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Value creation in European banking 2012

December 2012

Patrick Beitel

Joao Castello Branco

Pedro Carvalho

Ramandeep Chawla

Arpit Gupta

Oliver Vins

Zane Williams

Banking and Securities (Europe)

Contents

Value creation in European banking 2012

Introduction 1

Sources of underperformance 2

Different business lines face unique challenges 4

Retail banking 4

Corporate and investment banking 5

Private banking 5

Investor expectations 7

Needed: Clear strategic decisions 9

Increase revenue margins by improving strategic and tactical pricing 10

Apply smart methods to align the cost base to the new normal 11

Be prudent and keep future risks low 11

Improve resource allocation 11

Rethink portfolio strategy and take decisive actions with regard to noncore assets 12

1

Value creation in Europeanbanking 2012The performance of European banks took a turn for the worse in late 2011 and 2012, reversing signs of improvement in 2010 that had many investors and analysts thinking the crisis had largely passed. Instead, profitability in general has fallen, with the banks in our sample losing half of their market value of €700 billion over five years, largely due to a dramatic decline in operating profitability and major write-downs of around 40 percent of the capital that was in place at the beginning of 2007. In particular, while retail banking has stablilized, corporate- and investment-banking businesses are generating low profits and are a drag on overall performance and valuations. Private banking remains the most profitable of the three businesses we examined in detail and the only one to create substantial shareholder value—though at much lower levels than in 2007.

Turning performance around in the face of challenging macroeconomic conditions and more stringent capital requirements will require a substantial transformation of portfolios and business models by many of the banks in Europe. In addition, we believe banks will have to be more systematic in how they allocate capital and measure and monitor the performance of their portfolios of businesses.

IntroductionThe credit crisis that began in 2008 resulted in poor shareholder returns and earnings performance for banks generally and for European banks in particular. Indeed, McKinsey analysis shows that since the beginning of 2007, the total return to shareholders (TRS) for banking and insurance companies worldwide has trailed the market by about 6 percent per year and underperformed every other sector during the same period. Earnings for banks and insurance companies have followed a similar path and currently remain 15 to 20 percent below their 2007 levels.

To better understand the performance of European banks, we analyzed a representative selection of 40 of Europe’s largest banks (representing about 85 percent of the asset base and about 90 percent of the market capitalization of the sector) from 2007 to 2011. Specifically, we analyzed the financial performance and valuations of these banks over time. We also examined the performance of the three largest business units of these banks and related the business unit–level performance to the performance of the groups overall. 1 Our analysis found that European banks have underperformed, earning a lower TRS over the past five years than banks in any other region—and trailing North America and Asia annually by 7 percent and 15 percent, respectively (Exhibit 1). The sovereign-debt crises that intensified in 2011 accentuated these trends, and from January 2011 to September 2012, European banks had an annualized TRS of –15 percent.

The scale of lost value is staggering. Over the five-year period, the 40 banks in our sample combined lost 50 percent of their market value, or €700 billion—a drop in market capitalization that actually exceeded their total book value

1 Of the 40 banks we examined, 32 separately reported data for a retail-banking business unit, 28 reported data for a corporate and investment-banking business unit, and 10 reported data for a private-banking business unit. That data allowed us to estimate business unit valuation industrywide using a regression model.

Total return to shareholders for global banking indexes,1%

1 Represents defined banking indexes from Datastream. 2 Represents a sample set of Europe’s 40 largest banks used in our analysis.

Source: Datastream

Latin Americanbanks

European Unionbanks2

North Americanbanks

Rest-of-world banks

Asian banks

Jan 2007–Sept 2012 Jan 2011–Sept 2012

Exhibit 1 Within the world banking industry, Europeanbanks have been the laggards.

–1

–16

–9

–7

11

–15

–1

–6

–4

–8

2

at the beginning of 2007. In other words, they’ve lost more value than they had in capital invested when the crisis began.

