Rethinking bank risk in emerging markets

By Omar Costa, Jawad Khan, and Alfonso Natale

Macroeconomic developments, heightened regulation, and pressure on margins and profitability are moving risk management to the top of the agenda for CEOs and their boards.

The past decade saw an unprecedented rise in the fortunes of emerging-market banks. Less affected by the global financial crisis than their developed-world peers, their collective revenues grew from $268 billion in 2002 to $1.4 trillion in 2012 (exhibit). The future, however, may be a different story. Historically strong capital and liquidity positions have eroded, and operating pressures are mounting from a combination of factors including tighter US monetary policy, stronger growth in developed markets, a changing regulatory landscape, and increasing competition.

Profitability in emerging markets is still much higher than in developed markets: countries such as South Africa, for example, enjoy very high return-on-equity ratios and strong value creation. Yet revenue margins that have been double those in developed markets have already been hit in some regions, and further deterioration seems likely. The net result is that risk management has moved to the top of the agenda for emerging-market bank CEOs and their boards. Risk teams that once focused only on measurement, compliance, and control must now shift toward mitigating challenges on credit, capital allocation, and liquidity or funding. In our experience, supported by a survey we conducted with the Risk Management Association on practices in enterprise risk management, there are four priorities for emerging-market banks as they seek to address big-picture challenges:

Create a risk culture

Traditionally, banks in emerging markets have paid little attention to cultivating a risk culture, where employees feel encouraged to speak up when they observe new risks. One explanation is that fostering such an atmosphere not only requires the involvement of a multitude of stakeholders but also takes time. Yet in the current economic and banking environment—where banks must respond decisively to existing and emerging risks—it’s critical to develop a strong risk culture. Many banks have begun to take the initiative by setting up dedicated sessions with business, risk, and control functions to evaluate risk-response scenarios; explicitly defining what’s expected of all stakeholders; and engaging in tests to reinforce a strong risk culture. In addition, many emerging-market banks plan to introduce or upgrade institutional frameworks on risk to promote prudent decision making—an action strongly encouraged by regulators concerned about strengthening banks’ risk management and governance.

Improve the collections process

There is significant room for improving credit collections. For example, loan-loss impairments for emerging-market banks nearly tripled to €34 billion between 2007 and 2012. Addressing this issue requires two steps: identifying actions on nonperforming loans that can have an immediate positive impact on bank performance, and supporting improvements to credit management related to a defined recovery strategy, organizational structures and processes, and systems. We’ve found that programs of this sort can have a huge impact: in Eastern Europe, for instance, banks have been able to reduce their stock of nonperforming loans by as much as 20 percent.

Develop innovative risk models

Emerging-market banks need to make better-informed credit decisions. There is simply not enough information on creditworthiness, whether in the form of reliable financial data about customers (especially for small and midsize enterprises), credit-bureau information, or historical performance data. Given these gaps, banks have strong incentives to develop their own innovative risk models that incorporate both qualitative and quantitative factors. Where credit bureaus are active, they are having an impact. In one emerging market that adopted such models, loan defaults by micro, small, and medium-size enterprises fell by 79 percent at small banks, while large banks’ default rates fell by 41 percent. At the same time, the probability of a loan being granted to a smaller company rose 43 percent.

Rethink capital allocation

Bank capital will be increasingly scarce in most markets. Yet banks can support business growth and unlock profit potential by understanding where current capital is consumed and optimizing its absorption. We have seen some banks establish a capital-based threshold at which they retain a client’s business. Others seek more collateral or push for more favorable collateral from a risk-weighted-asset standpoint and add covenants to mitigate “rating drift.” Emerging-market banks can also optimize their product portfolio for capital consumption, steering customers toward receivables-based financing rather than working-capital financing.

Tackling these strategic and operational imperatives requires focus and effort, but the emerging-market banks that succeed will have important competitive benefits. Aside from stronger financial performance and improved strategic management, many will realize true competitive advantage as stronger capabilities lead to superior risk selection, risk pricing, and active risk management.

This article is an edited extract from “Risk in emerging markets: The way forward for leading banks (PDF–461KB).

About the author(s)

Omar Costa is a principal in McKinsey’s Warsaw office, Jawad Khan is an associate principal in the Dubai office, and Alfonso Natale is an associate principal in the Milan office.

The authors wish to thank Cindy Levy and Ozgur Tanrikulu for their contributions to this article.

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