Banks Must Reinvent Themselves to Survive Next Recession: Report

The global banking sector seems to be hanging by a thread. More than half of banks are not generating enough profit and need to find a fast way to reinvent themselves if they are to survive the impending economic downturn. These are the findings from a McKinsey & Co. study of banking services.

Almost 60% of banks are not generating enough return on equity. If the economy weakens in the next few years, this problem could become much more serious. “A prolonged economic slowdown with low or even negative interest rates could wreak further havoc,” the report stated.

According to Chira Barua, a co-author of the McKinsey report, this is a “do or die” moment for banks. Barua explained that a recession could mean disaster for banks if they don’t manage to reinvent themselves in time to recover their revenue-generating abilities. “Whilst imaginative institutions are likely to come out leaders in the next cycle, others risk becoming footnotes to history. However, there are steps every bank can take today to change their fortunes and begin the next cycle on a stronger footing, but time is running out. Boards and management should actively consider strategic moves now instead of the cycle forcing it on them in a downturn,” he said.

Low interest rates and fintech are the biggest threats

All across the globe, banks are having to face record-low interest rates. Governments cut interest rates to prevent an economic downturn, because lower rates encourage investing and borrowing. However, banks can suffer from lower interest rates because low rates restrict them from making a profit. This adds pressure to margins, and when rates turn negative, as they have in Europe, banks actually get penalized for storing cash deposits at central banks.

In addition to this, banks are threatened by the latest fintech solutions. Companies such as Revolt and Apple have entered the banking space, and they’re creating new IT solutions, using their resources to bring an edge to banking, making operations and processing easier and cheaper for consumers. This makes banks less competitive. According to the McKinsey study, most banks set aside only 35% of their IT budget to innovation and new strategies. In contrast, fintech companies usually set aside 70% of the IT budget for innovation.

While the report doesn’t name specific banks, it does outline a path the industry needs to take if banks want to stay afloat and get past economic downturns. The key priorities should be artificial intelligence-led risk management systems, identifying customer bases, data analytics, and hiring more talent in the digital field.

Last month a separate report was released by PwC Luxembourg and development agency Luxembourg for France. The report said that European banks and wealth managers need to turn to so-called “Amazonization” and translate their business to consumer-driven online platforms.

“With Europe’s financial industry facing up to Amazonization and the critical themes like ESG (environmental, social and governance) innovation and technology that accompany it, more traditional players must focus and invest, if they want to remain competitive on a global scale,” said John Parkhouse, senior partner at PwC Luxembourg.

Categories of banks

According to the McKinsey report, there are currently four categories of banks: market leaders, resilience banks, followers, and challenged banks.

Market leaders are the top 20% of banks that capture 100% of the economic value added by the entire industry. The resilients are the next 25%: banks that have managed to maintain their leadership despite the changing markets.

The followers are the next 20%: banks that are weaker than their peers and haven’t managed to achieve scale despite good market dynamics. They are at risk from recession and they need to change their business model and cut costs if they are to survive. The last 35% are the challenged banks. These are the institutions that are underperforming at all levels. The McKinsey report warns that their business models are inherently flawed and bound to lead to catastrophe when economic headwinds come: “To survive a downturn, merging with similar banks or selling to a stronger buyer with a complementary footprint may be the only options if reinvention is not feasible.”