The 11th edition of McKinsey’s annual banking review analyses the global industry’s profitability challenges, as well as the widening gap in market-to-book ratio between top and bottom performers.

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While the global banking industry held up under the difficult conditions presented by the Covid-19 pandemic compared to previous crises, a cause for concern can be found in two performance measurements: return on equity (ROE), a measure of current profitability; and market-to-book value, an indicator of how capital markets value banking.

The pandemic depressed ROE in all regions, according to McKinsey’s recent report ‘Global Banking Annual Review 2021: The great divergence’. In North America, ROE fell from 12% in 2019 to 8% in 2020. European banks’ ROE was halved, from 6% to 3%, while ROEs in Asia fell by a percentage point. Overall, the industry’s ROE was 6.7% in 2020.

Although this is above the 4.9% observed in 2008 in the aftermath of the global financial crisis, it is less than the cost of equity. Analysing more than 900 banks, McKinsey found that 51% of them operate with an ROE below cost of equity (COE) – and 17% are below COE by more than four percentage points.

The second area of concern for banks is market valuations. According to the research, banks are trading at about 1.0 times book value, versus 3.0 times for all other industries and 1.3 times for financial institutions excluding banks, with 47% of banks trading for less than the equity on their books.

“Banking valuations suggest that capital markets are discounting an industry whose baseline for profitability and growth is decent and resilient but not attractive – and that is undergoing disruption from financial-services specialists with limited reliance on the balance sheet,” according to the report. “This is reflected in the market multiples, where banking is currently valued more in line with an average utility, with a price-to-earnings ratio (P/E) of 15 times, than with a specialised financial services provider, where P/Es are 20 to 30 times.”

The banking industry now faces a “great divergence” between the industry’s top performers and its utility-like laggards. McKinsey analysed more than 150 financial institutions globally – including banks, specialists and fintechs – and found four sources for divergence: the geographies in which financial institutions operate, their relative scale, their segment focus, and, most importantly, their business model.

According to the report, specialised financial-services providers – in payments, consumer finance or wealth management – are generating higher ROEs and valuation multiples than most global universal banks. But some banks are among the top performers and their common characteristics include: customer ownership with embedded digital financial services; an efficient economic model that fosters growth beyond the balance sheet; and technology-enabled innovation and fast go-to-market.

According to the report, banks need to consider multiple questions if they are to land on the “right side” of the divergence, including ones covering:

  • Differentiated customer relationships and customer ownership;
  • Privileged data and insights on customers;
  • Clear resource and capital allocation;
  • New revenue streams;
  • Environmental and social transformation strategies;
  • Insights into and solutions for current risks and emerging exposures;
  • Entrepreneurial culture and talent.

“These questions cover a lot of ground; few banks will be able to tackle all of them,” says the report. “The important thing, in our view, is to pick the right challenges and confront them without reservation. Customers and shareholders will reward the right choices, while the wrong bets might be punished. But in an era of divergence, doing nothing is probably the riskiest approach.”

Joy Macknight is editor of The Banker. Follow her on Twitter @joymacknight

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