Banks doing a slow dance in a burning room

Singapore - The global banking industry has settled into a "low-growth, low-profit" rut that will extend into 2017, with European banks in the firing line as interest rates continue to hum low, says a McKinsey & Company report released on Wednesday.

And while banks in emerging markets are more profitable than their Western peers, looming bad debts could eat significantly into profits, especially if a hard landing in China comes to pass.

"Global banking is delicately perched between profit and loss, and the next move seems likely to be downward with the main questions being around timing and how quickly the industry can adjust," said the report from the consultancy firm.

"Tinkering around the edges, as banks have done for years, is not adequate to the scale of the task and will only exacerbate the sense of fatigue that comes from years of one-off restructurings."

The days of double-digit return on equity (ROE) appear to be behind the industry, which was fuelled by leverage prior to the collapse of Lehman Brothers in 2008. In 2015, global banking's ROE stayed around 9.6 per cent, up a notch from 2014's 9.5 per cent. 2016's numbers are looking to be the same, McKinsey said. 2015 was the fourth consecutive year that ROE came in just below 10 per cent, at or near the cost of capital.

Banks have been hamstrung by low interest rates, compressing the margins they earn on loans.

To be sure, a separate research report by Singapore's central bank in late November said the percentage of net interest income from banks in Europe and the US is less than 60 per cent of operating revenue, while that of Asia-10 banks is about 75 per cent.

Still, McKinsey's research noted that as economic growth languishes, and monetary policy continues to stay loose, about 25 per cent of current profits - or US$90 billion - is at risk in banks operating in developed markets by 2020. The profit slump is particularly clear for banks in Europe and the United Kingdom, which are already operating at low ROEs of about 4 per cent. Their ROEs could fall further to a measly one per cent by 2020.

Over in the emerging economies that include China, there is much stronger economic growth - although even that is slowing from before. But the story is dominated by the impact on the credit cycle amid an easing in economic growth, McKinsey said.

How bad it can get will depend largely on China. A soft landing may reduce revenues by only 7-9 per cent; a crash may raise that dramatically to 40 per cent of revenues at risk.

The impact on bad debt for China is a question worth about US$47 billion in profit, assuming that growth - while slow - still chugs along and there's no hard landing, according to McKinsey. If the Chinese economy crashes, though, the profit impact could jump to as high as US$220 billion. While significant, McKinsey pointed to the "currently high profitability" of Chinese banks at US$320 billion, and that state control in China can limit the impact.

Still, there are other risks. The Monetary Authority of Singapore (MAS) separately highlighted in its report that the share of wholesale funding from Chinese banks jumped to close to 40 per cent in 2015, compared with about 20 per cent in 2008. Wholesale funding is a cheaper but less stable form of funding compared to customer deposits.

Meanwhile, the potential for a slowdown in credit growth in China is another key external risk for ASEAN growth in the next couple of years, said a report from the Institute of Chartered Accountants in England and Wales (ICAEW) on Wednesday.

This would not only weaken global demand for raw materials - key exports for Indonesia and Malaysia - but would also hurt open economies such as Singapore, given its activities as a transport and logistics hub. The spillover effect will be felt in parts of this region, as will the new wave of protectionism that poses more threats to growth, ICAEW added.

On top of a lower or low-growth environment, global banks will have to deal with the digital onslaught from new entrants such as fintech (financial technology) firms. Even as most fintechs are now working with banks as partners, the disruptive players out there can crimp fees that banks earn. Fees make up the remainder of the income that banks make that are not linked to interest rates.

Banks are also facing mounting regulations presented as a sobering gift to the industry in the post-crisis period, with McKinsey urging banks to have a regulatory agenda that meets the intent of regulations.

"Given the size of today's regulatory agenda, banks are engaged in hundreds of implementation projects and remediation actions. Most of this activity is reactive and focused on making quick, efficient, affordable fixes," it said.

"However, regulators and lawmakers find this approach increasingly frustrating. 'Duct-taping' the issues often leads to sub-optimal and even insufficient results."

All in, McKinsey said banks must, among other things, continue to shed non-core assets, shift to an intermediary fee model that focuses on advisory and asset management businesses, and boost customer loyalty.

Singapore banks that sit in the midst of these challenges are well equipped to navigate the disruptions brought about by macroeconomic and credit cycles, as well as regulations and digital disruption, Denis Bugrov, senior adviser at McKinsey, told The Business Times.

"Singaporean banks are well positioned to succeed in the 'brave new world' of banking. Their advantages stem from serving a very sophisticated, highly digital and profitable home market and first-rate regulatory environment," he said.

"They are also mature institutions with sophisticated and effective risk management and governance, benefiting from considerable investments in digital technologies and new ways of working."

This article was first published on Dec 8, 2016.
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