Podcast: African banking in the new reality

The COVID-19 crisis will not leave the banking sector unscathed. The past year has seen the acceleration of seismic trends ranging from deglobalization and a radical shift in the macroenvironment to transformed customer expectations. As African banks chart their paths to recovery in this new reality, they can act swiftly to manage elements that are within their control to shape their recovery and growth trajectory. This could be critical not just for restoring ROEs to meet the needs of shareholders and to better serve their customers, but also in enabling the recovery of Africa as banks have an important role to support customers and economies during these challenging times.

Kerry Naidoo: Hello, and welcome to the McKinsey Africa podcast with me, Kerry Naidoo. The podcast that brings you conversations with leading experts, and shares actionable insights into the challenges and opportunities facing managers and leaders working in Africa.

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African banking in the new reality

Kerry Naidoo: In this episode, we're focusing on African banking in the new reality, the title of a new report calling for swift action, and a focus on three imperatives that could strengthen African banks and support recovery. We're all aware of the manifold crisis wrought by COVID-19 not least the implications of the rapid economic contraction we've witnessed across Africa affecting all industries, including banking. Now, as companies and leaders start to look toward recovery, new analysis from McKinsey provides us with some optimism and suggestions for the way forward.

Kerry Naidoo: I'm very pleased to welcome Uzayr Jeenah, an associate partner in our Johannesburg office, and co-author of this new McKinsey report on African banking. Welcome to the McKinsey podcasts, Uzayr, and thank you so much for joining us.

Uzayr Jeenah: Hi Kerry. It's a real pleasure to be here with you. And thank you for the invitation. And hello to our listeners out there.

Kerry Naidoo: Let's begin with the very basic question, Uzayr. Just given the depth of the humanitarian crisis on our continent and still uncertain trajectory of the pandemic, why the focus on banking?

Uzayr Jeenah: That's a really good question, Kerry. And whilst we're deeply invested in helping banks emerge from this crisis as unscathed as possible, our interest is much deeper than just restoring their ROEs or return on equity. Our interest is in the leading role that banks play in the recovery of a continent as a whole, including the important role that they play in helping to support customers, both businesses and consumers, and the swift actions that they've actually taken to do so.

Uzayr Jeenah: And so the good news is that government data and financials released by the banks in four of the major economies across the continent, Nigeria, Morocco, Kenya, and South Africa, show that the pandemic's impact on our banks was much less severe in 2020 than we'd initially expected. And given the important role that banks play in the broader economy, and as important employers and taxpayers in the broader society, this is good news and it could signal a much faster recovery for the continent as a whole.

Kerry Naidoo: Hence the optimism, right?

Uzayr Jeenah: That's it.

Kerry Naidoo: But there's an obligation in that, isn't there? As major role players in the continent's recovery, there's an obligation on banks to move decisively, to ensure their own health for the continent's wellbeing.

Uzayr Jeenah: Absolutely Kerry. I think as key drivers of stability and liquidity, a strong banking sector is absolutely essential for Africa, now more than ever.

Kerry Naidoo: You said the impact on the African banking sector wasn't as bad as feared. Can you just share a bit more about that? What has the impact of the pandemic been here on the continent and how does that compare with the rest of the world?

Uzayr Jeenah: Banks around the world have been affected by these cascading credit losses. As people have been out of their jobs, as companies are then forced to shut down as a consequence of the various lockdowns around the world, real pressure on credit repayments, both on the retail side and the corporate side. And so this uncertainty around demand has created a lot of concern with people particularly worried about the overall stability of the banking system. And you saw that reflected in share prices of banks globally. Bank share price is down anywhere from 30% to 60% market by market. Now, a lot of that has recovered as people have found that the extent of the loss has not been as severe as they originally expected.

Uzayr Jeenah: However, the impact on ROEs is real, and it's going to be substantive. We think average ROEs for banks will dip below 1.5% In 2021 before returning to the pre-crisis levels of around 9% in 2024. That's in developed markets. Now that's essentially five years worth of lost returns, so returns below the cost of capital, significantly below the cost of capital. Now in Africa, I think fortunately, the impact has not been as severe and will be less severe going forward. Certainly our ROEs started from a much higher base, roughly about 14, 15%. And so whilst those have fallen by about 50%, to about 7% in 2020, we actually expect this to rebound near pre-crisis levels in the next three years.

