McKinsey: Banks in the changing world

McKinsey released its eighth annual review of the global banking industry on November 7, “New rules for an old game: Banks in the changing world of financial intermediation”, based on data and insights from Panorama, McKinsey’s proprietary banking research arm, as well as the experience of clients and practitioners from all over the world.

Since the financial crisis, the global banking industry and financial regulators have worked in tandem to move the financial system to a solid grounding with a higher level of safety. The Global Tier 1 capital ratio – one measure of banking system safety – increased from 9.8 per cent in 2007 to 13.2 per cent in 2017. Other measures of risk have improved as well; for example the ratio of tangible equity to tangible assets, which increased from 4.6 per cent in 2010 to 6.2 per cent in 2017.

However, growth in the banking industry continues to be muted. Industry revenues grew at 2 per cent per year over the last five years; significantly below the historical annual growth of 5 to 6 per cent.

Furthermore, global banking return on equity (ROE) has hovered in a narrow range of between 8 and 9 per cent since 2012. McKinsey found significant geographical variance. Banks in both the UK and Western Europe increased their ROEs significantly, whereas their counterparts in the US and Japan registered declines.

Emerging markets are beginning to falter. In 2017, the price-to-book ratio of developed-market banks overtook that of emerging market banks for the first time in 14 years.

However, the banking sector’s price-to-book ratio was consistently lower than that of every other major sector over the 2012-17 period, trailing even relatively sluggish industries such as utilities, energy, and materials. This difference persists even when other valuation multiples, such as price-to-earnings ratios, are compared.

At the heart of the report is McKinsey’s new analysis (sizing and mapping) of the global financial intermediation system – the system that stores, transfers, lends, invests, and risk manages roughly $260 trillion in funds. 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. As recently as 2011, the average was approximately 230 basis points. The report explores how this revenue pool could evolve over time.

“We believe the lack of investor faith in the future of banking is tied, at least in part, to doubts about whether banks can maintain their historical dominance of the financial intermediation system,” said Mr. Miklos Dietz, report author and McKinsey senior partner. “The report looks at the two forces – technological (and data) innovation and shifts in the regulatory and broader socio-political environment – that are reshaping the market structure of financial intermediation and the role of banks in this system. These dual forces are opening great swaths of this financial intermediation system to new entrants, including other large financial institutions, specialist finance providers, and technology firms.”

A number of case studies are detailed in the report (cash equities, Swedish consumer finance, and Chinese payments) to illustrate the shift in market structure already underway as a result of the dual forces mentioned above.

McKinsey sees the current complex and interlocking system of financial intermediation streamlined by the forces of technology and regulation into a simpler system over the coming years, with three layers: 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 layer would comprise of products and services in which relationships and insights are the predominant differentiators (for example, M&As, derivatives structuring, wealth management, and corporate lending). Leaders here will use artificial intelligence to radically enhance, but not entirely replace, human interaction.

The third layer will revolve primarily around business-to-business services where scale will be a key differentiator (for example, parts of sales and trading and standardized portions of wealth and asset management). Institutional intermediation will be heavily automated and provided by efficient technology infrastructure with low costs.

“We believe that the changes coming to the global financial intermediation system will be profound,” said Mr. Rushabh Kapashi, report co-author and McKinsey partner. “However, they do not assume that banks will become irrelevant. For instance, there will always be demand for risk intermediation. The question is whether banks will be disintermediated, disaggregated, or commoditized, or whether they can maintain and expand their role in intermediation. Our report outlines a number of strategic choices that banks can make to thrive in this new world of financial intermediation.”

McKinsey & Company is a global management consulting firm deeply committed to helping institutions in the private, public and social sectors achieve lasting success. For 90 years, the firm’s primary objective has been to serve as clients’ most trusted external advisor. With consultants in over 120 cities in more than 60 countries, across industries and functions, McKinsey brings unparalleled expertise to clients anywhere in the world. The firm works closely with teams at all levels of an organization to shape winning strategies, mobilize for change, build capabilities, and drive successful execution.