A Financial Plan for Emerging Markets

(Corrects the number of Chinese banks among the world's largest in the eighth paragraph.)

The past two decades were an idyllic time to be in financial services. The global housing boom, worldwide rise in living standards and wealth, and the liberalization of financial markets fueled record profits for many banks, insurers, and capital-markets firms. But the housing bust and resulting downturn brought this era to an abrupt end, and three years later many financial-services executives are still looking for the formula that will enable them to recapture that earlier level of growth and profitability.

The answer is in emerging markets like China, Brazil, India, and Russia, which collectively will account for all of the world's economic growth this year. But to succeed, financial institutions will have to move quickly to develop new, and cheaper, ways of reaching consumers in these markets, where profit margins are much thinner than what U.S. and European firms are accustomed to back home. Up to now, even the most entrenched foreign companies have generated profits that were no more than a fraction of what they traditionally earn in their home markets. And the competition is only getting tougher in regions like Asia and East Africa, where the old order is already being upended by nontraditional players like retailers and cellular-service providers that are grabbing much of the growth for credit and other banking services.

If for no other reason than demographics, U.S. and European banks can't afford to ignore the emerging markets. In its latest projections, the U.N. estimates that the developing world will add 1.5 billion workers to its labor force by 2050, while the developed world will shrink by more than 100 million people. What's more, the Organization for Economic Cooperation and Development, for one, predicts that emerging countries will overtake the developed economies and contribute nearly 60 percent of global economic output by 2030.

Window Closing

Given the ascent of well-capitalized domestic players and the steady gains enjoyed by early movers like Santander (STD) and Grupo BBVA (BBVA)—which now generate 40 percent of their profits from these growth markets—the window of opportunity within these markets is closing quickly. Still, the penetration rates for financial services remain low in many of these countries. Consider that in Mexico the number of new credit accounts opened each year has doubled over the past decade, to roughly 700,000 last year. But consumers increasingly are bypassing the established banks in favor of alternative sources that are more flexible in their credit standards. According to a recent World Bank study, non-banks are providing the majority of new credit accounts in Mexico, with nearly half of all new credit accounts being opened by department stores, 6 percent coming from government sources, and another 26 percent coming from "other" sources. By comparison, banks, finance companies, and S&Ls accounted for less than 10 percent of this new credit.

Other challenges abound. Many emerging countries in Asia, Africa, and South America still place a variety of restrictions on foreign financial firms, be it to regulate outside capital flows or to protect their domestic companies. New entrants also must show they can operate with a much lower cost structure, given the lower household incomes and the thinner margins on products. Creating leaner, more efficient operating models will be imperative, because even those U.S. and European financial-services firms that have succeeded in building up in emerging markets like China have mostly generated revenues that, in aggregate, are less than those of the native competitors.

For insurers, that might mean consolidating the asset management and other support functions at headquarters or in regional hubs across the world. Insurers could then enter each country with just a sales and marketing team, allowing them to operate profitably in smaller countries where they couldn't hope to achieve the usual critical mass. And they'll need to embrace some of the new technologies like mobile banking that are taking off in many emerging markets. While only a third of adults in the largest emerging economies have bank accounts, a larger share—roughly half—have cell phones.

Low-Cost Services

That is providing an opportunity for some financial-services firms to serve the masses with a low-cost solution. For instance, one of India's largest mobile-phone operators can enable an Indian working in the city to load money onto his cell phone, which can be collected by a relative in a rural area. Some U.S. banks are getting ahead of the competition: Citibank has partnered with Zain, a Kuwaiti wireless service provider, to sell mobile banking services in East Africa and other rural areas.

In addition to these upstarts, banks face stiff competition from the native banks, some of which have achieved the scale to compete aggressively for business customers. Three of the world's five largest banks are now Chinese. What's more, banks in China, Brazil, and other emerging countries have held up far better than their Western rivals during the downturn, maintaining capital ratios that are largely 10 percent to 15 percent, vs. the average 8 percent capital ratios for banks in developed economies.

The emerging markets may not provide the immediate payoff of, say, funding a large private-equity deal, bundling mortgages into securities, or any of the other activities that defined the past two decades. But providing mobile credit in places like East Africa may be the future of banking. And with luck, it could one day be as profitable.

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