for new clean energy, such as green hydrogen. They can capture transition financing opportunities with the existing client base and expand capabilities for advisory to support clients.

Commercial and small-business banking. Where clients are retrofitting buildings and shifting their energy mix, banks can provide equipment finance for energy-efficiency measures or financing for retrofits. They can also finance vehicle fleets as companies transition to electric and fuel-cell vehicles.

Retail banks can provide financing solutions for retrofitting, home appliances, and rooftop solar panels. They also can capture the sizable opportunity in auto finance from EV adoption.

Wealth and asset management can develop thematic investment options with targeted climate-forward investment theses to meet the demand from institutional and retail investors. Institutions and retail investors alike are increasingly shifting their focus from general ESG themes to the low-carbon transition.

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Even before this year’s macroeconomic volatility and geopolitical disruption ended more than a decade of relative stability, bank valuations were trading at a steep discount to other sectors. That pattern continues in 2022—unsurprisingly, given that a majority of the world’s banks earn less than their cost of equity.

The overall patterns mask the success of groups of banks in geographies such as the United States, Canada, India, Indonesia, and Mexico. Studying these banks can suggest insights about the conditions associated with high performance.

In addition, banks are looking beyond short-term profitability. Most notably, evidence suggests that the initial surge of funding for renewable energies has opened a door to deeper engagement with banking clients across sectors.

For best viewing, download an optimized version of Global Banking Annual Review 2022: Banking on a sustainable path, the full report on which this article is based (PDF–1.87 MB).

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ABOUT THE AUTHORS

Miklos Dietz is a senior partner in McKinsey’s Vancouver office, Attila Kincses is an associate partner in the Budapest office, Archana Seshadrinathan is an associate partner in the Singapore office, and Dee Yang is a partner in the New York office.

The valuation gap between leading banking institutions and those trailing behind is once again widening. Decisions made in the next 18 to 24 months will determine which firms emerge on the right side of this divergence.

As we approach the end of the second year of a worldwide pandemic, the global economy has surprised to the upside, and banks have escaped the worst. But the outlook for the industry remains clouded with half of banks not covering their cost of equity.

Unlike the previous economic crisis, this time banks did not witness any abnormal losses, material capital calls, or “white knight” acquisitions. In fact, bank profitability held up better than most analysts expected. ROE in 2020 was 6.7 percent—less than the cost of equity but still a better showing than expected and above the 4.9 percent observed in 2008 in the aftermath of the financial crisis. (A PDF of the full 2021 McKinsey Global Banking Annual Review, with more detailed data, and a set of strategic questions for banks, is available for download on this page.)

But if the pandemic has not had the expected harmful financial effects on the global banking industry, it has certainly had plenty of others. Digital banking accelerated, cash use fell, savings expanded, remote became a way of working, and environment and sustainability are now top of mind for customers and regulators.

The banking system is at least as solid as it was before the pandemic—and much healthier than after the last crisis. But can we say a bright and smooth future lies ahead for banks and their shareholders? Not really. Cause for concern is evident in banks’ performance on two yardsticks: ROE, a measure of current profitability, and market-to-book value, a leading indicator of how capital markets value banking.

Fifty-one percent of banks operate with an ROE below cost of equity (COE), and 17 percent are below COE by more than four percentage points. In an industry that has high capital requirements and is operating amid low interest rates, creating value for shareholders is structurally challenging. In fact, the almost $2.8 trillion of capital that was injected by shareholders and governments into banking over the past 13 years eroded three to four percentage points of ROE.

The challenges facing a capital-intensive industry in a low-price environment also show up in valuations. Banks are trading at about 1.0 times book value, versus 3.0 times for all other industries and 1.3 times for financial institutions excluding banks, with 47 percent of banks trading for less than the equity on their books. And these undervaluations persist even after a period in which the financial system as a whole gained about $1.9 trillion (more than 20 percent) in market cap from February 2020 to October 2021.

Out of 599 financial institutions we analyzed, just 65 accrued all the gains (Exhibit 1). Most of these deploy a specialized and capital-light business model or operate in fast-growing markets. A few universal banks also gained, but the vast majority either realized small gains in their share price or lost value.

