* Few banks earn their costs of capital
* Role in global economy is decreasing
* Business models require massive makeovers, consulting firm
By Jed Horowitz
NEW YORK, Oct 8 Banks worldwide remain scarred
by the 2007-2009 financial crisis and are years away from
developing new business models that will produce sustainable
profits, according to a new study.
Despite progress in meeting regulators' requirements to
build capital, revenue growth is slow, costs are rising and new
competitors exploiting digital technologies are emerging,
McKinsey & Co said in a report released on Monday evening.
The consulting firm prescribes a rigorous mix of cost
cutting, business simplification models adapted from the auto
industry and image repair that requires fundamental changes in
employee culture and respect for societal values.
"It's the banks' game to lose," Toos Daruvala, a McKinsey
director who helped write the report, told Reuters.
The challenges are so great, though, that the consultant
expects a host of large and small U.S. banks over the next five
years to throw in the towel and merge.
"You will see significant consolidation, particularly among
banks with less diversified income streams that are highly
dependent on net interest margins," Daruvala said. "They will be
troubled and forced to sell."
The report also sends an ominous message about banks'
central role in the global economy.
A 30-year trend in which national average bank revenue has
grown faster than countries' gross domestic products "is likely
now being broken," the study says. "In both emerging and
developed markets, banking revenues are expected to flatline at
around 5 percent of GDP for the foreseeable future."
In the United States, where almost two-thirds of U.S. banks
are earning less than their cost of capital, investors will have
to wait three to five years for returns on equity (ROE) to
return to historical averages of 10 to 12 percent, Daruvala
Banks cannot control central bank interest rate cuts that
are squeezing their net interest margins but have only
themselves to blame for outdated business models and internal
cultures that fall short of customer needs and perceived
societal values, the report says.
"MASSIVE" COST CUTS
Banks that rely heavily on trading and other capital markets
activities are particularly challenged because of regulatory
changes eradicating their proprietary trading models, according
to the report. It prescribes "massive cost cutting" to
supplement what has already occurred at the capital markets
Retail banks, however, face decreasing customer loyalty and
business banks "no longer enjoy structurally lower funding costs
than many of their large corporate clients," the study
Compounding banks' problems are technologies that make it
much easier for new competitors to steal customers. Wal-Mart
Stores Inc and American Express Co on Monday
announced a joint venture to provide financial services through
a prepaid debit card aimed primarily at low-income customers.
U.S. banks had an average ROE of 7 percent last year, up
from 6.2 percent in 2010 as credit quality gradually improved,
but "are still far from earning their cost of equity," McKinsey
said. Even if interest rates rise and banks reprice their
services upward, they are "unlikely to return ROE to acceptable
levels" any time soon, the report said.
Expenses for U.S. banks last year exploded to 68 percent of
total income from 60 percent in 2010 while revenue grew just one
percent, according to the study.
Bank revenue globally rose 3 percent to $3.4 trillion in
2011 from the previous year, slowing from a 9 percent rise from
2009 to 2010. Returns on equity last year fell to an average of
7.6 percent from the low double-digits and profit fell by 2
Investors' doubts remain strong.
More than two-thirds of publicly traded banks in developed
markets now trade "significantly" below book value, according to
McKinsey, and the average price of insurance against bond
defaults for 124 banks sampled by McKinsey rose to the highest
level on record last year.
Bank stock prices globally last year traded at 11 times
earnings, down from 15 in 2007.
Some analysts challenged the dire report. Focusing on
conventional double-digit returns to shareholders when interest
rates and funding costs are at historic lows is irrational, said
Richard Bove, an analyst at Rochdale Securities.
"Anyone who says that banks should be making traditional
returns on equity today when the ten-year Treasury is around 1.6
percent has got to explain themselves," he said.
Bove said he was excluding the outlook for banks that are
heavily involved in capital markets such as Goldman Sachs Group
and Morgan Stanley.
Sanford Bernstein analyst Brad Hintz, in a note to clients
last week, said few trading units anywhere are generating
returns and echoed McKinsey's pessimism about the outlook for
their profitability. "Simply cutting compensation ratios and
implementing technological improvements may not be enough to
reach a target ROE," he wrote.
The good news is that banks that adapt can prosper by
financing infrastructure projects that are expected to grow 60
percent by 2020, the report says, and by selling advice and
retirement products to aging populations in developed nations
and core banking services to new customers in emerging markets.
The study was based on a review of financial data at the
world's 30 largest banks, with some data extending to over 2,400
banks in the 69 countries followed by McKinsey.