Global banking in best performance since 2007, says McKinsey report

• Higher rates boost profits by $280bn in 2022
• ROE average 12% in 2022, 13% expected in 2023
• Against 9% average ROE since 2010 
• 4 global trends to shape financial institutions
• 5 priorities to reinvent, future-proof themselves

Global banking posted its best performance in the last 18 months since 2007 on the back of sharp increases in interest rates in many advanced economies, including a 500-basis-point rise in the United States, a world  review of the banking sector by global management consulting firm McKinsey, has shown.

McKinsey’s just published “Global Banking Annual Review 2023: The Great Banking Transition”,  found that on the average global banking saw “long-awaited improvement in net interest margins” enabled by higher interest rates which boosted profits by about $280 billion in 2022, lifting return on equity (ROE) by 12 percent in the same year with a projection that this will post higher at 13 percent at the end of 2023.

It noted that in comparison ROE had been posting an average of just nine percent since 2010.

The report describes the past 18 months as bringing the banks their highest highs and their lowest lows, but noted that in the last 12 months, the banking sector’s journey in cost improvement continued with cost-income ratio dropping from 59 percent in 2012 to about 52 percent last year, a seven percentage points which was driven partially by margin changes. “The trend is also visible in the cost-per-asset ratio”, which declined from 1.6 to 1.5, the report added.

The McKinsey report also found that while return on equity in the global banking landscape grew, the growth was accompanied by volatility over the past 18 months, which contributed to the collapse or rescue of high-profile banks in the United States and the government-brokered takeover of one of Switzerland’s oldest and biggest banks. 

“Star performers of past years, including fintechs and cryptocurrency players, have struggled against this backdrop,” the report authors stated.

Shedding light on the ROE performance, the report noted that this varied widely within categories, observing that while “some financial institutions across markets have generated a premium ROE, strong growth in earnings, and above-average price-to-earnings and price-to-book multiples, others have lagged.”

The report found that while more than 40 percent of payments providers have an ROE above 14 percent, almost 35 percent have an ROE below eight percent. 

“Among wealth and asset managers, who typically have margins of about 30 percent, more than one-third have an ROE above 14 percent, while more than 40 percent have an ROE below 8 percent. Bank performance varies significantly, too. These variations indicate the extent to which operational excellence and decisions relating to cost, efficiency, customer retention, and other issues affecting performance are more important than ever for banking. Strongest performers tend to use the balance sheet effectively, are customer centric, and often lead on technology usage,” the report further explained.

There was also geographic divergence, a recurrence from previous years, which also continues to widen, the authors noted, adding that “banks grouped along the crescent formed by the Indian Ocean, stretching from Singapore to India, Dubai, and parts of eastern Africa, are home to half of the best-performing banks in the world. In other geographies, many banks buoyed by recent performance are able to invest again. But in Europe and the United States, as well as in China and Russia, banks overall have struggled to generate their cost of capital,” they stated.

However, global banking is still challenged by the price-to-book ratio, which at 0.9 in 2022 has remained flat since the 2008 financial crisis, standing “at a historical gap to the rest of the economy,” the report stated.

Providing explanation for this flatness, the report stated that it is “a reflection that capital markets expect the duration-weighted return on equity to remain below the cost of equity. While the price-to-book ratio reflects some of the long-term systematic challenges the sector is facing, it also suggests the possible upside: every 0.1-times improvement in the price-to-book ratio would cause the sector’s value added to increase by more than $1 trillion.”

Providing a future outlook for financial institutions, the report stated that it was likely “to be especially shaped by four global trends.”

The report identified the four global trends as, macroeconomic environment, which has shifted substantially, with higher interest rates and inflation figures in many parts of the world, as well as a possible deceleration of Chinese economic growth. 

“An unusually broad range of outcomes is suddenly possible, suggesting we may be on the cusp of a new macroeconomic era,” it said of the first trend that will shape the future of global banking.

It added that technological progress continues to accelerate, and customers are increasingly comfortable with and demanding about technology-driven experiences, noting in particular, “the emergence of generative AI could be a game changer, lifting productivity by 3 to 5 percent and enabling a reduction in operating expenditures of between $200 billion and $300 billion,” by the report’s estimates. 

The report also pointed to a third trend, namely, that governments are broadening and deepening regulatory scrutiny of nontraditional financial institutions and intermediaries as the macroeconomic system comes under stress and new technologies, players, and risks emerge. 

McKinsey noted, for example, that recently published proposals for a final Basel III “endgame” would result in higher capital requirements for large and medium-size banks, with differences across banks. 

A fourth trend that the report identified is that systemic risk is shifting in nature as rising geopolitical tensions increase volatility and spur restrictions on trade and investment in the real economy.

For global banking, the report found that a great transition for the balance sheet, transactions and payments has gained momentum, noting that its future dynamics “are critical for the banking sector overall.”

According to the report, evidence of the transition’s profound effect on the sector abounds, noting that “between 2015 and 2022, more than 70 percent of the net increase of financial funds ended up off banking balance sheets, held by insurance and pension funds, sovereign wealth funds and public pension funds, private capital, and other alternative investments, as well as retail and institutional investors.”

It added that this shift off the balance sheet is a global phenomenon, noting that in the United States, 75 percent of the net increase in financial funds ended up off banking balance sheets, while the figure in Europe is about 55 percent.

The report identified the growth of private debt as another manifestation of the transition away from traditional financial institutions. “Private debt saw its highest inflows in 2022, with growth of 29 percent, driven by direct lending,” McKinsey wrote.

It also identified other items shifting besides the balance sheet to include transactions and payments, observing that consumer digital payment processing conducted by payments specialists grew by more than 50 percent between 2015 and 2022.

The report pointed out that the oscillating interest rate environment will affect global banking’s Great Transition, but it remains unclear exactly how this will happen.

“We may be going through a phase in which a long-term macroeconomic turning point — including a higher-for-longer interest rate scenario and an end to the asset price super cycle — changes the attractiveness of some models that were specifically geared to the old environment, while other structural trends, especially in technology, continue. Fundamentally, the question for banks is to what extent they can offer the products in high demand at a time when risk capacity is broadening and many clients and customers are searching for the highest deposit yields,” the report queried.

Amid the challenges they are confronted with, including macroeconomic developments, financial institutions will have to adapt to the changing environment of the Great Transition, the report notes, especially the trends of technology, regulation, risk, and scale, adding that mergers and acquisitions may gain importance.

The report offers what it called “five priorities” for financial institutions as they look to reinvent and future-proof themselves. These are: exploiting leading technologies (including AI), flexing and potentially even unbundling the balance sheet, scaling or exiting transaction business, levelling up distribution, and adapting to the evolving risk landscape.

“All financial institutions will need to examine each of their businesses to assess where their competitive advantages lie across and within the three core banking activities of balance sheet, transactions, and distribution. And they will need to do so in a world in which technology and AI will play a more prominent role, and against the backdrop of a shifting macroeconomic environment and heightened geopolitical risks,” the report advised.