Divergent Growth: Post-COVID Banking

GDS Modellica
20/01/2022
An unprecedented global event that had such a profound effect on all aspects of life that one of the most key strategic sectors took a battering but has managed to stay on its feet – could this be the best way to describe the impact of COVID-19 on the banking industry? The latest annual report published by McKinsey certainly appears to reach that conclusion. The sector has not only survived better than expected but forecasts for the next few years are also reasonably optimistic. However, we should remember that we are living in a time of exceptional instability.

The pandemic has undoubtedly had a severe impact on the economy, leading to collapses in many sectors, and the medium-term outlook for recovery is still a little hazy. But the impact on the banking industry has been somewhat surprising, particularly the fact that it has not witnessed any “abnormal” losses, performing better than most analysts expected.

For example, Return on Equity (ROE) in 2020 was 6.7%, which is greater than the 4.9% seen in 2008 when the financial bubble burst, and even though this figure is below the Cost of Equity (COE), it is still significantly better than expected.

This unusual situation is largely due to consumer behaviour, with people opting to prioritise savings given the growing uncertainties. However, even if the pandemic has not wrought complete disaster, it has still had a deep and lasting impact on the global banking industry: digital banking has accelerated, cash use has fallen and working from home has been normalised. Furthermore, both customers and regulators have become increasingly demanding, with a particular emphasis on matters ranging from the environment and sustainability to fraud prevention and data security.

The McKinsey report’s executive summary confidently states that “the banking system is at least as solid as it was before the pandemic—and much healthier than after the last crisis”. However, it also warns that it is “not really” possible to say that a “bright and smooth” future lies ahead for banks or their shareholders. Banks’ performance on two basic measures (ROE and the market-to-book ratio) is the first challenge which, if tackled, would allow the sector to steer clear of any surprises in the medium term.

Just over half of banks (51%) operate with an ROE below COE and 17% are below COE by more than 4%. “In an industry that has high capital requirements and is operating amid low interest rates, creating value for shareholders is structurally challenging”. And all this is taking place against a backdrop in which shareholders and governments have provided capital injections to the tune of almost $2.8 trillion over the last 13 years.
As for the market-to-book ratio, banks are trading at about a third of what we can find in all other industries and 70% of the value of financial institutions excluding banks. In fact, almost half of banks (47%) are trading for less than the equity on their books. These are persistent undervaluations even after a period (February 2020 to October 2021) in which the financial system as a whole gained around $1.9 trillion.

In their report, McKinsey analysed 599 financial institutions, of which little more than a tenth (65) managed to accrue all the gains, compared with 519 that maintained relative stability with gains or losses of up to $8 billion in market capitalisation. Fifteen of the institutions analysed clearly deserve the title of “underperformers”, recording losses of more than $8 billion.

We at GDS Modellica highly recommend reading the full report, which covers various topics, including predictions up to 2025. According to McKinsey, their expectation is that the next five years will see the industry move from “convergent resilience” to “divergent growth”. “In a low-interest-rate world, a commoditized business model based on the balance sheet yields less income and brings no differentiation to the customer. If we split revenues between those generated by the balance sheet and those that come from origination and sales (for example, mutual funds distribution, payments, consumer finance), the trend is clear: growth and profitability are shifting to the latter category, which has an ROE of 20 percent”.
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