The valuation gap between leading banking institutions and those trailing behind is widening, a new report by management consultancy McKinsey has said.
Banks are splitting into “rock star” performers and “utility-like” laggards, based on their total returns to shareholders, said the 11th McKinsey Global Banking Review report, which revealed great divergence in industry performance with time running out for poorly performing companies to adapt business models and catch up.
“The outlook for the industry remains clouded with half of banks not covering their cost of equity,” McKinsey said in the report.
“Unlike the previous economic crisis, this time banks did not witness any abnormal losses, material capital calls or white knight acquisitions. In fact, bank profitability held up better than most analysts expected. ROE in 2020 was 6.7 per cent, above the 4.9 per cent observed in 2008 in the aftermath of the financial crisis."
Banks across the world have faced a tougher operating environment amid pandemic-driven headwinds that tipped the global economy into its worst recession since the 1930s. Historically low interest rates have also made it difficult to boost profits. However, the global economy has bounced back this year, easing pressure on lenders’ profitability.
The global industry is set for a recovery that could put ROE at between 7 per cent and 12 per cent by 2025, the report said.
This baseline is nuanced by region and will be shaped by three macro factors beyond banks’ control: inflation and interest rates, government support for the recovery and liquidity. These variables will determine whether the industry will operate in the upper (12 per cent) or lower (7 per cent) range of profitability, McKinsey said.
The challenges facing a capital-intensive industry in a low-price environment show up in valuations, the report said.
“Banks are trading at about 1.3 times book value, versus 3 times for all other industries and 1.3 times for financial institutions excluding banks, with 47 per cent of banks trading for less than the equity on their books,” McKinsey said.
Payments specialists, exchanges and some securities firms captured more than 50 per cent of the $1.9 trillion in market cap that the industry added. Only 65 institutions out of 599 analysed accrued all the gains, McKinsey found.
“FinTechs and specialised financial services providers – in payments, consumer finance or wealth management – are generating higher valuation multiples than most global universal banks. Some FinTechs are going from a rough sketch to billion-dollar valuation in a few years,” the company said.
There are four primary sources for the divergence in performance, the report said. The first three – geography, scale and segment focus – are difficult for banks to change. The fourth – business model – is well within their power to adapt, the consultancy recommended.
Decisions made in the next 18 to 24 months will determine which companies emerge on the right side of this divergence, it said.
Two-thirds of the value generated by the banking industry is created during the first couple of years after a crisis, McKinsey’s analysis of historical data showed.
“Value will be captured by those institutions that radically shift their business models in response to today’s market pressures: margin compression, the digital expectations of customers and the rapid growth and success of non-traditional banking players. Not only is there simply no value to waiting, but history shows that institutions that take bold steps toward growth in the first years after a crisis generally hold on to those gains for the longer term,” the report said.
Three elements to make a future-proof business model include customer ownership with embedded digital financial services, an efficient economic model that fosters growth beyond the balance sheet, and continuous innovation and fast go-to-market, leveraging technology and talent, the McKinsey report suggested.