Not every player performed poorly: corporate and investment banks did best when they cut costs, but not so deeply as to preclude growth. And retail banks that managed to increase or sustain higher returns on equity (ROE) actually improved their revenue yields substantially. But turning performance around more generally in the face of challenging macroeconomic conditions and more stringent capital requirements will require a substantial transformation of portfolios and business models by many of the banks in Europe. In practice, this means that banks must make clear strategic decisions along five dimensions: improving margins through better pricing, reducing costs in line with the new normal of lower revenues, improving risk management, increasing capital efficiency, and rethinking portfolio strategy.

Sources of underperformance Much of the poor performance among Europe’s banks is due to a dramatic decline in operating profitability and major

write-downs (Exhibit 2). The banks in our sample wrote off assets worth approximately 40 percent of the capital that was in place at the beginning of 2007, contributing to an annualized 8 percent drop in TRS since 2007. Rising loan-loss provisions (LLPs), increasing cost-to-income ratios, and higher capital ratios reduced operating ROE, with operating profits falling from 1.4 to 0.8 percent of risk-weighted assets (RWA). The ratio of tangible equity to RWA has also increased, from 8.2 to 12.1 percent, further depressing ROEs and leading to a 21 percent decline in TRS (Exhibit 3). Rising price-to-earnings (PE) multiples have since partially offset the losses from poor performance, suggesting that investors expect performance to recover somewhat (although not to return to previous levels). More recent drivers of TRS performance have followed the same pattern: in 2011, write-offs and falling ROEs lowered bank TRS, but rising PE ratios offset some of the damage.

Poor ROE performance has also destroyed value from an economic-value-added perspective. ROEs remained well below the cost of equity from 2008 to 2011, destroying €278 billion—far more than the €179 billion the industry created from 2001 to 2007, when ROEs exceeded the cost of equity (Exhibit 4).

1 Book value of equity is measured excluding goodwill.2 Compound annual growth rate.

Source: Capital IQ; Datastream; McKinsey analysis

Total TRS –16

Compounding effect 2

Change in trailing price-to-earnings multiple 13

Net change in book value 2

Change in operating return on equity (excluding write-offs) 21

Impact of write-offs 8

Earnings yield 5

CAGR, Jan 2011–Sept 2012

–15

0

29

2

20

27

4

CAGR,2 Jan 2007–Sept 2012

Exhibit 2 A decline in profitability has resulted in negative returns for European banks since 2007.

Decomposition of total return to shareholders (TRS) for sample of 40 European banks,1 %


Value creation in European banking 2012 3

1 Book value of equity is measured excluding goodwill, based on a sample of 38 banks.2 Represents a multiplier of change in operating profit and change in equity.

Source: Annual results and presentations; McKinsey database on venture capital in banking

Levers for changes in ROE Change in operating profit normalized by risk-weighted assets (RWA)

2011 operating ROE

Interaction term2

Impact of change in equity

Impact of change in operating profit

2007 operating ROE

2011 operating profit/RWA

RWA growth 0

Tax 0.1

Additional loan-loss provisions

Operatingexpenditures

Noninterest income

Net interest income


Operating return on equity (ROE) excluding write-offs,1 2007–11, %

Exhibit 3 Operating ROE declined due to higher costs, increased provisioning, and equity requirements.

6.52.2

4.9

7.716.9

1.0

0.4

0.5

0.8

0.8

1.4

Value-creation perspective, %

Source: Capital IQ; Datastream; McKinsey analysis

2007200620052004200320022001 2011201020092008

COE

ROE

20062005200420032002

–2

2001

–86

20112010

–46

2009

–69

2008

–77

2007

Evolution of economic profit, € billion

Value creation: reported ROE > COE

Economic profit = shareholders’ equity x (reported ROE – COE)

10%

179 –278

8%

Average reported return on equity (ROE)

Average cost of equity (COE)

Exhibit 4 European banks have destroyed significant shareholder value.

05

10152025

3757452994

4

Different business lines face unique challengesIndividual lines of business within banking groups have been challenged in different ways. To better understand them, we examined the three largest lines of business—retail banking, corporate and investment banking, and private banking. On the whole, retail banking seems to have stabilized and is earning returns in line with its cost of capital. Corporate and investment banking continues to struggle and to destroy value, while private banking is the only activity of the three to be clearly creating value at the moment.

