Signs from the banking industry point to the end of an economic cycle. Growth in volumes and top line revenue is slowing, as is loan growth, which has sunk to the lowest levels in five years.
But there’s something different about this late-stage cycle. In McKinsey & Co’s annual global banking report, the consulting firm found that nearly 60 percent of global banks weren’t economically viable (their cost of equity was higher than their return on equity). Essentially, the banking sector — and more importantly, individual banks themselves — need to develop their own late-cycle priorities to stay competitive.
4 bank archetypes
McKinsey describes four different types of banks based on their enterprise strength and market stability.
- Market leaders: 20 percent of banks globally come close to capturing almost 100 percent of the economic value produced by the entire industry. These banks operate at-scale, serve a significant demographic or geography, and operate in ‘favorable market conditions’. McKinsey recommends these banks reinvest capital and resources into innovation and scale to prepare for the next economic cycle.
- Resilients: Close to 25 percent of banks have leadership positions in challenged markets. These types of institutions should muster resources and develop new products to expand beyond their current customer bases. These banks can take an ecosystem approach to connect with other leading institutions in and outside their markets and differentiate through innovation.
- Followers: About 20 percent of banks haven’t reached scale and underperform their peers, even with favorable market conditions. These firms are at risk in an economic downturn and must build scale in their existing businesses, shift business models in favor of innovation, and severely cut costs.
- Challenged banks: 36 percent of banks fall in the bottom-left quadrant, sub-scale and competing in tough markets. Their entire business models are flawed, according to McKinsey. Their hope to survive a downturn? Merge or sell first to a stronger buyer with a similar footprint– reinvent themselves second.
Market leaders and resilients should focus primarily on things that will allow them to gain further scale and grow revenues through ecosystems and innovation. These types of FIs can look toward productivity improvements by outsourcing non-differentiated activities to third-party utilities.
As for followers and challenged banks, they are best served by finding some scale in their niche segments. More likely, though, is to grow through inorganic means by being acquired.
Innovation at the end of the cycle
So, how can banks use the ecosystem opportunity to their advantage over the next few years? McKinsey offers two models: the firms that run existing platforms and participants on ecosystems controlled by others.
Ecosystem orchestrators: By bundling low and high frequency products and services, cross selling through partner channels and really harnessing data for marketing, these organizations can ramp monetization of their platforms. For example, the State Bank of India launched a digital banking platform (YONO) in 2017, combining low frequency touch points (banking) with higher frequency options (online shopping). The platform handles 2.5 million transactions the first quarter of 2019, up 224 percent from the previous quarter. The bank, on average, opened 27,000 new accounts every day.
Ecosystem participants: For firms that don’t own their ecosystems, they can manufacture key products and services, like payments and credit, for distribution through existing platforms. They can choose to do this under their own brands or through a white label relationship, according to McKinsey. To do this, participating banks will need commercial APIs for use with multiple platforms — there’s no need to choose a single ecosystem.
Banks can take a portfolio approach to innovation that includes a systematic and holistic approach to a bank’s innovation work. Banks should be able to start by asking how much revenue and ROI they’re looking for from innovation initiatives and then move forward. As a portfolio, FIs need to be cognizant of the changing risk profile of their activities as they move through the cycle.
Banks don’t remain stuck in their archetypes forever. Organizations and markets change and institutions may find themselves migrating across the 2*2 matrix. Endowment shapes a bank’s odds of where it ends up: the size, regulatory capital levels and past investments all contribute. Geography plays a role, too. Local markets see changes in profitability and GDP — both of which can passively impact a bank.
Lastly, a bank controls part of its own destiny by choosing what activities to focus on. Reinvesting to promote organic growth, reallocating resources to high ROE businesses with growth potential and cutting costs all influence whether a bank remains in its original archetype.