Uzayr Jeenah: However, I must point out that African banks are facing a challenging path to recovery. Increasing risk, and the low-for-long interest rates owing to all-time high government debt levels, and subdued demand given low consumer business confidence are likely to be major headwinds facing them as they start to look beyond the crisis.

Kerry Naidoo: Well, we've been here or something like here before, and not that long ago. The last global financial crisis we faced was in 2008, that's only 13 years ago. Plus the Nigerian oil crisis from a few years back. Are there any important lessons from the last crisis that could help banks negotiate this one?

Uzayr Jeenah: A couple of points. The first one and the most important one is speed. Speed is everything at a time of crisis. It was the most important lesson from the 2008 crisis when we saw the American banks, and the US government respond quickly, we saw European banks, and banks in other parts of the world respond much more slowly. And as a consequence, they had to deal with the consequences for a very long time. And the banks that reacted decisively and quickly just fared much, much better. Have been much healthier and not had the problems to deal with. Of course, you got to be moving fast and in the right direction, as a strategic part of it, but you can't do this without moving quickly.

Kerry Naidoo: Of course. And many African banks have already acted boldly to manage the economic fallout of the pandemic. You could say that they've been pretty strategic already. What should their focus, their direction be now?

Uzayr Jeenah: So if I can just kind of stress right, the banks can't just wait for things to get better by themselves. Getting back to the pre-crisis levels is going to require significant effort from the banks. So if risks are not mitigated, our estimates suggest that the African banking market could lose more than $48 billion in post risk cost revenues by 2024. So that's the underlying driver for this, the low cost of capital returns that I was talking about earlier. And broadly, we think that there's three big things that you've got to do to fix it. The first one risk management, and it's an absolute imperative in bringing down the cost of risk.

Uzayr Jeenah: There's a second, which is about, how do I drive productivity across the institution and across the sector? And at the heart of that there's this huge shift to digital in the customer behavior. So how do I reduce the cost of my branch networks, et cetera. But also, how do I just digitize a lot of my back office processes? And then thirdly, as you heard me alluding to, at the heart of this and enabling all of this, is going to be technology. And actually being able to use technology to extract a lot of those cost savings, to unlock and enable some of those other revenue growth opportunities going forward is what's going to help to build a core strength and post pandemic resilience that the bank is going to need.

Kerry Naidoo: Okay. So you talk about productivity, scaling our technology, and risk management as the three areas of focus. Let's look at those three in more detail. Talk to us about why a focus on productivity is so crucial now.

Uzayr Jeenah: Productivity is always important of course, but in this context, it's particularly important for African banks to build the productivity engine. Because their cost to asset ratio is more than twice the global average. Now the impact on their returns has been masked, to an extent, by the high banking margins that are underpinned across the continent by a kind of relatively high interest rates. So even if you look at South Africa now, as an example, we're at the lowest rates in a generation, but rates in South Africa still... The prime lending rate is still 3.75% versus in Europe where central banks are lending out money at nil, or close to nil. And in some places even below nil.

Uzayr Jeenah: So I think that impact has helped to protect the banks for the kind of productivity challenges. But now, the rates of cotton we've had across the continent anywhere from 300 to 500 basis points, and 3 to 5% worth of interest rates cuts, and they're going to stay low for a while. Banks need to kind of actually start addressing those root causes. Based on our estimates, banks will need to increase their operating efficiency by 20, 25%, or it's a fifth to a quarter to get back to that pre-crisis ROE.

Kerry Naidoo: 20 to 25% increase. That's seriously upping the game. How do they do that?

Uzayr Jeenah: Yeah, absolutely. A big ask, but completely achievable and we believe. So, kind of four big levers that banks want to kind of improve their productivity, and to engage. And all of these are kind of fully within their control. And the first is really about resetting third-party spend. So in 2020, a lot of banks had some categories where demand has massively reduced, things like travel and events. And the most aggressive banks here are going to establish policies and really manage this demand, and reduce those costs into the future. Now there's some cases where demand has increased, telecoms, equipment around remote working. And banks that are going to be successful are establishing policies and already renegotiating their contracts with their telecoms and other providers to get volume discounts.

