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Global banking annual review 2019: The last pit stop? Time for bold late-cycle moves

As growth slows, banks across the globe need to urgently consider a suite of radical organic or inorganic moves before we hit a downturn.

A decade on from the global financial crisis, signs that the banking industry has entered the late phase of the economic cycle are clear: growth in volumes and top-line revenues is slowing, with loan growth of just 4 percent in 2018—the lowest in the past five years and a good 150 basis points (bps) below nominal GDP growth (Exhibit 1). Yield curves are also flattening. And, although valuations fluctuate, investor confidence in banks is weakening once again.

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Industry veterans have been through a few of these cycles before. But, notwithstanding the academic literature, 1 this one seems different. Global return on tangible equity (ROTE) has flatlined at 10.5 percent, despite a small rise in rates in 2018 (Exhibit 2). Emerging-market banks have seen ROTEs decline steeply, from 20.0 percent in 2013 to 14.1 percent in 2018, largely due to digital disruption that continues unabated. Banks in developed markets have strengthened productivity and managed risk costs, lifting ROTE from 6.8 percent to 8.9 percent. But on balance, the global industry approaches the end of the cycle in less than ideal health, with nearly 60 percent of banks printing returns below the cost of equity. A prolonged economic slowdown with low or even negative interest rates could wreak further havoc.

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What explains the difference between the 40 percent of banks that create value and the 60 percent that destroy it? In short, geography, scale, differentiation, and business model. On the first, we find that the domicile of a bank explains nearly 70 percent of underlying valuations. Consider the United States, where banks earn nearly ten percentage points more in returns than European banks do, implying starkly different environments. Then comes scale. Our research confirms that scale in banking, as in most industries, is generally correlated with stronger returns. Be it scale across a country, a region, or a client segment. Having said that, there are still small banks with niche propositions out there generating strong returns, but these are more the exception than the rule. Underlying constraints of a business model also have a significant role to play. Take the case of broker dealers in the securities industry, where margins and volumes have been down sharply in this cycle. A scale leader in the right geography as a broker dealer still doesn’t earn the cost of capital.

Domicile is mostly out of a bank’s control. Scale can be built, although it takes time; attractive acquisitions and partnerships are currently available for most banks. But on their individual performance irrespective of scale or business model, banks can take immediate steps to reinvent themselves and change their destiny, inside the short window of a late cycle. Three universal organic performance levers that all banks should consider are risk management, productivity, and revenue growth. All while building the talent and the advanced data-analytics infrastructure required to compete.

Worldwide, risk costs are at an all-time low, with developed-market impairments at just 12 bps. But just as counter-cyclicality has gained prominence on regulators’ agendas, banks also need to renew their focus on risk management, especially the new risks of an increasingly digital world. Advanced analytics and artificial intelligence are already producing new and highly effective risk tools; banks should adopt them and build new ones. On productivity, marginal cost-reduction programs have started to lose steam. The need of the hour is to industrialize tasks that don’t convey a competitive advantage and transfer them to multitenant utilities. Industrializing regulatory and compliance activities alone could lift ROTE by 60 to 100 bps. Finally, on generating elusive revenue growth, now is the time to pick a few areas—client segments or products—and rapidly reallocate top customer-experience talent to attack the most valuable areas of growth and take share as competitors withdraw and customer churn increases late in the cycle.

What’s the right next step?

The right moves for the right bank

Each bank is unique. The degrees of strategic freedom it enjoys depend on its business model, assets, and capabilities relative to peers, as well as on the stability of the market in which it operates. Considering these factors, we narrow the set of levers that bank leaders should consider, to boldly yet practically take achievable moves to materially improve—or protect—returns within the short period of time afforded by a late cycle. To that end, we classify each bank into one of four archetypes, each with a set of levers that management should consider. In combination with the universal levers discussed in the full report, these archetypal levers form a full picture of the degrees of freedom available to a bank.

The four archetypes are defined by two dimensions: the bank’s strength relative to peers and the market stability of the domain within which the bank operates (Exhibit 3):

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  • Market leaders are top-performing financial institutions in attractive markets. They have had the best run economically in this cycle, growing returns faster than the market and earning well above their cost of equity. Their critical challenge is to sustain performance and maintain their leadership position into the next cycle.
  • Resilients tend to be top-performing operators that generate economic profit despite challenging market and business conditions. Their strategic priority is to sustain returns in a low-growth, low-interest-rate, and highly disruptive environment. For resilient leaders in challenged business models such as broker dealers, reinvention of the traditional operating model itself is the imperative.
  • Followers tend to be midtier organizations that continue to generate acceptable returns, largely due to the favorable conditions of the markets in which they operate, but whose overall enterprise strength relative to peers is weak. The key priority for followers is to rapidly improve operating performance to offset market deterioration as the cycle turns, by scaling, differentiating, or radically cutting costs.
  • Challenged banks generate low returns in unattractive markets and, if public, trade at significant discounts to book value. Their strategic priority is to find scale through inorganic options if full reinvention of their business model is not feasible.

