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Banks will need to become more resilient and reinvent their business models to ride out the current volatile period and achieve long-term growth and profitability. At a time of growing corporate and government commitments to reduce greenhouse-gas emissions, we also shine a spotlight on sustainable finance, a much-discussed theme in banking. Despite lingering skepticism and concerns about greenwashing, we find strong evidence suggesting that climate-related financing is entering a “next era,” as the initial surge of funding for renewable energies gives way to a deeper engagement with banking clients across all sectors.
Global banking scenario concerned, 2022 has been a tumultuous year of shocks and growing uncertainty. Banks rebounded from the pandemic with strong revenue growth, but the context has changed dramatically. Now a series of interrelated shocks some geopolitical and others lingering economic and social effects of the pandemic are exacerbating fragilities. Bank profitability reached a 14-year high in 2022, with expected return on equity between 11.5 and 12.5 percent. Revenue globally grew by $345 billion. This growth was propelled by a sharp increase in net margins, as interest rates rose after languishing for years on their cyclical floors. For now, the banking system globally is sitting comfortably on Tier 1 capital ratios between 14 and 15 percent the highest ever.
Geopolitical tensions are roiling the financial sector: Rude return of geopolitics as a disruptive force. Five resulting shocks are affecting banks globally: Macroeconomic shock, soaring inflation and the likelihood of recession are sorely testing central banks, even as they seek to rein in their quantitative-easing policies. Asset value shock, these include steep declines in the Chinese property market and the sharp devaluation of fintechs and cryptocurrencies, including the bankruptcy of some high-profile crypto organizations. Energy and food supply shock, disruptions to the energy and food supply, related to the war in Ukraine, are contributing to inflation and putting millions of livelihoods at risk, Supply chain shock, the disruption of supply chains that began during the first pandemic lockdowns continues to affect global markets, Talent shock, employment underwent major shifts during COVID-19 as people changed jobs, began working remotely, or left the workforce altogether to join the “great attrition” shifts with no sign of easing.
Consequences diverge transversely and within regions, especially in emerging markets: One of the striking characteristics of this period is that some banks in some geographies are growing robustly and posting buoyant and rising profits and revenues. This far more upbeat picture is to be found in select markets many regional banks in the United States and top five banks in Canada, for example. In emerging economies such as India, Indonesia, Mexico, and South Africa, the largest banks by market capitalization are performing very well. This is not the old story about emerging markets versus advanced economies. Indeed, this year it’s possible to make the case that, in banking at least, the whole notion of “emerging markets” is dead. The group of countries to which it refers is no longer colossal: some of the best-performing and high-growth banks are to be found in Asia, as are some of the worst-performing and lowest-growth ones.
Economy slows, the deviation between banks will widen more: The current uncertain macroeconomic outlook will affect banks in two ways, even though to different degrees. First, there is likely to be a continuing boost to profitability from higher margins as interest rates increase but this may prove transitory. Second, banks face a long-term growth slowdown. The result of these pressures will be an increase in the “great divergence” trend among banks that we noted last year, with outcomes varying considerably, depending on funding profile, geography, and operating model.
The effects on banks of two possible macroeconomic scenarios: inflationary growth and stagflation. In either scenario, it is expected the initial stage to be positive for banks. Rising interest rates will lift net interest as short-term lending products such as consumer finance are repriced faster than liabilities. In this phase, both scenarios forecast that costs and risks remain under control. The big question is what will happen during a transition phase when economic growth deteriorates, followed by a phase when the full effects of the scenario kick in. Banks could see three effects a slowdown in volume growth, higher costs, and greater delinquencies which, depending on the scenario, could be small or large. The divergence story will continue to play out through these scenarios. Banks in Asia Pacific may gain from a stronger macroeconomic outlook, whereas European banks may see the full effects of the scenario sooner and with more detrimental impact. In the event of a long recession, it may estimate that return on equity globally could fall in the following years for European banks. The net impact will likely be a further concentration of growth in emerging Asia, China, Latin America, and the United States. It is expected that these regions will account for about banking revenue growth between 2021 and 2025.
Performance of banks varies by geography, specialization, customer segmentation, and scale: To understand why and how banks end up where they do, it should look at them across four dimensions: geography, specialization, customer segmentation, and scale. Geography is a key factor, overall, we find that a bank’s primary business location accounts for fifty percentages and above of its valuation, a share that has been rising consistently. Specializing can be profitable, well-valued specialist players and fintechs are not surprisingly active in banking products that generate profits, including deposits, payments, and consumer finance. The result is a two-speed system in which traditional banks are left behind. But the divergences were very large across areas of banking specialization. Take a fresh look at customer segments and demographics, it suggests that, in retail banking, disproportionate revenues tend to be locked in specific segments. One notable feature of this analysis is the gap between the demographic distribution of the population and the age at which they generate banking revenue. In China, the trend is reversed: the revenue peak arrives 20 years before the demographic peak. Scale matters, about fifty percent of market capitalization is held by banks and the rest of these “value-creating” banks could benefit from M&A to increase their scale.
The dual challenge: Managing the present while preparing for the future: Due to market pressures and shifts, including technological changes that disrupt traditional banking, will amount to fundamental structural breaks. Banks will need to improve their short-term resilience and invest in the long term to innovate and prepare the path for future profitability, increased growth, and higher valuations. In the near term, four strategic objectives can help bolster resilience: Financial resilience, the best-performing banks will have a net income structure with low sensitivity to interest rates and risk costs, and they should target a cost-to-income ratio of 35 to 40 percent. Operational resilience, that means reducing or eliminating a presence in high-risk countries and building exceptional risk management practices, Digital and technological resilience, cyberattacks remain a serious risk, and the best banks have a well-protected and future-proof technology infrastructure, as well as superior data security. Organizational resilience, banks that perform best will have rapid reaction times and invest in attracting, reskilling, and retaining the best talent.