Uzayr Jeenah: Now, this kind of momentum needs to be sustained, and a lot of banks in 2020 already set up this, what we call, spend control towers, to really manage the demand. And this simply needs to continue. And last is this idea around supply a clean sheeting, really building up the detailed view of what it costs to provide a service. Understand supply margins, and made a call as to whether or not that's going to be something that you willing to tolerate. If your provider is earning return and equity is vastly in excess of the cost of capital, maybe that's somebody you need to go and have a discussion with.

Uzayr Jeenah: The other kind of big area is on, how do we think about these kind of what we call, minimum viable central functions? Really this question of what does a truly zero-based structure look like? And it starts with self-service, and automating processes, and really embracing that. And so in areas like HR and finance, many banks already on a path to achieving 20, 30% productivity gains through initiatives like this. With significant opportunities for other areas, like risk and compliance, still to come.

Kerry Naidoo: I'm guessing that the third lever has something to do with digital? McKinsey's Financial Insights Pulse Survey conducted in October, 2020, found that most consumers expect to increase their use of digital and mobile banking services after the crisis. That must impact on banks choices going forward.

Uzayr Jeenah: So, yeah, you're absolutely right. The third is absolutely all about digital, and banks will need to significantly change their makeup of channels, and footprint to get to this greater productivity. And we've been running these quarterly surveys across the continent on consumer behavior in financial services in Africa, and what you've seen is a huge shift, of course, towards different channels. But more importantly, a big part of that population then saying, "Hey, we're actually going to continue this behavior afterwards as well." And so how do banks actually start to capitalize on that adoption, both from a cost and productivity perspective, by accelerating their own digitization drive and channel migration, but also from revenue growth opportunity. Can I be the person who's the easiest to set up for merchant acquire? Can I be the person who's going to provide the sickest, simplest, cheapest, peer-to-peer payment transaction? Because the people who do that are going to be the winners, whether those are banks or non-bank financial attackers as well.

Kerry Naidoo: Well, I know that I'm not going to ever visit a physical branch again, unless I really have to. I definitely expect my bank to meet me online. What would you say is the fourth productivity lever?

Uzayr Jeenah: Absolutely. The fourth lever is really about how do you better use those kind of agile methodologies, and taking the lessons that people have learned from the crisis around, how do we take quick decisions, how do we collaborate remotely, and actually leveraging those kinds of things for it. So how do I improve the delivery of projects? How do I offer better access to online training? How do I actually get access to larger talent pools? Particularly for people in some of the smaller markets. Those are all about embedding new ways of working.

Kerry Naidoo: So increasing productivity was the first imperative for recovery and post pandemic resilience. The second imperative you spoke about was scaling our technology, which is also a part of increasing productivity. Just how important is technology becoming in the sector? And how can it be deployed in the short and longterm?

Uzayr Jeenah: Technology definitely has a huge role to play in helping banks to actually deliver on their productivity imperative. And then of course, to unlock future growth rate, whether it's through digital sales, whether it's through using analytics to identify new customer groupings and then be able to credit score them in ways that we haven't been able to do in the past. But there's separate opportunity, which is really, how do I actually just drive a ton of productivity, and cost savings, and speed to market in my IT engine?

Uzayr Jeenah: We think, based on our analysis, that there's opportunity to double productivity in the IT organizations of most African banks. So where does that come from? So there's two pieces. So one is how do I better use newer modular, typically cloud based technology platforms? And then the complement with that, is really around how do I use new ways of working?

Uzayr Jeenah: So in the short term, banks can do a lot more with less. Through probably kind of two or three pieces, but one is how do I really simplify the IT state. How do I automate the infrastructure provision, and a lot of leading banks, both here and across the world have done a lot there. And then on the software delivery side. And that's through continuous integration, continuous delivery CICD and in the trade platforms. And then actually just taking a much more granular approach to managing demand, and prioritizing it.

Uzayr Jeenah: And then in the longer term there's well, how do I actually think about using platform oriented architecture? And so that's going to move away from this typically, "Hey, I build one thing, I expected to use it." Versus "I actually built a series of what we call micro services that allows you to swap in and out of components and be upgrading much more quickly."

Uzayr Jeenah: And then much more use of public cloud where we've seen the likes of Google cloud, Amazon web services, Azure, et cetera, rolling out onto the continent, bringing their locations onto the continent here in South Africa, but in other places we've seen a wave of investment. And so banking it with a tap into that is going to help them bring that cost down significant.

