Why global banking profitability will remain a challenge in 2020

What is certain is that the banking sector remains committed to investing in technology to transform customer experience, even in the absence of growth environment. The challenge will be knowing how to free up capital to fund these investments, as different factors impact profitability and shape opportunities across the world’s regions.

Europe focuses on cost control

In Europe, higher capital ratios and a significant decline in non-performing loans (NPLs) point to a healthier sector. However, the European economy remains weak. Trade tensions and Brexit-related uncertainty have contributed to anemic Gross Domestic Product (GDP) growth, with Germany and the UK narrowly avoiding recession. Further monetary easing in the Eurozone will continue to erode margins and constrain revenues, while negative rates mean deposit margins, a significant driver of industry revenues before the global financial crisis, are now a significant drag. In addition, the regulatory agenda in Europe continues to increase compliance costs at banks and new capital rules (i.e., Basel IV. which will be phased in between 2022 and 2027) might force banks to hold more capital.

Concerns about profitability, particularly at Europe’s weakest banks, are driving increased discussions of consolidation across the sector. Europe is overbanked – there is one bank for every 82,000 individuals in the EU. Most are inefficient too, with numerous cost transformation programs of the past decade failing to lower efficiency ratios below 60%. The average cost-to-income ratio of European banks is 62.3%. Average ROEs remain well below the cost of equity, at less than 7%. Recent improvements in profitability have been principally driven by lower impairments rather than income growth, though this too may be negatively impacted as the outlook for 2020 weakens.

However, without structural changes such as progress on the Banking Union, including the European Deposit Insurance Scheme, cross-border M&A is likely to remain low. Even if these structural impediments are addressed, any bank looking to grow (or shrink) inorganically still needs to think carefully about how it can do so in a value-accretive way. How do you grow through acquisition without destroying value? How can you exit businesses without retaining the costs of underlying systems?

With consolidation only foreseeable in the longer-term, in 2020, the focus of banks’ efforts to improve profitability will be on cost reduction. In fact, without revenue growth, European banks will need to cut almost one-fourth of their cost base to achieve the industry’s typical ROE target of 12%. Achieving this will require firms to look beyond traditional cost-cutting approaches to radical transformation that includes extensive use of managed services, or industry utilities, to take on critical but non-core activities in a more cost-effective manner. Scaling back and reconfiguring branch networks is also required, alongside increased automation, simplification of products, services, and underlying processes and use of partnerships to build scale. With such challenging fundamentals, the difficulty for banks will be deciding how to free up capital to invest in this transformational agenda.

US war for talent amid technology transformation

In the US, the banking sector continues to deliver double-digit returns, putting US banks in a comparative position of strength. A bounce back in financial markets drove record performances for a number of institutions in FY19, but can this be maintained? While at the beginning of 2020 US market fundamentals remained positive, with consumer confidence — the core driver of the US economy — robust as business confidence declined the market is now entered a period of uncertainty and decline (see Figure 3).

However, banks in most Asia-Pacific markets are in a strong position to manage these risks. They are generally well-capitalized, and while average ROEs have consistently fallen since the global financial crisis, they remain in double digits. Efficiency ratios are significantly better than those in the US or Europe.

Of greater concern is the risk that new competitors pose to incumbents. Asia-Pacific is home to successful BigTech banking competitors, a thriving FinTech scene and leading digibanks. Open banking agendas across the region, whether regulatory driven as in Australia, or more organic as in China, will encourage competition.

Liberalization in China is also likely to change the competitive dynamic in the region. For years, the country’s financial markets have been largely closed to foreign financial institutions, but this looks set to change in the wake of reforms to standardize market entry rules and remove ambiguity around foreign FIs’ entry policies.

These competitive dynamics mean banks in the region will need to continue investing in building digital banking capabilities to further drive efficiency and productivity and enable them to better serve customers as effectively as possible, particularly across markets. Doing this successfully will help banks reach more customers, especially unbanked and underbanked individuals and micro, small-and medium-sized enterprises, which we estimate could generate an additional US$88b in revenues across Asia-Pacific.

Uncertainty shouldn’t delay transformation

The groundwork laid over the past decade means most banks are relatively well-prepared to manage through current market challenges, even if conditions worsen. The 10th annual EY/ International Institute of Finance (IIF) global bank risk management survey found bank executives are relatively sanguine about their ability to weather a downturn, perhaps because mechanisms are now in place to help them adapt to shifts in external conditions. This flexibility, if real, will prove important should the market deteriorate.

As the economic outlook worsens banks will face a mammoth task to deliver stable year-on-year returns. Even if the economy didn't worsen and without revenue growth, the world’s largest 200 banks would need to cut more than US$200b (15%) from their combined cost base to achieve an average ROE of 12%.

In 2020, we see banks focusing their transformation agendas to streamline businesses and better serve customers. Against this backdrop, banks need a strong control infrastructure to manage change, but also to invest heavily in technology.

Many banks have announced significant technology budgets, although it is often unclear how much of this investment is directed to maintaining legacy systems or an innovative and transformative agenda. It is also uncertain what the ROI of spend on innovation is, and how those initiatives are aligned to organizations’ core strategies.

For banks, the ability to continue to invest in digital transformation will depend on efforts now to improve profitability. Banks can learn lessons from peers that have consistently outperformed through driving efficiency, strengthening resilience, and creating a customer-centric culture.