Retail bankingThe performance of the retail-banking units of the banks in our sample has improved over 2010 levels but continues to be well below its pre-crisis peak. After hitting a postcrisis low of 7.9 percent in 2010, the ROE of retail banking jumped up to 10.1 percent—just above our estimated 10 percent cost of equity for the segment. As a result, the segment is no longer destroying value and instead is effectively a neutral contributor to bank portfolios.

ROEs were affected both by falling profits and increased capital needs. Profits relative to RWAs fell from 2.3 to 1.3

percent over the period, which we estimate was responsible for about 11 percentage points of the decline in ROE, due to increased LLPs and increased operating costs—up 0.9 percent of RWA and 0.5 percent of RWA, respectively. Meanwhile, an increase in equity levels from 9.4 to 12.4 percent of RWA knocked about 6 percentage points more off ROE. The interaction of the two effects somewhat mitigates their combined hit on ROE, which nonetheless reaches approximately 10 percent (Exhibit 5).

Not surprisingly, the best-performing banks varied significantly from the worst. Interestingly, it seems that the change in revenue yield—the amount of revenue generated per euro of RWA—is the primary driver of financial performance for retail-banking units. The highest-ROE retail-banking units have been able to improve their revenue yields substantially—enough to offset the growth in operating expenses, LLPs, and additional equity and still improve their ROEs relative to 2007. The worst-performing retail-banking units, in contrast, saw their revenue yields decline sharply. Even though business units in this group managed to lower their expenses, had better loan-loss performance, and added less equity, they still experienced sharp declines in ROE (Exhibit 6).

Pressures on ROE also affected the TRS of retail-banking units. In particular, we estimate that falling ROEs reduced the value of these units at a 20 percent annual rate since 2007,

1 Represents a multiplier of change in operating profit and change in equity.


Levers for changes in return on equity (ROE) Change in operating profit normalized by risk-weighted assets (RWA)


Tax 0.2


Operating expenditures

Noninterest income

Net interest income


0.1Revenue

Exhibit 5 Retail-banking performance remains below pre-crisis levels.

Sample: 32 banks, FY 2007–11, %

6.2


11.1

2007 operating ROE

24.6

10.1

Interaction term1

2.8


2011 operating ROE

0.6

0.5

0.5

0.9

1.3

2.3



which has been partly offset by increasing PE ratios. Overall, we believe that the value of retail-banking franchises has fallen by 5 percent annually since 2007.

Corporate and investment bankingUnlike retail banking, the corporate- and investment-banking units in our sample saw their collective performance decline in 2011 relative to 2010, as ROEs fell to 9.7 percent from 12.3 percent. As a result, from a value-creation perspective, the segment has gone from essentially breaking even to destroying value.

However, corporate- and investment-banking units did earn higher operating profits in 2011 relative to RWA than they did in 2007 (6.9 percent) as a result of higher revenues as a percentage of RWA. Those profits were only slightly offset by higher equity levels, as well as increases in operating expenses and LLPs. Specifically, their improved operating profits increased ROE by 3 percent, while increased capital depressed ROE by only 0.1 percent, with a minor overall adjustment reflecting the interaction of the two effects (Exhibit 7).

As we saw in retail banking, revenue yields are critical. The corporate- and investment-banking players that have done the best have avoided the kind of cost cutting that hurts their

ability to generate revenues. From 2007 to 2011, the best performers were those that most improved their revenue yields, even as their expense base grew. The worst performers were those that managed to constrain their cost growth, but seemingly at the expense of any improvement in revenue yield (Exhibit 8).

From a TRS perspective, we estimate that corporate- and investment-banking business units returned –21 percent annually to shareholders, driven primarily by the capital infusions required for the business. In addition, falling PE multiples for these units—a sign of investor nervousness about the future—have also dragged down TRS performance.

Private bankingPrivate banking remains the most profitable of the three businesses we examined in detail and the only one to create substantial shareholder value—albeit at sharply lower levels than in 2007. The private-banking units we analyzed had an ROE of 19.3 percent in 2011, well above our estimated cost of equity of 9.5 percent. As a result, these businesses created an estimated €2.7 billion in value in 2011 alone.

