Covid-19 aftermath could wipe off $4.7 trillion from banking sector

The global banking sector faces a multi-trillion stress-test in the coming three years, according to a new review of the industry by consulting giant McKinsey & Company. By the firm’s reckoning, banks could lose as much as $4.7 trillion in cumulative revenue by 2024, threatening a huge decline in return on equity if financial institutions do not act swiftly.

Throughout the coronavirus pandemic, banks have played a key role in offsetting the worst economic impacts. As well as supporting small businesses, companies and individual citizens through their own lending, banks have also been an essential conduit for state support – such as the British Business Bank’s Future Fund – which have been vital for keeping many companies afloat during the lockdown months.

While financial institutions were rightly admonished for their role in the Great Recession of 2008, then, this time they have been crucial in helping bolster the economy in a period of ever-deepening crisis.

According to the latest research from McKinsey & Company, however, this has placed banks in an extremely vulnerable position with regards to the coming four years. The consultancy’s Global Banking Annual Review suggests that while the industry has withstood the stress-test of Covid-19 to-date – demonstrating resilience and purpose in the process – the test presented for banks by the pandemic will evolve in two stages in the months and years ahead.

First, this means severe credit losses, and while “almost all banks and financial systems are expected to survive” that, amid a muted global recovery, banks will then face “a profound challenge to on-going operations” in the form of tumbling return on equity.

Globally, loan-loss provisions in the first three quarters of 2020 surpassed those for all of 2019. The situation may peak with loan-loss provisions accounting for just over 1% of all loans in the case of a rapid recovery – however, it looks more likely that there will be a muted or a stalled recovery at present, suggesting that by 2021 they could exceed those of the 2008 financial crisis. According to McKinsey, depending on how slow the economy is to recover in the coming years, banks could face a $1.5 trillion to $4.7 trillion loss in cumulative revenue between 2020 and 2024 due to this.

In McKinsey’s base-case scenario, $3.7 trillion of revenue will be foregone – the equivalent of more than a half year of industry revenues that will never return. Alone, this would be something the banking system could withstand, however, in that same scenario, return on equity (ROE; a measure of financial performance calculated by dividing net income by shareholders' equity) would continue its decline, from 8.9% in 2019 to 4.9% in 2020 to 1.5% in 2021.

The researchers suggest that regionally the impact of this could vary, however it will likely be felt worst in North America and Europe – both home to a number of the world’s largest financial hubs. ROE could fall as low as -1.1% in North America at their worst point during 2021, while in Europe this could collapse as low as -1.8% – notably worse than the -0.2% in developed Asia. This could see global profitability of banks fall beneath the rates seen at the last recession, in the event of anything but a rapid recovery.

According to Matthieu Lemerle, London-based Senior Partner and report author, banks will need to take urgent action to mitigate the situation. He explained, “Answers are available for each of the problems banks will face in the coming ‘long winter’ of zero percent rates continuing to reduce net interest margins, pushing incumbents to rethink their risk-intermediation-based business models; the need to re-build capital buffers and the inflation of risk-weighted assets. We see opportunities on both the numerator and denominator of ROE: banks can use new ideas to improve productivity significantly and can simultaneously improve capital accuracy.”

For the long term, then, banks need to reset their agenda in ways that few expected nine months ago. McKinsey’s study set out three imperatives to position banks well against the trends now taking shape. First, banks will need to embed newfound speed and agility in their operations, evaluating their response to the crisis and finding ways to preserve the best practices they learned during it.

Second, banks are advised to “fundamentally reinvent their business model” to compensate for the zero percent interest rates during the continuing crisis, as well as other economic challenges, while also adopting the best new ideas from digital challengers.

Finally, McKinsey suggests that banks need to bring their broader purpose to the fore, especially environmental, social, and governance issues – as the crisis presents an opportunity to collaborate with the communities they serve to recast their contract with society – something which will help improve their public perception in the long-run.