Banks must make deeper and more sweeping cost reductions if they want to restore profitability levels that are acceptable to investors, McKinsey & Co. said in an annual review of the industry.
“It has to go a lot further,” Toos Daruvala, a director in the consulting firm’s North American banking practice and a co-author of the report, said yesterday in a phone interview. “Banks have done quite a lot on cost-cutting but frankly the environment has deteriorated over the last year” because of economic weakness, he said.
Banks globally are failing to produce return on equity -- a measure of how well they reinvest shareholder money -- that meets investors’ requirements, McKinsey said in the report. Higher capital requirements imposed by regulators, low interest rates that reduce how much banks earn on loans, slow economic growth and new rules that eliminate or reduce some fee income have hurt results, Daruvala said.
“Banks are sort of running to keep in place,” Daruvala said. “We’re still two to five years out from creating a more normalized return environment.”
Global banking return on equity, or ROE, fell to 7.6 percent in 2011 from 8.4 percent a year earlier, “well below” the 10 percent to 12 percent average cost of equity, McKinsey said in the report titled “The Triple Transformation: Achieving a Sustainable Business Model.” U.S. banks earned an average ROE of 7 percent last year and European lenders earned zero -- or 5 percent when excluding the most indebted nations such as Spain and Greece, according to the report.
“I still see a lot of banks do what I would call ‘belt-tightening’ as opposed to structural, more fundamental cost reduction,” Daruvala said. “If you look at other industries that have had to have massive cost-takeout, like the auto industry in the ’90s or the telecom industry, they managed to cut costs by 30-plus percent.”
For banks that are large, diverse, global and complex, “one of the big levers on the cost front is massive simplification,” he said.
That doesn’t mean the biggest, most complex banks must break up, a measure that some investors and former industry executives advocate, Daruvala said.
“Breaking up is one answer, the other way is to simplify as well,” he said. “To me the issue is not so much size as it is complexity.”
European banks in particular could benefit by doing more financing through the capital markets, like issuing high-yield bonds for clients instead of giving them loans that banks hold on their own balance sheets, Daruvala said. About 19 percent of total financing in Europe is in the form of securitized loans and corporate debt, compared with 64 percent in the U.S., according to the report.
Securitized products were promoted in the late 1980s by McKinsey consultants including Juan Ocampo and James Rosenthal in their 282-page book “Securitization of Credit: Inside the New Technology of Finance.”
“Some forms of securitization would make sense for Europe,” Daruvala said, referring to the practice of selling bonds backed by a pool of loans. That depends on “obviously having learned the lessons of the crisis, and there’s a lot of lessons to be learned there about what kinds of capital-market solutions make sense and others that don’t.”
One solution that does would be “plain vanilla” securitization such as “a simple mortgage-backed security with some of the risk held on the originator’s balance sheet,” he said. “Obviously, I don’t mean those crazier forms of securitization like CDO-squareds and so forth,” he said, referring to collateralized debt obligations made up of other collateralized debt obligations.
Mortgage-backed securities and collateralized debt obligations, which are bonds backed by pools of debt, were among products that caused more than $1.5 trillion of losses and writedowns at banks worldwide from 2007 through 2009, leading to the biggest-ever government bailout of financial companies.
Global regulators, led by the Basel Committee on Banking Supervision, now demand that banks have more capital to buffer potential losses on such products.
McKinsey alumni have gone on to senior banking jobs. They include Peter Wuffli, who was replaced as UBS AG (UBSN)’s chief executive officer in July 2007 as credit losses began eroding profit; Johnny Cameron, who ran Royal Bank of Scotland Plc’s investment bank until October 2008; Stephen Green, former CEO and chairman of HSBC Holdings Plc (HSBA); Peter Sands, CEO of Standard Chartered Plc; and Morgan Stanley (MS) Chairman and CEO James Gorman.
The industry’s position in the economy, measured by banking revenue as a percentage of gross domestic product, won’t reach pre-crisis levels before 2020, McKinsey said in its report.
“For the past three decades, the regulated global banking sector grew faster than underlying national economies,” according to the report. “This trend has come to a halt.”