Operating profits, which fell by nearly half over this period—from 41 to 21 basis points per RWA—accounted for 30 percent

1.4

0.7

1.4

4.9

8.4

Sample average Bottom-quartile average

–1.1

0.2

0.9

0.5

0.1

–3.4

0.6

0.8

2.1

–5.2

∆ ROE

∆ equity1

Top-quartile average

1 Normalized by risk-weighted assets.


∆ revenue1

∆ operating expenditure1

∆ loan-loss provisions1

∆ tax1

∆ net income1

–41

4.9 3.0 3.1

Exhibit 6 The best- and worst-performing retail-banking units vary significantly.

Sample: 32 banks, quartiles based on ∆ return on equity (ROE), 2007–11, %

3

3

6

–15

5

–10

10

–31Net income effect

Equity effect

6

2.7

4.8

0.4

1.7

0.1

Sample average Bottom-quartile average2

–1.0

0.1

0.6

0.3

–0.3

∆ ROE

∆ equity1


1 Normalized by risk-weighted assets. 2 AIB, as a strong outlier, not considered.


∆ revenue1

∆ operating expenditures1


∆ tax1

∆ net income1

3.2 1.5 2.6

0.4

0

0.6

0.7

1.7

Exhibit 8 Revenue yields and operating expenses are both important in corporate and investment banking.

Sample: 28 banks, quartiles based on ∆ return on equity (ROE), 2007–11, %

Net income effect

Equity effect

19

1

20

1

4

4

5

–9

–13

Change in operating profit normalized by risk-weighted assets (RWA)


Tax 0


Operating expenditures

Revenue

Noninterest income

Net interest income


1 Represents a multiplier of change in operating profit and change in equity.


Levers for changes in return on equity (ROE)

Exhibit 7 Corporate- and investment-banking profits are offset by higher equity levels.


3.0

2007 operating ROE

6.9

0.1


0.1

2011 operating ROE

Interaction term1

9.7

0.8

0.9

1.7

0.7

0.6

1.0

0.6

Sample: 28 banks, FY 2007–11, %



1.8

Operating expenditures 6.0

Revenue 11.7

Noninterest income

20.7

Tax 1.0


2011 operating profit/AUM

2007 operating profit/AUM 41.2

10.6

1.1Net interest income

1 Represents a multiplier of change in operating profit and change in equity.2 Assets under management.


Change in operating profit normalized by AUM,2 basis points

Levers for changes in return on equity (ROE),%

0.4


0.7


30.4

2007 operating ROE

49.5

2011 operating ROE

Interaction term1

19.3

Exhibit 9 Private banking is profitable but creates less value than it did in 2007.

Sample: 10 banks, FY 2007–11

of the drop in ROE from 2007 to 2011. These were driven by a sharp decline in revenue per RWA and higher operating costs (Exhibit 9).

Unlike the top-performing retail-banking and corporate- and investment-banking units, the private-banking units with the best ROE performance since 2007 have been the best at managing costs—again, without damaging their ability to generate revenues. Revenues have fallen for both strong and weak performers, but the best-performing units managed to offset that decline by lowering their operating and tax expenses—and reducing the amount of equity they committed to the business. The worst performers were those that maintained relatively static cost levels even as revenue yields fell and equity needs increased (Exhibit 10).

We estimate that the TRS for the private-banking segment was –4 percent annually from 2007 to 2011. Much of the poor performance was driven by falling ROEs and increased capital committed to the businesses, but this has been offset by an increase in the PE ratio, suggesting that investors expect the ROEs of this segment to rebound even further.

Investor expectations Valuations of Europe’s banks have declined substantially since 2007, with our sample falling from an aggregate

market-to-tangible-book ratio of 2.0 in January of that year to 0.7 in September 2012.

These low valuations can be interpreted in two ways. If investors believe that banks have already taken most of the significant write-downs, then current valuations imply that they expect European banks to maintain ROEs of less than 7 percent over the next several years (compared to a cost of equity of 10.5 percent), with revenue growth rates around 2 to 3 percent. In other words, in this scenario, investors expect that European banks will continue to destroy value for many years to come. Alternatively, if investors believe that ROEs will slowly increase to 10.5 percent (just above their cost of equity) over the next five years, then current valuations imply an expectation of further write-downs of approximately €350 billion—or 33 percent of current shareholders’ equity, excluding goodwill (Exhibit 11).

