Banks sit at the center of a vast, complex system that intermediates more than $250 trillion in global funds. What happens when the system itself is significantly streamlined and reshaped?
A decade after a financial crisis that shook the world, the global banking industry and financial regulators have worked in tandem to move the financial system from the brink of chaos to a solid ground with a higher level of safety. In numerical terms, the global Tier 1 capital ratio — one measure of banking-system safety — increased from 9.8 percent in 2007 to 13.2 percent in 2017. Other measures of risk have improved as well; for example, the ratio of tangible equity to tangible assets has increased from 4.6 percent in 2010 to 6.2 percent in 2017.
Performance has been stable, particularly in the last five years or so and when the above-mentioned increases in capital are figured in (Exhibit 1), but not spectacular. Global banking return on equity (RoE) has hovered in a narrow range between 8 and 9 percent since 2012 (Exhibit 2). Global industry market capitalization increased from $5.8 trillion in 2010 to $8.5 trillion in 2017. A decade after the crisis, these accomplishments speak to the resiliency of the industry.
But growth for the banking industry continues to be muted — industry revenues grew at 2 percent per year over the last five years, significantly below banking’s historical annual growth of 5 to 6 percent.
Compared to other industries, the RoE of the banking sector places it squarely in the middle of the pack. However, from an investor’s point of view, a jarring displacement exists. Banking valuations have traded at a discount to non-banks since the 2008–2009 financial crisis. In 2015, that discount stood at 53 percent; by 2017, despite steady performance by the banking sector, it had only seen minor improvements at 45 percent (Exhibit 3).
What do investors know or think they know about the future prospects for the banking industry? In part, low valuation multiples for the banking industry stem from investor concerns about banks’ ability to break out of the fixed orbit of stable but unexciting performance. Lack of growth and an increase in nonperforming loans in some markets may also be dampening expectations. Our view, however, is that the lack of investor faith in the future of banking is tied in part to doubts about whether banks can maintain their historical leadership of the financial intermediation system.
By our estimates, this financial-intermediation system stores, transfers, lends, invests and manages risk for roughly $260 trillion in funds (Exhibit 4). The revenue pool associated with intermediation — the vast majority of which is captured by banks — was roughly $5 trillion in 2017, or approximately 190 basis points. (Note that as recently as 2011, the average was approximately 220 basis points.)
Banks’ position in this system is under threat. The dual forces of technological (and data) innovation and shifts in the regulatory and broader sociopolitical environment are opening great swaths of this financial intermediation system to new entrants, including other large financial institutions, specialist-finance providers and technology firms. This opening has not had a one-sided impact nor does it spell disaster for banks.
Where will these changes lead? Our view is that the current complex and interlocking system of financial intermediation will be streamlined by the forces of technology and regulation into a simpler system with three layers (Exhibit 5). In the way that water will always find the shortest route to its destination, global funds will flow through the intermediation layer that best fits their purpose.
The first layer would consist of everyday commerce and transactions (for example, deposits, payments and consumer loans). Intermediation here would be virtually invisible and ultimately embedded into the routine digital lives of customers. The second and third layers would hinge on a barbell effect of technology and data, which, on one hand, enables more effective human interactions and, on the other, full automation. The second layer would also comprise products and services in which relationships and insights are the predominant differentiators (for example, M&A, derivatives structuring, wealth management, corporate lending). Leaders here will use artificial intelligence to radically enhance but not entirely replace human interaction. The third layer will largely be business to business, such as scale-driven sales and trading, standardized parts of wealth and asset management and part of origination. In this layer, institutional intermediation would be heavily automated and provided by efficient technology infrastructures with low costs.
This condensed financial intermediation system may seem like a distant vision, but there are parallel examples of significant structural change in industries other than banking. Consider the impact of online ticket booking and sharing platforms such as Airbnb on travel agencies and hotels or how technology-enabled disruptors such as Netflix upended film distribution.
Our view of a streamlined system of financial intermediation, it should be noted, is an “insider’s” perspective: we do not believe that customers or clients will really take note of this underlying structural change. The burning question, of course, is what these changes mean for banks. McKinsey’s view is that there will be four strategic options open to banks in the reshaped system:
• The innovative, end-to-end ecosystem orchestrator.
• The low-cost “manufacturer.”
• The bank focused on specific business segments.
• The traditional but fully optimized and digitized bank.
The right path for each bank will, of course, differ based on its current sources of competitive advantage and on which of the layers matches its profile — or the profile it intends to take in the future.
We believe the rewards will be disproportionate for those firms that are clear about their true competitive advantage and then make — and follow through on — definitive strategic choices. The result will be a financial sector that is more efficient and delivers value to customers and society at large. That is a future that should energize any forward-looking banking leader.