Future bank profitability, growth seen in resilience, investment, says McKinsey

Facing market pressures and shifts, including technological changes disrupting traditional banking, banks will need to improve on their short-term resilience and invest long term to innovate for future profitability, increased growth and attain higher valuations.

According to a McKinsey global banking review report, the global banking industry faces a dual challenge, one of managing the present and the other preparing for the future. And the renowned global management consultancy in the report says over the next five to ten years the pressures and shifts in the landscape for banking will amount to structural breaks.

For resilience, the report notes that in the near term, to bolster resilience, banks would have to focus on four strategic objectives, namely financial resilience, operational resilience, digital and technological resilience, and organisational resilience.

With regards to financial resilience, it stated that the best-performing banks will have a net income structure with low sensitivity to interest rates and risk costs, and advised that they should target a cost-to-income ratio of 35 to 40 percent.

For operational resilience, the report states that this would mean global banks having to reduce or eliminate their presence in high-risk countries and building exceptional risk management practices.

And with cyberattacks on the increase globally and remaining a serious risk, banks would need to have and manage their digital and technological resilience by having a well-protected and future-proof technology infrastructure, as well as superior data security.

The report also advised that banks that perform best will need to maintain organisational resilience by having rapid reaction times and investing in attracting, reskilling, and retaining the best talent.

Looking far ahead, the McKinsey report states thus: “… 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,” the report stated.

The McKinsey report also advised that banks could develop a strategy for targeting environmental transformations.

In a broader review of the global banking landscape in year 2022, the McKinsey report notes that banks had a tumultuous year of shocks and growing uncertainty

Banks rebounded from the pandemic with strong revenue growth, it states, but adds that 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,” the report states.

Performance for the industry globally shows that bank profitability reached a 14-year high in 2022, with expected return on equity at between 11.5 and 12.5 percent, the report states, adding that revenue globally grew by $345 billion with this growth being 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,” it observed.

Still on performance, it noted that improvement in margins accounted for 60 percent of the revenue gains of the global banking industry, adding that almost all segments of banking have seen improvements with capital markets and investment banking being the exception.

It noted that the lingering effects of COVID-19 and geopolitical tensions, including the invasion of Ukraine by Russia and heightened tensions over Taiwan, continue to roil the financial sector.

The report identified five resulting shocks affecting banks globally on account of these, including macroeconomic shock, asset value shock, energy and food supply shock, supply chain shock and talent shock.

Expanding on macroeconomic shock, the report notes that soaring inflation and the likelihood of recession are sorely testing central banks, even as they seek to rein in their quantitative-easing policies, with asset value shock manifesting in steep declines in the Chinese property market and the sharp devaluation of fintechs and cryptocurrencies, including the bankruptcy of some high-profile crypto organisations.

Explaining further, it noted that disruptions to the energy and food supply, related to the war in Ukraine, are contributing to inflation and putting millions of livelihoods at risk, while the disruption of supply chains that began during the first pandemic lockdowns continues to affect global markets.

As to talent shock, it noted that 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 global banking review report found that consequences differ across and within regions, notably in emerging markets.

According to the report 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,” it stated.

According to the McKinsey report, this is not the typical 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. 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,” the report asserted.

The report alerts banks to the possible scenarios of the current uncertain macroeconomic outlook, stating that it could affect them 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,” the report stated.

In examining the two economic scenarios and how bad (or good) they might be for banks, McKinsey said it modelled 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,” it stated.