Banking valuations suggest that capital markets are discounting an industry whose baseline for profitability and growth is decent and resilient but not attractive—and that is undergoing disruption from financial-services specialists with limited reliance on the balance sheet. This is reflected in the market multiples, where banking is currently valued more in line with an average utility, with a price-to-earnings ratio (P/E) of 15 times, than with a specialized financial services provider, where P/Es are 20 to 30 times.

Baseline for 2022–25: Decent but not attractive

Taking into account the likely macroeconomic and pandemic scenarios and factoring in the highly varied starting position of banks worldwide, we see the global industry set for a recovery that could put ROE at between 7 and 12 percent by 2025—which is somewhat aligned with what happened in the last decade (2010–20), when the average ROE was 7 to 8 percent.

This baseline is nuanced by region and will be shaped by three macro and interconnected factors beyond banks’ control: inflation and ultimately interest rates, government support for the recovery, and liquidity. These variables will determine whether the industry will operate in the upper (12 percent) or lower (7 percent) range of profitability.

If stars align, ROE in its upper range would compare favorably with the levels achieved in 2017–19. But that’s still far from being attractive to investors, who have many rapidly growing, more profitable opportunities to consider.

From convergent resilience to divergent growth

Since 2008, the gap between the banking industry’s leaders and followers, as measured by total returns to shareholders, has steadily widened. By 2019, top-decile performers were delivering about five times more value to their shareholders than the bottom decile (and 3 times more than the average bank). Now we’ve arrived at another defining moment in the shareholder value race: the aftermath of a crisis. As an example, after the last crisis (2007–09), about 60 percent of the performance gap over the next decade occurred during the first two years of recovery (2010 and 2011). During the remainder of the decade, the gap continued to widen, but more slowly (Exhibit 2).

If we are fortunate with regard to COVID-19, 2022 will be about navigating the aftermath of a crisis. Declaring an end to COVID-19 is, of course, premature, and perhaps not the right way to think about it. Today, many countries do seem to be on a path back to a form of normalcy, thanks to effective government support and the success of many vaccines. However, some regions are confronting third and fourth waves of the disease, many of them triggered by the Delta variant, and by struggles with vaccination rates. In late November, the World Health Organization designated a new variant of concern: Omicron.¹“Update on Omicron,” November 28, who.int. As we publish this report, it is too early to say how effective current vaccines will be against the new variant. However, the emergence of a new variant underscores a simple fact: In an interconnected world, none of us are safe until we’re all safe.

Our expectation however, is that the coming five years or so will mark the beginning of a new era in global banking, in which the industry will move from a decade of convergent resilience (2011–20) to a period of divergent growth (2022–27).

Over the last decade, banks mainly focused on the same activities: rebuilding regulatory capital, mending regulatory fences, investing in digitization, and achieving productivity and efficiency gains. The result was a convergence of profitability to levels below cost of equity as average global ROE fell from 8 percent in 2010 to 6 percent in 2015. The gap between the industry’s top 10 percent and average ROE performers narrowed from 17 percentage points to 14. Valuation followed the same pattern, with market-to-book premiums moving from 250 percent to 234 percent over the same period.

This convergent resilience was an outcome of necessary actions taken by banks, especially in the early years. But as banks moved in lockstep, their offerings became commoditized, and customer expectations skyrocketed. In a low-interest-rate world, a commoditized business model based on the balance sheet yields less income and brings no differentiation to the customer. If we split revenues between those generated by the balance sheet and those that come from origination and sales (for example, mutual funds distribution, payments, consumer finance), the trend is clear: growth and profitability are shifting to the latter category, which has an ROE of 20 percent—five times higher than the 4 percent for balance-sheet-driven business—and now contributes more than half of banks’ revenues (Exhibit 3).

Not coincidentally, origination and sales are where specialists and platform companies are extending their tentacles to offer innovative, fee-based services that are challenging traditional banks’ business models. At launch, Revolut offered payment services with no fees and an app with spending insights. Recently, the UK-founded fintech entered the wealth management business by facilitating investments in fractional shares or cryptocurrency. The result: growth from 2 million to 15 million customers worldwide in three years. Mercado Libre, an established Latin America e-marketplace, is setting up its own payments solution, Mercado Pago. Square, founded 12 years ago to enter the merchant acquiring business, is valued at almost $100 billion and trades at a price-to-book of roughly 33 times (as of November 30, 2021).