However, performance data at the group level can obscure significant differences in investor attitudes and expectations about the various businesses. Differences in the level and trend of ROE affect investor expectations—and hence overall valuation multiples. As one might expect, private banking has the lowest estimated beta, at 1, and hence the lowest cost of equity. Retail banking is slightly higher, at 1.1, but corporate and investment banking appears to have a much higher beta, at 1.5, and hence a relatively high cost of equity of 12 percent.

8

–1.8

12.7

5.5

13.7

–22.7

Sample average Bottom-quartile average

–26.2

2.7

1.2

–20.7

1.6

∆ ROE

∆ equity1


1 Normalized by assets under management.


∆ revenue1

∆ operating expenditures1


∆ tax1

∆ net income1

–51

–55.2 24.0 26.6

1.0

–20.5

1.8

6.0

–11.7

Exhibit 10 Top performers in private banking offset revenue declines by lowering operating and tax expenses.

Sample: 10 banks, quartiles based on ∆ return on equity (ROE), 2007–11, basis points

–1

6

5 –30

9

–21 –33

17Equity effect

Net income effect

1 Return on equity. 2 15-year explicit forecast discounted-cash-flow model, assuming cost of equity of 10.5% and terminal growth rate beyond 15 years of 2%. Market value as of Sept 1, 2012. Book value of equity is measured excluding goodwill.

Source: Bloomberg; McKinsey analysis

Expected write-offs required in 2011 book value at different sustainable ROE1 levels(using 2% growth in assets between 2012 and 2025)2

–55

–44

–33

–21

–10

12.5

11.5

10.5

9.5

8.5

7.50

Write-off in equity, % Absolute write-off in equity, € billion

Exhibit 11 Current valuations embed low expectations on profitability for European banks, or there are expectations of future write-offs.

ROE(average 2012–25), %

To sustain an average ROE of 10.5% for 2012–25, European banks need to write off ~33% or ~€350 billion of their 2011 year-end equity

0

~100

~225

~350

~450

~575



To capture the effect of these differences, we used a regression model to estimate the market-to-book ratios assigned by the market to the three segments. After a steep fall, the multiples of the three followed different trajectories. Private-banking multiples have bounced back and now stand at an estimated 1.2 times book value. Retail-bank multiples are a bit lower, at 0.8 times book value, and imply that the market expects value destruction to resume in this business. The estimated multiple for corporate and investment banking is 0.4 times book value, suggesting either that the segment will continue at very low ROEs for a very long period or that the market expects that banks have yet to write off a substantial portion of current book value.

This pessimism about corporate and investment banking and retail banking is consistent with the scenarios McKinsey has laid out for the potential development of the European sovereign-debt crisis.2 In each, we have also forecast RWA, revenues, and LLPs. If we hold cost and equity levels constant at current levels, industry ROEs will remain below the cost of equity for the next decade or more,

regardless of scenario. This suggests that value destruction is likely to continue for several years (Exhibit 12).

Needed: Clear strategic decisionsImproving the industry’s lot will require improving performance in several ways—it is unlikely that any single performance change will be enough. For instance, we calculated that improving ROEs to a healthy 12.5 percent would require a 16 percent increase in the revenue yield, a 25 percent reduction in total expenses, a 76 percent reduction in LLPs, or a 31 percent decline in equity if only one of these paths were pursued. But a mix of improvements that is more reasonable would get the industry to the same point. Depending on the scenario, for example, a 1 to 5 percent increase in revenue yield combined with a 5 to 8 percent cost reduction, a 0 to 15 percent reduction in LLPs, and a 9 percent reduction in the capital base would get the same result (Exhibit 13).

1 Risk-weighted assets.2 The fiscal-pact-plus scenario focuses on structural reforms, liquidity provisions, and debt reduction.3 The monetary-bridging scenario is characterized by a focus only on liquidity buying time, with no long-term solution.4 The fiscal-union scenario goes beyond the fiscal pact plus but focuses on integration of fiscal policies, including transfers.