To identify the degrees of freedom relevant for each bank archetype, we assessed who they are, or a description of how banks in each archetype have performed economically in recent years (Exhibit 4), and where they live, or the underlying health of the markets in which they operate (Exhibit 5). These factors point to what they should prioritize, that is, the critical moves banks in each archetype should prioritize during the late cycle.

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Archetypal levers comprise three critical moves—ecosystems, innovation, and zero-based budgeting (ZBB)—in two of the three dimensions discussed in Chapter 2 of the full report—that is, productivity and revenue growth. Combining the universal and archetypal levers results in the degrees of freedom available to each bank archetype. Unsurprisingly, market leaders and resilients should focus primarily on levers that will allow them to gain further scale and grow revenues through ecosystems and innovation, with productivity improvements limited to outsourcing nondifferentiated costs to third-party “utilities.” By contrast, followers and challenged banks both need to achieve productivity improvements through ZBB, and additional scale within their niche segments with inorganic options as the most credible choice.

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Who you are, and what are your late-cycle priorities? Game board for the archetypes

Market leaders: Priorities to retain leadership into the next cycle

Who they are. Market leaders have benefited from favorable market dynamics as well as their (generally) large scale, both of which have allowed them to achieve the highest ROTEs of all bank archetypes—approximately 17 percent average ROTE over the previous three years. And they have achieved this leadership without having to focus too much on improving productivity, as reflected in their average cost-to-asset ratio (C/A) of approximately 220 bps. Unsurprisingly, most of the market leaders in developed markets are North American banks; however, it is also interesting to note that a significant proportion (approximately 46 percent) of market leaders consists of banks in emerging markets in Asia—mainly China—and the Middle East. These banks, even with declining ROTEs in the previous cycle, still have returns above the cost of capital.

Priorities for the late cycle. For this group, the need for action is clear as we head into the late cycle: these banks must understand their key differentiating assets and invest in innovation using their superior economics, especially when peers cut spending as the late cycle bites. As noted earlier, history shows us that approximately 43 percent of current leaders will cease to be at the top come the next cycle (Exhibit 6). The investments made now—whether organic or inorganic—will decide their place at the top table in the next cycle.

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Given the scale advantages that leaders enjoy, banks in this group will be challenged to sustain revenue growth, especially as credit uptake typically slows in the late cycle. The focus now needs to shift toward increasing their share of wallet among current customers by extending their proposition beyond traditional banking products. This should be done through a classic ecosystem move, where they can generate capital-light fees by introducing other products into their platforms. This approach should allow them to expand revenues in a short period of time without spending significant amounts in development or acquisition costs. Meanwhile, improvements to the bank’s innovation capabilities as well as to capital commitments to innovation should remain in the forefront. Market leaders are also in a prime position to explore opportunities—to acquire smaller banks that have a customer base that is like their own, or a struggling fintech that has digital capabilities that can supplement the bank—and to pursue a programmatic M&A strategy across a select set of key technologies. In most cycles, a downturn creates the best opportunities, and now is the time to create the wish list. Fundamental to all these is the need to retain a strong capital and management buffer beyond regulatory capital requirements to capitalize on a broad range of opportunities that will likely arise.

Resilients: The challenge of managing returns in sluggish markets

Who they are. Resilients have been strong operators and risk managers that have made the most of their scale in what have been challenging markets, due to either macroeconomic conditions or to disruption. This has allowed them to generate returns just above the cost of equity, with an average ROTE of 10.7 percent over the previous three years, without taking on undue risk, as reflected in the lowest impairment rates of all archetypes (24 bps). Banks in this archetype have worked hard at costs even as they have struggled to maintain revenues, beating the C/A ratios of market leaders (their peers in buoyant markets) by nearly 50 bps. However, at 170 bps, there is still significant opportunity for productivity improvements when compared with best-in-class peers. Unsurprisingly, resilients are almost all in Western Europe and developed Asian markets such as Japan, which have been the toughest banking markets over the past three years. Leading broker dealers also feature in this group.

Priorities for the late cycle. Like market leaders, resilients must constantly seek a deeper understanding of which assets set them apart from the competition, and take advantage of their superior economics relative to peers to invest in innovation, especially when peers cut spending as the late cycle takes hold. However, unlike market leaders, given that they already operate in an unattractive market and barely earn their cost of capital, they have a higher sense of urgency in making their late-cycle moves.

The first item on their agenda, just like market leaders, should be to focus on increasing their share of wallet among their current customers through enhanced customer experience (CX) and by building a value proposition that extends beyond the traditional set of banking products. The most practical path is to expand their ecosystem activities and improve their ability to innovate. Second, those with a large infrastructure asset (for example, securities companies) should innovate by their platforms across noncompeting peers and other industry participants to find new ways of monetizing their assets. Furthermore, on the cost front, resilients need to pay closer attention to opportunities for improving productivity by exploring the bankwide appetite for ZBB. Where the resilients differ from market leaders is in inorganic levers. Due to their lower excess capital reserves, they should explore strategic partnerships to acquire scale or capabilities rather than material acquisitions. However, they should remain alert to the possibility of a compelling distressed asset becoming available.