For the longer term, banks will need to move from traditional business models to more future proof platforms, potentially decoupling business units such as everyday banking and complex financing or advisory services. Banks could consider several approaches. For example, they could foster highly differentiated customer relationships, with a strong focus on establishing a deep emotional connection. They also could develop proprietary data and insights on sets of customers, including with the use of advanced analytics. A third option would be to make substantial and clear bets when allocating resources and capital. Fourth, banks could create new customer access and revenue sources, such as subscription fees, payments fees, and distribution fees, that do not involve the balance sheet. And banks could focus on innovation, with the goal of instilling a truly entrepreneurial culture and attracting and retaining the talent needed to contribute within such a culture. Finally, banks should develop a strategy for targeting environmental transformations.
Share of bank business and sustainable finance: There is scope has created to issue of sustainable debt instruments, which was close to zero few years ago, having huge prospect of substantial year-on-year growth in the following periods.The volume of sustainable bonds, including green bonds, sustainability bonds, social bonds, and sustainability-linked bonds will reach a level (including sustainable syndicated loans, including green loans and sustainability-linked loans). Sustainable financing activities related to the capital markets including M&A, equities, and carbon trading having also scope to expand over the following periods. As sustainable instruments gain acceptance, scrutiny of how they are labeled also increases. In particular, sustainability-linked loans and bonds need to establish their credibility. More broadly, there is a need to disaggregate ESG categories in order to distinguish climate finance and track it separately. Green bonds initially dominated the sustainable debt market, but they have been overtaken by sustainability-linked loans. These are performance-based instruments that tie interest rates to the achievement of defined sustainability targets. Challenges remain in setting goals, including incentives for meeting the targets set and penalties for failing to do so.
Era of transition: In the next era of transition, perhaps it will observe the continuous focus on capital deployment for sustained growth in low-emission power generation, along with many new aspects of the global energy transition being pushed as priorities that require financing. These new initiatives include growth in electrification, the build-out of energy transmission and distribution infrastructure, emission reductions in high-emission and energy-intensive sectors such as steel and cement, and natural climate solutions. Signs of this next era are already visible. Along with continued investments in power generation, they include increased funding for emerging technologies such as hydrogen and grid storage and bank innovations aimed at financing the low-carbon transition. Leading global banks and smaller local banks alike are developing new products, platforms, and in some cases, separate financing entities across sectors. Growth has been fueled by policy shifts, new technologies, and growing corporate momentum. As a result, banks are maturing from a simple understanding of the baseline to exploring with clients the levers to finance reduced emissions in the real economy. Banks will need a nimble approach to assessing a rapidly changing market for sustainable finance. The experiences vary by type of institution. Corporate and investment banks have made the most progress, but many opportunities remain. To build on the progress made in renewable energy over the past decade, banks could scale financing capabilities to close the gap for solar, wind, and hydro while simultaneously developing capabilities for new clean energy, such as green hydrogen. They can capture transition financing opportunities with the existing client base and expand capabilities for advisory to support clients.
Commercial and small-business banking, where clients are retrofitting buildings and shifting their energy mix, banks can provide equipment finance for energy-efficiency measures or financing for retrofits. They can also finance vehicle fleets as companies transition to electric and fuel-cell vehicles. Retail banks can provide financing solutions for retrofitting, home appliances, and rooftop solar panels. They also can capture the sizable opportunity in auto finance from EV adoption. Wealth and asset management can develop thematic investment options with targeted climate-forward investment theses to meet the demand from institutional and retail investors. Institutions and retail investors alike are increasingly shifting their focus from general ESG themes to the low-carbon transition.
Concluding thoughts and remarks: Legacy Banks Can Reinvent Themselves. Nowadays, Banks are operating in an Economy of Disruption where customers are getting amazing Experience. The Business Environment is disruptive where competition is coming from outside the industry as well. Technology is changing at an exponential pace. All of this is making an eco-system very challenging for any legacy Bank. But now, the users are not just information consumers. They are generating the content themselves. They are reviewing the product and rate the product with their remarks. They do chat and expect two-way participation in the process of sales & service. They are exchanging value which is far beyond mere information exchange. Ability to operate at hyper-scale is not enough. Ability to hyper-personalize is the key. Ability to quickly adapt to changing market needs and respond to competitive threats is critical. Net-net, there is a huge focus needed on how to deal with disruptive eco-system.
Where are today’s threats to tomorrow’s growth prospects. Fintechs are down, but they’re not necessarily out. The disruptors are reducing cash burn rates as capital raising is challenging for business models that often rely on low-cost debt. But as macro conditions improve, capital raising may be concentrated on the strongest fintechs which have a better chance of disintermediating banks. Established technology and retail brands, hoping to capture more client time and money, are pushing financial services toward captive financing and strategic partnerships. With access to millions of customers, they can quickly scale a digital offering, threatening a bank’s market share similar to what we have seen across credit products and payments. In a worst-case scenario, digitally-savvy established brands may become the face of financial services, pushing traditional banks - and possibly some fintechs into the background. Still, the most likely near-term competitive threat comes from banks that are more digitally agile, delivering simpler, seamless and individualized experiences across their portfolio of products and services. Superior digital capabilities, especially those that offer advice to help customers navigate a difficult economy, can be a differentiator, inspiring customers to switch banks for a better experience. It’s a challenging time for banking executives, balancing the opposing needs of spending to increase competitiveness, while managing an expanding set of financial and non-financial risks. It is the view that what’s next in banking and capital markets, and how these forces can help shape banking’s future.