Return on equity, %RWA1 (volume), € trillion

Revenues/RWA, %

Loan-loss provisions/revenues, %

Exhibit 12 Profitability for European banks is expected to remain below cost of equity in all scenarios.

5.0

5.5

6.0

6.5

12

10

0

11

10

9

8

7

6

5

4

3

0

Cost of equity

20202011

2011 202010

20

30

40

Fiscal pact plus2 Monetary bridge3 Fiscal union4 Euro breakup5

2 Miklos Dietz et al., “Strategic insight through stress-testing: How to connect the ‚engine room‘ to the boardroom,” McKinsey Working Papers on Risk, Number 35, July 2012.

10

Thus, we believe that banks must pursue a multipronged strategy. Specifically, we believe banks will need to do the following:

� increase revenue margins by improving strategic and tactical pricing

� apply smart methods to align the cost base to the new normal

� be prudent and keep future risks low

� increase capital efficiency with more sophisticated capital- or resource-allocation processes

� rethink portfolio strategy and take decisive actions with regard to noncore assets

Increase revenue margins by improving strategic and tactical pricingOur experience shows that banks can improve their gross margins by 5 to 10 percent without risking volumes by improving their pricing. Raising prices is challenging and must be done with great care, especially given the industry’s current competitive dynamics. Still, we believe this lever could safely contribute the 1 to 5 percent increase necessary

in the potential scenarios laid out above. This requires several elements:

� Aligning the product range with pricing to reflect customer preferences. Specifically, banks should evaluate the structure of their account prices to better align themselves with customer preferences. This includes looking at trade-offs between interest rates and annual fees, relative to fees for inactive accounts or charges for lost cards, and adjusting pricing accordingly.

� Implementing price differentiation by micromarket. This includes differentiating key price elements based on local competitive scenarios and growth targets for each micromarket or branch.

� Pricing to value at individual customer level. This includes customizing products for individual customers or customer segments and setting prices relative to their next best alternatives and key buying factors.

� Improving price execution and price discipline. For example, this includes reducing price leakage by redesigning discount rules, optimizing discount processes, and introducing ad hoc key performance indicators and monitoring systems.

1 Return on equity. 2 Risk-weighted assets. 3 The fiscal-pact-plus scenario focuses on structural reforms, liquidity provisions, and debt reduction.4 The monetary-bridging scenario is characterized by a focus only on liquidity buying time, with no long-term solution.5 The fiscal-union scenario goes beyond the fiscal pact plus but focuses on integration of fiscal policies, including transfers.6 Loan-loss provisions.

Combination of improvement in ROE1 drivers at 2020 required to reach 12.5% ROE

2020basecase

–9%

ROEof12.5%

11.012.1

ROEof12.5%

–9%

11.0

2020basecase

12.1

ROEof12.5%

–9%

11.0

2020basecase

12.1

ROEof12.5%

–9%

11.0

2020basecase

12.1

0%

0.70.7

–15%

0.70.8–15%

0.70.8

–10%

0.70.8

–5%

3.23.4

5%

3.03.2

–8%

3.03.3 3.13.3

–6%

5.85.7

1%

5.65.3

5%

5.65.5

1%

5.75.6

2%

Monetary bridge4 Fiscal union5Fiscal pact plus3 Euro breakup6

Revenue/RWA2

Increasing revenue yield

Cost/RWAReducing absolute cost base

LLP7/RWAMaintaining constant provisioning levels

Tangible equity/ RWAReducing equity Tier 1 ratio

Exhibit 13 Improvements in operational efficiency are required to return banks to sustainableprofitability (cost of equity + 2%).



Such efforts may require a more centralized approach to pricing than many banks use today. They require the implementation of control systems that allow for real-time monitoring, the reinvention of established processes to ensure full control over price execution, and the buildup of necessary pricing capabilities.