Uzayr Jeenah: And so when we move more globally, we're seeing banks actually reducing costs by more than 20% through such initiatives. And you're starting to see African banks doing the same. And so actually being able to do this, really step changing the infrastructure, getting those productivity gains, can help banks then focus their attention on the growth agenda.

Kerry Naidoo: Uzayr, You mentioned a step change in infrastructure. What will this entail? What could be expected of chief information officers and of banks in order to affect this kind of shift?

Uzayr Jeenah: One way that banks are doing this pretty quickly is partnering with FinTechs, which have a lot of the skills, and off the shelf solutions that they can rapidly deploy. Contrary to popular belief, not all of them out here trying to eat the bank's lunch. Many more are eager to collaborate with established players, seeing them as a route to market for hundreds of thousands, even millions of customers.

Kerry Naidoo: Technology surely also has a role to play in strengthening the risk management muscle, your third imperative. We've seen how leading banks have significantly reduced their cost of risk management by embracing new technologies and processes. Uzayr, could you give us some examples and also talk to us about future possibilities?

Uzayr Jeenah: Yeah, absolutely. So the future is digital. And digital analytical tools hold real potential for banks to reduce the cost of risk management and also position themselves for a future return to growth. For example, let's talk about analytics, and real time reporting. And even using kind of relatively sparse data sets that all banks have like transaction data, debits and credits in and out of their core banking system, we can absolutely transform risk detection. We worked recently with a bank in East Africa, and built a early warning system for their SME clients using just the account transaction data that the bank already had. And it allowed us to get with 70, 80% probability, to identify potential defaults one to three months out in advance. Obviously this allows the bank to then intervene and potentially change the course of action and ensures that customers does not go into default.

Uzayr Jeenah: Now if we think about the broader digitize lending journey, and these are digital collections, another great example of how operations can really streamlined and enable banks to make better decisions, at a much lower cost. And so these new analytical capabilities will also allow bank to capture some real growth opportunities in the future. Untapped segments, areas like SME, non salaried workforces, basically areas of the economy, where banks have struggled in the past to assess risk. And some of that is going to come from learning from FinTechs and other kind of innovators. So one bank that we know has taken an equity stake in a non-bank lender, with some really innovative credit scoring capabilities, and a new business model that revolves around the ability to allow them to serve SME customers better. So really no shortage of digital possibilities. If anything, I'd say the shortage is in a bank's ability to ingest all of these opportunities, prioritize it, put the right capabilities against it, and then really grasp those opportunities.

Uzayr Jeenah: At the moment around 70% of technology capacity is directed towards maintaining the current IT infrastructure for daily operations. You have to fix the bugs, you have to make sure that everything's still working, and manage the known and emergent technical debt as it arises. And so as we move and shift towards a much more platform oriented architecture, automated infrastructure with public cloud underneath it, there's going to be a real opportunity to move and redeploy resources across the IT estate. And so using those freed up resources, CIOs can reinvest and redeploy employees in completely new capabilities. Digital first sales and servicing, growing in analytics, just delivering new products faster, and even potentially exploring new business lines, new business opportunities, ecosystems, et cetera. And so ultimately by scaling up their technology banks may be able to serve an increasing amount of demand at a much, much lower cost.

Kerry Naidoo: Uzayr, it's been such a pleasure talking to you, and hearing your views on the state of banking, and your analysis on how the sector can take significant strides forward, providing better service with greater reach and so importantly, as you say, contributing to recovery on the continent. Any last takeaways for our listeners?

Uzayr Jeenah: Only to encourage African bankers to heed the lessons from the 2008 global financial crisis, and all of the many crisis we've had in Africa, Nigerian oil crisis, interest rate corridors in Kenya, et cetera. And that's act quickly, act decisively, and move with certainty. Africa needs a robust and resilient banking sector.

Kerry Naidoo: On that note, I'd like to thank our listeners of our McKinsey Africa podcast series. If you'd like to learn more about this particular report, African banking in the new reality, we encourage you to visit our insights page on mckinsey.com, where you may also find links to our latest insights. We also encourage you to follow us on Twitter by searching our handle @McKinseyAfrica and follow us on LinkedIn by searching McKinsey Africa. Thanks again for listening, and we hope you can join us again soon.