Banks may have to accept lower earnings, warns McKinsey

Higher profits enjoyed by global banks over the last two years could prove “fleeting,” consultants at McKinsey & Co. warned in their annual state of the industry report, predicting headwinds from lower interest rates and flagging loan demand. 

Return on tangible equity across a group of around 1,700 listed deposit takers rose to 11.7% last year, confirming that the past two years were “the best for banking since before the global financial crisis,” according to McKinsey.

The report, whose authors include seven partners from across the firm’s global practice, said under some scenarios recent profitability could only be maintained if banks cut costs at five times their usual annual rate, a tall order for an industry that has struggled to meaningfully boost productivity.

“The improvement in returns could be fleeting,” McKinsey said, describing how its analysis showed ROTE could have been just 8% — or below the cost of capital — in several geographies for the last few years without the backing of higher interest rates. That support is now fading. 

The study by the New York-based consultancy reinforces concerns raised by industry analysts about falling profitability as monetary authorities around the world turn their focus away from taming inflation to stimulating economic growth. The US Federal Reserve cut its benchmark rate by half a percentage point in September, its first reduction in more than four years. The European Central Bank and the Bank of England have also started lowering theirs, with more expected in the coming months.  

McKinsey said lower interest rates could lead to net interest margins – a key profitability measure that describes the gap between a bank’s cost of funding and its lending – dropping by about 16% by 2030 from 2023. In anticipation, many of the biggest lenders have already started to tighten their belts, including by way of job cuts across the board.

But these cost reductions may not be able to bridge the industrywide profitability gap. To maintain current ROTE in the face of some macro-driven scenarios, the industry would need to reduce its cost per asset by 5% a year, or five times the industry’s historic performance of 1%, McKinsey said. 

“Banks are going to have to work a lot harder as they go forward,” said Vik Sohoni, a McKinsey partner based in Chicago. 

The consultancy, known as a factory that’s produced some of the high-profile bank chief executive officers including Citigroup Inc.’s Jane Fraser, Lloyds Banking Group Plc’s Charlie Nunn and former Morgan Stanley CEO James Gorman, argues that lenders can “avoid gravity” by following the tried and tested methods of current leaders, including being selective about their markets and embracing wealth management.

The report also showed that banks’ share-price discount to other publicly listed companies widened to 68% last year based on the ratio of price-to-book value of assets. Banks trade at 90% the value of their assets. 

“Even though banking is the single largest profit-generating sector in the world, the market is skeptical of long-term value creation and ranks banking dead last among sectors on price-to-book multiples,” McKinsey said.

Pradip Patiath, a McKinsey partner based in Miami, said that banking so far defied the logic that growth in other sectors would fuel growth in the sector financing their activities, partly because finance has not had the same labor productivity gains as other industries.

“There’s no evidence of scale benefit,” Patiath added. “Biggest doesn’t necessarily mean better.” 

Banks, particularly those in Europe, also blame post-crisis regulation for the discount. The landscape there is shifting, with policymakers in the US and UK watering down the latest package of reforms, and the EU’s three biggest economies calling for an easing of rules more generally.