Capital markets are already factoring in this growing divergence. In 2020, the premium from top to bottom performers widened to 470 percent (8.5 times market to book versus 1.5 times). In October 2021, this gap widened further to 518 percent (Exhibit 4). This divergence is more evident if we separate traditional banks, which are more reliant on balance sheet business, from the specialists and platform companies, which are more focused on origination and sales. The reason is that banks are valued similarly to utilities (that is, with low valuations and a narrow though widening gap between top and bottom performers), while specialists and platform companies are valued more like tech companies in other industries, with high valuations and wide gaps (Exhibit 5).

Sources of divergence

Decisive strategic commitments made today will separate the leaders from the also-rans in the race for shareholder value over the next five years, and position them to flourish in the future of banking. What are today’s leaders doing differently? What can banks emulate? What factors lie beyond their control? We analyzed more than 150 financial institutions globally—including banks, specialists, and fintechs—and found four sources for divergence: the geographies in which financial institutions operate, their relative scale, their segment focus, and the business models they deploy.

Geography

In 2010, a bank’s core geographic market accounted for 73 percent of the standard deviation in price to book (P/B). For the first half of the preceding decade, emerging economies had been the global growth engine; logically, banks that focused on serving these regions could count on that growth to boost investors’ confidence in their strategy.

Then, five years ago, there was an inflection point: growth returned to the developed world after the financial and European sovereign-debt crises, and the contributors to value were reversed. In 2017, the region a bank operated in accounted for only 41 percent of its P/B standard deviation.

Now location is again the biggest factor, accounting for about 65 percent of P/B standard deviation, according to our analysis. After the pandemic, we expect that emerging markets will again grow faster. According to our estimates, emerging markets’ share in global banking revenue pools will exceed 50 percent by 2025—a striking figure, considering that at the start of the millennium, these countries represented 20 percent of revenues.

Banks with the good fortune to have sizable and fast-growing economies as their core market will naturally benefit. Others will have to work harder to achieve similar results. Investors are already pricing in some of these geographic distinctions.

Scale

Our analysis shows that banks with leading in-country market shares display an ROE premium compared with peers. This scale effect is more pronounced in Asia and Latin America, where leaders enjoy approximately 400 and 450 basis points of ROE premium, respectively. In Europe, both large banks and small specialized players outperform midsize banks.

Larger banks are generally more cost-efficient, although the magnitude of the difference varies. In Sweden, Denmark, Germany, or Russia, the top three banks by assets are noticeably more efficient than the bottom 20 percent, with a cost-to-assets gap of 200 to 300 basis points. In the United States or China, the difference is lower—less than a 50-point gap.

We expect scale to matter even more as banks compete on technology. One reason for its importance continues to be that most IT investments tend to involve a fixed cost that makes them cheaper over a higher asset or revenue base. The initial impact of scale is this ability to bring marginal costs down as an organization gains operating leverage with consistent increase in size. But we expect greater benefits than cost cutting as digital scale begins to deliver the network effects of mass platforms offering peer-to-peer payments and lending, among other applications.

Segments

Another contributor to the great divergence is differences in banks’ capabilities to serve the fastest-growing and more profitable customer segments. Consider what’s happening in US retail banking. Over the past 15 years, the revenues from middle- and low-income households have shrunk considerably. According to our proprietary data, an average US household generates roughly $2,700 in banking revenues annually after risk costs, while a self-employed customer between the ages of 35 and 55 with a bachelor’s degree and an annual income above $100,000 generates four times more ($11,500).

The divergence in segment profitability is growing, and not only in retail banking. Small and medium-size enterprises (SMEs) represent one-fifth (about $850 billion) of annual global banking revenues, a figure that is expected to grow by 7 to 10 percent annually over the next five years. However, the profits of banks in this segment vary significantly, partly because of highly varied credit quality in the portfolio. Finding the optimal balance between providing a great customer experience and managing the cost to serve has also proven to be difficult. As a result, many banks have not prioritized SMEs—forsaking the vast potential value and leaving many SMEs feeling that their needs are ignored.

Future-proof business models

In a world that continually surprises, we hesitate to talk about a “future-proof” business. Many companies that thought they were ready for anything in 2019 are frantically reinventing themselves—or disappearing. Nonetheless, the concept is useful: What does it take to build a bank that is impervious to disruption as we understand it today?

