Signs that the banking industry has entered the late phase of the economic cycle, a decade on from the global financial crisis, are clear. Growth in volumes and top-line revenues are 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 Yield curves are also flattening. And although valuations fluctuate, investor confidence in banks is weakening once again.
The Global Return on Tangible Equity
These cycles are not new to seasoned industry experts. Global Return On Tangible Equity (ROTE) has flat lined at 10.5 percent, despite a small rise in rates. Emerging-market banks have seen ROTEs decline drastically, 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 are geography, scale, differentiation, and business model.
It can be realised 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.
Global 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 present need is to industrialize tasks that don’t convey a competitive advantage and transfer them to multi-tenant utilities. Industrializing regulatory and compliance activities alone could lift ROTE by 60 to 100 bps. Last but not least, 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.
Making the right moves for the right bank
All banks are not the same. The level of strategic freedom every bank enjoys depends on its business model, assets, and capabilities relative to peers as well as on the stability of the market in which it operates.
The Four Archetypes
Each bank can be classified into one of four archetypes, each with a set of levers that management should consider. These archetypal levers form a full picture of the degrees of freedom available to a bank. These are defined by two dimensions: the bank’s strength relative to peers and the market stability of the domain within which the bank operates.
- Market leaders: Consider them as the top-performing financial institutions in attractive markets.
- Resilients: These tend to be top-performing operators that generate economic profit despite challenging market and business conditions.
- Followers: Tend to be midtier organizations that continue to generate acceptable returns, largely due to the favourable conditions of the markets in which they operate, but whose overall enterprise-strength relative to peers is weak.
- Challenged banks: These banks generate low returns in unattractive markets and, if public, trade at significant discounts to book value.
Strategies of Archetypal Levers
Archetypal levers comprise three critical moves—ecosystems, innovation, and zero-based budgeting (ZBB). Combining the universal and archetypal levers results in the degrees of freedom available to each bank archetype.
Market leaders: Priorities to retain leadership into the next cycle
Market leaders have benefited from favourable 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. Whereas most of the market leaders in developed markets are North American banks, 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.
Goals for 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. 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.
Resilients: The challenge of managing returns in sluggish markets
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.
They are 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 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.
Goals for the late-cycle
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. 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. On the cost front, resilients need to pay closer attention to opportunities for improving productivity by exploring the bank-wide appetite for ZBB. They should remain alert to the possibility of a compelling distressed asset becoming available.
Followers: Preparing for tailwinds turning to headwinds
Approximately 76 percent of followers are North American and Chinese banks. Followers are primarily midsize banks that have been able to earn acceptable returns, largely due to favourable market dynamics. However, their returns (on average 9.6 percent ROTE) have been a little more than half of those of market leaders, who have also operated with the same favourable market dynamics. The principal driver of their underperformance relative to market leaders is in revenue yields, where they are 100 bps lower. Again, 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.
Goals for the late-cycle
A clear need for action is needed 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 favourable market gives them.
Given their subscale operations and the fact that they are still in a favourable market, they should look for ways to grow scale and revenues within the core markets and customer sets that they serve. 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.
The challenged: Final call for action
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. With an average C/A ratio of 130 bps, they have the best cost performance. However, the problem 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. Most of these banks are in Western Europe, where they compete with weak macro conditions (for example, slow loan growth and low interest rates).
Goals for the late-cycle
The sense of urgency for challenged banks 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.
Thus, exploring opportunities to merge with banks in a similar position would be the shortest path to achieving that goal.
The only other lever at hand costs, in which this group already leads other banks. However, there should still be further opportunities, including the outsourcing of non-differentiated 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.
As the current market uncertainty generates concerns for market players, one question that rests heavily on the minds and lips of stakeholders is ‘what will result in an imminent recession or a prolonged period of slow growth?’ As growth slows and is unlikely to quicken in the medium term, there is no doubt that this is the era of the late cycle. Aggravating this situation is the continued threat posed by fintechs and big technology companies, as they take stakes in banking businesses. Whether a market player or an underdog, the time for bold and critical moves is now.