This article first appeared in The Edge Malaysia Weekly on October 16, 2023 - October 22, 2023

THANKS to aggressive interest rate hikes around the world, 2022 and 2023 are turning out to be the best years for global banking sector profits since the 2008 global financial crisis, though with considerable variation between institutions, according to McKinsey & Co.

The rate hikes resulted in a long-awaited improvement in banks’ net interest margins, which helped boost the global sector’s profits by about US$280 billion in 2022.

This lifted the sector’s return on equity (ROE) to 12% in 2022 and it is expected to reach 13% in 2023, compared with an average of just 9% since 2010, the New York-based consulting firm said in its global banking annual review released last week.

However, with growing macroeconomic headwinds, including the recent eruption of war between Israel and Hamas, can banks sustain those ROEs going into 2024?

According to Renny Thomas, a senior partner at McKinsey, a contraction of global banking margins may be coming.

“For now, there appears to be a sense of stabilisation and cautious optimism about the short-term outlook. However, [the] long-term outlook depends on the trajectory of interest rates and the macroeconomy,” Thomas tells The Edge.

He notes that value creation diverges widely among business models and products, as well as across markets.

“In a sustained high-interest-rate environment, some of the successful business models of recent years could be challenged. Conversely, for traditional banks based on a balance sheet model, higher rates and spreads can potentially bring about a revival in their prospects.

“Despite [the] recent positive performance, our analysis suggests that some contraction of global banking margins from here may happen. Gains in net interest income could be short-lived and interest margins could decline again if and when interest rate hikes slow, and ultimately reverse. Having said that, there will still be a number of ‘North Stars’ that will outperform and create significant value,” he says. North Stars refer to banks that offer high returns today and also have future growth.

Thomas believes that banks grouped along the crescent formed by the Indian Ocean — or what is termed the “Indo Crescent”, which stretches from Singapore to India, Dubai and parts of eastern Africa — will continue to do well, despite the growing challenges.

Interestingly, in its report, McKinsey found that slightly more than half of the world’s best-performing banks are currently to be found in the Indo-Crescent region. In contrast, in Europe, the US, China and Russia, banks have on the whole struggled to generate their cost of capital.

“The Indo-Crescent region is home to 8% of global banking assets and 51% of the top- performing financial institutions globally that are achieving breakthrough growth and is expected to continue to do well,” says Thomas.

“This superior performance is enabled by several factors, including higher gross domestic product and population growth in some, but not all, of the Indo-Crescent countries. Note that countries along the crescent include not only advanced economies such as Australia and Singapore, but also developing markets, such as Indonesia, India, Kenya and the Middle East. Other enablers of high performance include breakthrough disruptions, ecosystem plays, and cost-efficient service delivery models,” he adds.

McKinsey sees Malaysia’s banking industry revenue expanding at a compound annual growth rate of 6% from 2021 to 2030 — the same as for Singapore, Thailand and Australia. It expects a stronger growth rate of 8% for Indonesia, 12% for Vietnam and 10% for the Philippines over the same period, but a slower rate of 5% for China.

The consulting firm notes that the global industry may be undergoing a phase in which a long-term macroeconomic turning point — including a higher-for-longer interest rate scenario and an end to the asset price super cycle — changes the attractiveness of some models that were specifically geared to the old environment, while other structural trends — especially in technology — continue.

“Fundamentally, the question for banks is, to what extent can they offer the products that people are looking for, at a time when risk capacity is broadening and many are searching for the highest deposit yields?

“Regardless of the macroeconomic developments, all financial institutions will have to adjust and adapt to the changing environment of the great banking transition, especially the trends of technology, regulation, risk and scale. Mergers and acquisitions may gain importance,” it adds.

McKinsey notes that, increasingly, financial assets have been growing and migrating out of banks’ balance sheets — that is, away from corporate and retail deposits, bank bonds, and other liabilities and equity — and into non-banks, or off-balance-sheet vehicles such as public pension funds, digital assets, private capital and institutional assets under management.

“This is most visible in the shift from bank deposits to money market funds,” it notes.

In the US, more than 75% of the net increase in financial funds now go off the banking balance sheet. In Europe, the figure is about 55%. In contrast, the proportion of off-balance sheet in China is less than 30%, while in Latin America it is less than 40%.

Meanwhile, the consulting firm found that one aspect of banking that has not changed, despite the better profits recently, is the sector’s price-to-book ratio. The ratio stood at 0.9% in 2022, unchanged since the 2008 financial crisis, reflecting some of the long-term systematic challenges the sector is facing, but also suggests possible upside, McKinsey says. 

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