Apply smart methods to align the cost base to the new normalApart from cost-reduction programs run by most banks in Europe in recent years, the banking industry has never gone through a fundamental adjustment of its cost base similar to what other industries have experienced in times of crisis. The telecommunications industry, for example, reduced its total cost base by about 40 percent in the late nineties, the automotive industry followed with cost reductions of more than 20 percent, and the semiconductor industry slashed costs by 40 percent at the beginning of this century. Such examples make clear that significant adjustments in the cost base, such as are necessary now for many banks, require a fundamental rethinking of business strategies and a partial rebuilding of the value chain. However, they also make clear that the more modest 5 to 8 percent cost reduction required in our scenario should be quite achievable—without cutting into investment needed for growth. In fact, our estimates show cost-savings potential in the banking industry of 10 to 15 percent just from short- to midterm measures and up to 20 to 40 percent if the banking operating model is adjusted. The necessary alignment of the cost base could be achieved, for example, by a forced shift from branches to direct channels, true internal productivity leaps through lean programs and much more industrialized production, and disposal of all noncore activities. It might be complemented by large-scale M&A deals that enable significant cost synergies. However, all of these potential levers are huge multiyear programs that can only be driven from the top.

Be prudent and keep future risks lowDepending on the scenario, a further reduction of up to 15 percent in LLPs will be necessary to return banks to value-creating levels of profitability. Along with margin pressure, skyrocketing additions to LLPs since 2007 are one of the main reasons for the strong decline of ROE and a main driver of negative TRS. Retail banking and corporate and investment banking are, naturally, the main contributors to this development. For example, 9.4 percentage points of

the 10.5-percentage-point loss in ROE from 2007 to 2011 on a group level can be attributed to higher LLPs. Likewise, analysis of current valuation levels indicates a further equity write-off of more than 30 percent until 2025, assuming an average expected ROE of 10.5 percent.

Thus, generating positive TRS and increasing a bank’s valuation requires continuing a prudent risk strategy with regard to financial investments and credit-lending rules. Our recent activities in this area are proof of the enormous potential to reduce LLPs. Optimizing the credit process end to end, especially origination and underwriting, can yield some 20 percent in reduced risk cost. This includes everything from better tool-supported risk selection over improvements in the decision rules to strengthening the risk culture within all relevant departments of the bank. Even more interesting, our recent experience shows that building a leading credit-monitoring function alone can reduce risk cost by 10 to 20 percent.3 Leading banks are able to detect risky customers up to nine months earlier through better models and classification rules. For example, this advantage, together with superior management of watch-list customers, allows them to reduce their exposure to default by 60 percentage points versus 20 for other banks. A prerequisite is setting up a monitoring unit that allows for an independent assessment of customers and that has the influence to initiate necessary actions.

Improve resource allocation Managers must conceive of resource allocation in a new way that includes all the scarce resources at their organization, in particular capital, liquidity, and full-time employees (FTEs). McKinsey research suggests that banks can create significant value by allocating resources more carefully to their various businesses. In a recent study, companies (nonbanks) that actively reallocated their resources generated 30 percent higher TRS over a 15-year period than companies that were less active.4 At the same time, the study also found that most companies do not follow an active reallocation process. Quite often the resources allocated to a business in a given year are almost the same as they were in the year before.

In a world of strong revenue pressure and increasing demand for equity from regulators, it goes without saying that a robust improvement in capital efficiency is essential to regain acceptable ROE levels. Moreover, in all of our scenarios, a 9 percent decrease in equity/RWA is required. This can be achieved with both technical mitigation and a focus on more

3 Bernhard Babel et al., “First-mover matters: Building credit monitoring for competitive advantage,” McKinsey Working Papers on Risk, Number 37, October 2012.

4 Stephen Hall, Dan Lovallo, and Reinier Musters, “How to put your money where your strategy is,” mckinseyquarterly.com, March 2012.

12

capital- and funding-light operating models. As McKinsey research describes,5 the former measure can improve ROE by between 30 and 160 basis points. It requires improving the efficiency of capital and funding through higher-quality data, better risk processes, and refined risk models. The latter measure can boost ROE by 10 to 80 basis points and includes efforts such as changing the product mix and characteristics, pursuing collateral more vigorously, and improving their ability to manage risks (by issuing covered bonds for mortgage portfolios, for instance).