Within resilients are banks that are less challenged by the macro conditions and more by the declining economics of their own underlying business models. For these, the playbook listed above definitely holds but they need to go beyond. As mentioned earlier in this report, there is an urgent need to find areas where they can actually add value and get rewarded as their core business economics fall. Identifying those areas and ramping up on those capabilities organically or inorganically will be the late cycle priority.

Followers: Preparing for tailwinds turning to headwinds

Who they are. Followers are primarily midsize banks that have been able to earn acceptable returns, largely due to favorable market dynamics. However, their returns (on average 9.6 percent ROTE) have been little more than half of those of market leaders, who have also operated with the same favorable market dynamics. The principal driver of their underperformance relative to market leaders is in revenue yields, where they are 100 bps lower. Finally, given their underperformance relative to other banks in similar markets, they have invested in productivity improvements and have C/A ratios 20 bps lower than market leaders but 70 bps higher than similarly underperforming peers in more challenged markets. Approximately 76 percent of followers are North American and Chinese banks.

Priorities for the late cycle. There is a clear need for action with bold moves to ensure that returns do not deteriorate materially during a downturn. Furthermore, if they are to be among the 37 percent of follower banks that become leaders regardless of the market environment, now is the time to build the foundation, as they still have time to benefit from the excess capital that operating in a favorable market gives them.

Given their subscale operations and the fact that they are still in a favorable market, they should look for ways to grow scale and revenues within the core markets and customer sets that they serve. This includes both organic and inorganic options. On the latter, followers, which have underperformed their peers in buoyant markets, should also reevaluate their portfolios and dispose of nonstrategic assets before the market turns.

Organically, growth priorities for this group are best realized by achieving a high standard of CX and improving the bank’s innovation capabilities, with an emphasis on understanding ways to better serve the specific needs of their niche market rather than developing revolutionary new products. They should also explore strategic partnerships that allow them to offer new banking and nonbanking products to their core customers as a platform, thereby extending much needed capital-light, income-boosting returns.

Cost is also a significant lever for this group. With an average C/A ratio that is 70 bps higher than peers in more challenged markets (where challenged banks as a group have pulled the cost lever harder than other archetypes), followers have the potential to improve productivity significantly. For the portion of the cost base that cannot be outsourced to third parties, implementing ZBB is a highly effective way to transform the bank’s approach to costs.

The challenged: Final call for action

Who they are. Some 36 percent of banks globally have earned a mere average of 1.6 percent ROTE over the past three years. This is the lowest average return of all archetypes and well below the cost of equity of these banks, which we classify as “challenged banks.” With an average C/A ratio of 130 bps, they have the best cost performance. The problem, however, is in revenues, where they have the lowest revenue yields, at just 180 bps, as compared with an average revenue yield of 420 bps among market leaders. Further analysis of this category also points to the fact that most operate below scale and are “caught in the middle,” with neither high single-digit market share nor any niche propositions. Unsurprisingly, most of these banks are in Western Europe, where they contend with weak macro conditions (for example, slow loan growth and low interest rates).

Priorities for the late cycle. For challenged banks, the sense of urgency is particularly acute given their weak earnings and capital position; banks in this group need to radically rethink their business models. If they are to survive, they will need to gain scale quickly within the markets they currently serve.

To that end, exploring opportunities to merge with banks in a similar position would be the shortest path to achieving that goal. Potentially high-value mergers within this segment are of two kinds: first are mergers of organizations with completely overlapping franchises where more than 20 to 30 percent of combined costs can be taken out, and second are those where the parties combine complementary assets, for example, a superior customer franchise and a brand on one side and a strong technology platform on the other.

The only other lever at hand is costs, in which this group already leads other banks. However, there should still be further opportunities, including the outsourcing of nondifferentiated activities and the adoption of ZBB, both discussed earlier. With an average C/A ratio of 130 bps, challenged banks as a group still have a good 50 bps to cover before they produce the best-in-class cost bases we’ve seen from Nordic banks. In addition, costs (especially complexity costs) could creep up as the group chases higher revenue yields through product introductions. It is better to launch products off a leaner base and, should a bank seek an acquirer, a lower cost base would also help strengthen valuations.


While the jury is still out on whether the current market uncertainty will result in an imminent recession or a prolonged period of slow growth, the fact is that growth has slowed. As growth is unlikely to quicken in the medium term, we have, without question, entered the late cycle. Compounding this situation is the continued threat posed by fintechs and big technology companies, as they take stakes in banking businesses. The call to action is urgent: whether a bank is a leader and seeks to “protect” returns or is one of the underperformers looking to turn the business around and push returns above the cost of equity, the time for bold and critical moves is now.

Download Global Banking Annual Review 2019: The last pit stop? Time for bold late-cycle moves, the full report on which this article is based (PDF—2MB).

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