Payments can serve as an example. Fiserv, Global Payments, Klarna, and Square are very different and operate in different parts of the payments value chain, but they all have thrived in a business in which most banks have been struggling to create value. Their business model is capital-light, focused on sales growth in the most relevant and attractive revenue pools and with a strong investment in technology and scalable and integrated systems. Banks, on the other end, have focused on the debtor-side interfaces where value creation has been limited and revenue sources are under pressure—for example, current accounts and cross-border payments.

Overall, specialized financial-services providers—in payments, consumer finance, or wealth management—are generating higher ROEs and valuation multiples than most global universal banks. Some fintechs are going from a rough sketch to billion-dollar valuation in a few years. And there are indeed some banks among the institutions diverging from the pack. What do these top performers have that others can build, acquire, or access through partnerships to deliver a higher shareholder value? Our analysis points to three common elements that make a future-proof business model:

1. Customer ownership with embedded digital financial services

Companies like Amazon, Apple, Google, Netflix, and Spotify have taken existing services and transformed them into digital experiences that are now embedded in customers’ daily lives. Leading fintechs, specialists, and banks are replicating this model in financial services, turning products into features to meet customer needs and keep them engaged. The existing, underlying elements are still there—the checking account, the personal loan, or the POS terminal—but they are less visible, a seamless part of a digital experience that goes beyond banking.

Successful financial-services providers take three steps to position their business for this shift. First, they attract customers by solving very specific yet relevant needs. Examples include Alipay and Klarna, which make shopping and cash management easier and convenient for small businesses through quick and simple onboarding, transparent pricing, new POS terminal features, and buy-now-pay-later checkout solutions.

Second, top performers bring customers into an ecosystem, connecting them with other services and building a dynamic and distinctive customer experience. For example, Square’s core offering is a payments service, but from there it developed comprehensive value-added services for sectors such as restaurants.

The third step is providing customers with personalized analytical insights. This increases customer engagement and, eventually, advocacy through word of mouth and social media. And in a virtuous cycle, it tells the bank or fintech more about customer behaviors and needs. The Canadian bank RBC’s AI-powered financial assistant app NOMI provides users with cash flow forecasts that take into account loan installments and subscription services, and applies deep learning techniques to customer transaction behaviors.

2. Efficient economic model that fosters growth beyond the balance sheet

Financial institutions with higher valuations tend to have a 40 to 60 percent lower cost to serve than the average universal bank and four times greater revenue growth. Higher revenues and low costs lead to more value, of course, but a deeper analysis of these leading financial institutions also shows that 55 to 70 percent of their revenues come from origination and distribution, compared with 40 to 50 percent for an average universal bank, and they leverage digital channels to interact with customers two to three times as frequently as the average bank (Exhibit 6).

China’s WeBank, for example, was launched in 2014 and today serves more than 200 million individual customers and 1.3 million SMEs. This growth was achieved without branches and with only 2,000 employees. Profitability is above 25 percent, sustained by a cost to serve of 50 cents per customer—one-thirtieth that of an average bank.

Future-proof business models are less dependent on financial intermediation (and its correlation with interest rates) and more focused on value-added services that generate greater customer involvement and sustainable fees. Businesses like payments or wealth management have a natural advantage, because they gather fees without involving the balance sheet. For banks, the challenge—and opportunity—is to leverage their massive customer base, go beyond traditional banking offerings, and increase revenue by providing value-added services.

Pioneers are already pursuing an ecosystem model of some kind. In 2020, CBA created x15, a wholly owned subsidiary with the mandate to build, buy, or back at least 25 concrete solutions for CBA customers by 2024. Sber is scaling up a non-financial-services ecosystem that in the first six months of 2021 accounted for 4 percent of its overall revenues.²Adrien Henni, “Sberbank Accelerates Ecosystem Investment,” Moscow Times, August 4, 2021, themoscowtimes.com. In 2021, Itaú partnered with cloud software start-up Omie to launch Itáu Meu Negócio, a platform offering nonbanking business management services for SMEs.