To be successful, a resource-allocation strategy must first meet the needs of priority activities. Managers must also implement reallocation thoughtfully, with lines of communication open to all relevant stakeholders in the organization. Our experience shows that four main steps are key to win in resource allocation:

� Get the inputs for the resource-allocation process right. First, define and understand the operating baseline of your businesses by defining a common metric. Second, compare your business’s performance to external developments such as the performance of key competitors and the expected development of the markets as a whole. Last, define the right set of key performance indicators as a basis for capital and resource allocation, including criteria for current and expected financial performance, strategic priorities, market development, and risk appetite. It is also important to use a clear capital metric, such as alignment of regulatory versus economic capital.

� Define the right reallocation methodology. In order to depersonalize the allocation process, it has proved successful to move the decisions to a level above the business-portfolio heads. It can also help to establish a mandatory rule that a certain percentage of the capital employed needs to be released and reallocated each year. In order to achieve a 9 percent decrease in equity/RWA, the company would need to release at least 15 to 20 percent of the capital employed to be reallocated to businesses with significantly lower equity needs. For resource allocation to be effective, it is also important to take a sufficiently granular view of the business portfolios. Typically, this is one or two levels below the traditional profit-center logic and can easily comprise

50 to 70 business portfolios for an average European universal bank.

� Align the resource-allocation process with the other main processes within the bank. To be efficient, the new resource-allocation process must be closely integrated with the strategic-planning processes of the group and the different business units, with regard to both their content and the business cycle. It should also be aligned with other relevant processes in the bank, for example, an FTE-planning process.

� Ensure senior-management commitment and talent fungibility. To be successful, senior management must be fully supportive of the overall allocation process and must also be provided incentives accordingly. The same holds true for all relevant committees within the bank that make decisions about resources, including credit committees and investment committees, for example.

Active resource allocation also helps to sharpen the strategic direction of the bank and creates a great deal of transparency. This can be a powerful tool for executives communicating with investors and ratings agencies—an important link to ensure value creation reaches your shareholders.

Rethink portfolio strategy and take decisive actions with regard to noncore assetsThe fundamental changes in economics for the different banking businesses and the diverging outlook for them based on customer behavior, regulation, and competitor behavior makes it essential for most banks to include a thorough review of their business portfolio in their value-creation journey. Banks should rethink their strengths and weaknesses and adjust their portfolios accordingly to continue to get rid of noncore assets that tie up equity and management resources—both are needed elsewhere in the organization.

Most banks have already begun this process. One European universal bank, for example, recently announced plans to reduce a greater number of jobs in its investment-banking division and to dispose of its asset-management business. Others have taken decisive steps to strengthen their retail-banking businesses with M&A transactions. However, the

5 Dina Chumakova et al., “Day of reckoning for European retail banking,” McKinsey Working Papers on Risk, Number 36, September 2012.



Patrick Beitel is a principal in McKinsey’s Frankfurt office, where Oliver Vins is an associate principal. Joao Castello Branco is a director in the Madrid office and Pedro Carvalho is a principal in the Lisbon office. Ramandeep Chawla and Arpit Gupta are consultants in the McKinsey Knowledge Center in India. Zane Williams is a consultant in the New York office.

European banking industry overall is just beginning to transform its business models.

Rethinking the portfolio strategy requires a concerted effort to understand a bank’s current position, to define a target portfolio based on its strengths and expected market developments, and to develop a plan to move toward its target portfolio. What’s new this time is that banks need to assess the impact of increasing regulation and changing consumer behavior on their different businesses. That is, they need to develop a clear understanding of which low-demand activities, like certain investment-banking businesses, are likely to recover—and hence whether it makes more sense to retain capabilities or to shift resources into other businesses. Furthermore, the view of the capital

markets on different banking business lines has changed, valuing more stable retail-banking and private-banking earnings more than certain investment-banking activities. Some noncore activities and potentially critical credit portfolios can also be a burden on a bank’s valuation.

Our research into the value creation of major European banks shows that their recovery from the financial crisis in 2008 has stalled yet again. In fact, a full recovery to the profitability of the pre-crisis days seems very unlikely within the foreseeable future. Getting back on the path to value creation will require bold strategic steps by top managers.

Banking and Securities (Europe) December 2012 Designed by Global Editorial Services design team Copyright © McKinsey & Company

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Value creation in European banking 2012/media/Corporate/Images...2012/02/02 · value, while private banking is the only activity of the three to be clearly creating value at the