3. Continuous innovation and fast go-to-market, leveraging technology and talent

Today’s top performers in providing banking services are valued more like tech firms than banks—a clear sign that banks need to increase their innovation metabolic rate. WeBank launches up to 1,000 updates per month and takes only ten to 11 days to go from ideation to production. Brazil’s digital NuBank is fostering financial inclusion by providing credit cards and personal loans to 50 million customers, most of whom lacked a credit history and thus were not served by traditional banks. NuBank uses behavioral data sets and proprietary algorithms to overcome this obstacle.

For traditional banks faced with more agile and digitally advanced competitors like these two firms, the challenge can seem daunting. And the clock is ticking. As technology and digital adoption evolves, these competitors—as well as the big tech firms—appear to be positioned to continue their upward divergence.

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An optimist would note banks’ strong and sizable balance sheets and capital positions, coupled with high levels of trust backed up by decades of customer relationships. Such organizations would seem able to resist any attacker, navigate the upcoming divergence, and wind up on the right side of the divide. A pessimist, however, would claim that it’s a matter of time until fintechs and big techs replace banks as customer owners and financial-services providers, relegating the banks we know today to the role of balance-sheet operators. A realistic view would be somewhere in the middle.

The next few years are crucial for any bank with aspirations to land on the right side of the divergence described in this report. Not only is there simply no value to waiting, but also history shows a pattern in which institutions that take bold steps toward growth in the first years after a crisis generally hold on to those gains for the longer term. The coming years will be disruptive in banking, but this can be a sort of “golden era” for strategic decision making. In the current moment, banks and their many stakeholders can justifiably enjoy some brief satisfaction for having weathered a storm. Then banks must quickly return to forward-thinking action.

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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.

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.

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.

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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.

For best viewing, download an optimized version, Global Banking Annual Review 2020: A test of resilience: Banking through the crisis, and beyond, the full report on which this article is based (PDF–6MB).

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

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.³To view exhibit, refer to Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves. Yield curves are also flattening. And, although valuations fluctuate, investor confidence in banks is weakening once again.

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 2018.⁴To view exhibit, refer to Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves. 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.

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:⁵To view exhibit, refer to Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves.

• 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,⁶To view exhibit, refer to Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves. and where they live, or the underlying health of the markets in which they operate.⁷To view exhibit, refer to Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves. These factors point to what they should prioritize, that is, the critical moves banks in each archetype should prioritize during the late cycle.

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.

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.⁸To view exhibit, refer to Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves. The investments made now—whether organic or inorganic—will decide their place at the top table in the next cycle.

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.

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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).

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,⁹To view exhibit, refer to Global Banking Annual Review 2018: New rules for an old game: Banks in the changing world of financial intermediation. but not spectacular. Global banking return on equity (ROE) has hovered in a narrow range between 8 and 9 percent since 2012.¹⁰To view exhibit, refer to Global Banking Annual Review 2018: New rules for an old game: Banks in the changing world of financial intermediation. 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.¹¹To view exhibit, refer to Global Banking Annual Review 2018: New rules for an old game: Banks in the changing world of financial intermediation.

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.¹²To view exhibit, refer to Global Banking Annual Review 2018: New rules for an old game: Banks in the changing world of financial intermediation. 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.¹³To view exhibit, refer to Global Banking Annual Review 2018: New rules for an old game: Banks in the changing world of financial intermediation. 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.

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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).

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.¹⁴To view exhibit, refer to Global Banking Annual Review 2017: The Phoenix Rises: Remaking the Bank for An Ecosystem World. 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.¹⁵To view exhibit, refer to Global Banking Annual Review 2017: The Phoenix Rises: Remaking the Bank for An Ecosystem World. 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.¹⁶To view exhibit, refer to Global Banking Annual Review 2017: The Phoenix Rises: Remaking the Bank for An Ecosystem World. 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 2025.¹⁷To view exhibit, refer to Global Banking Annual Review 2017: The Phoenix Rises: Remaking the Bank for An Ecosystem World.
• 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.¹⁸To view exhibit, refer to Global Banking Annual Review 2017: The Phoenix Rises: Remaking the Bank for An Ecosystem World. 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.

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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).

By 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.¹⁹To view exhibit, refer to Global Banking Annual Review 2016: A brave new world for global banking.

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.

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

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.

Download Global Banking Annual Review 2015: The Fight for the Customer to read the full report on which this article is based (PDF–1MB).

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.

Download Global Banking Annual Review 2014: The Road Back to read the full report on which this article is based (PDF–2MB).