Value creation in European banking 2012

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Mieke Van Oostende, Partner, McKinsey & Company
Wouter De Ploey, Director, McKinsey & Company

Value creation in European banking 2012


Since 2007 banks have been operating in a turbulent economic environment that does not seem to be lessening. In response, McKinsey has been following the performance of 40 major European banks from 2007 to 2012 and attempted to answer three questions:

  1. How have banks performed, both at the aggregated level and by individual business unit?
  2. What are the expectations of investors for future performance?
  3. What will be required to improve performance of the banking sector?

McKinsey analysis shows that profitability in general has fallen, largely due to a dramatic decline in operating profitability and major write-downs. In particular, while retail banking has stabilized, corporate and investment banking are generating low profits and are a drag on overall performance and valuations. Private banking remains the most profitable business unit and is the only one to create shareholder value at the moment.

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, banks will have to be more systematic in how they allocate capital and monitor the performance of their portfolios of businesses.

Underperformance of European banks

The credit crisis resulted in poor shareholder returns and earnings performance for banks generally and for European banks in particular. The 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, McKinsey & Company analysis shows that European banks have underperformed, earning a total return to shareholders (TRS) of -16 percent over the period 2007 to September 2012, lower than banks in any other region. The sovereign-debt crisis that intensified in 2011 accentuated these trends, and from January 2011 to September 2012, European banks had an annualized TRS of -15 percent.

Much of the poor performance among Europe’s banks is 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. 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.

Poor ROE performance has also destroyed value from an economic-value-added perspective. Over the five-year period, the 40 banks in our sample combined lost half of their market value, or €700 billion, a drop in market capitalization that actually exceeded their total book value at the beginning of 2007. In other words, they have lost more value than they had in capital invested when the crisis began.

Performance and challenges of the different business lines

Performance has varied substantially by line of business.The performance of retail banking has improved over 2010 but continues to be well below its pre-crisis peak. After hitting a post-crisis low ROE of 7.9 percent in 2010, the ROE of retail banking jumped up to 10.1 percent. ROEs were affected both by falling profits and increased capital needs. Pressures on ROE also affected the TRS of retail banking units, which has been partly offset by increasing PE ratios. This segment is basically earning its cost of equity, and no longer destroying value and instead is effectively a neutral contributor to bank portfolios.

Corporate and investment banking saw their collective performance decline in 2011 relative to 2010, as ROEs fell to 9.7 percent from 12.3 percent. These units did earn higher operating profits than they did in 2007 due to higher revenues. However, those profits were offset by higher equity levels, as well as increases in operating expenses and loan loss provisions (LLPs). 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. As a result, from a value-creation perspective, the segment has gone from essentially breaking even to destroying value.

Private banking remains the most profitable of the three businesses with an ROE of 19.3 percent in 2011. 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. As a result, these businesses are the only one to create substantial shareholder value, albeit at sharply lower levels than in 2007.

Investor expectations

In general, 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 2007 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.

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. After a steep fall, the multiples of the three businesses followed different trajectories. Private banking multiples have bounced back, but still seem to be valued at a premium to their book value at about 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 corporate and investment banking units are trading at the deepest discounts, at 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.

Clear strategic decisions are required to improve performance

Turning performance around more generally in the face of challenging macroeconomic conditions and more stringent capital requirements means that banks must pursue a multipronged strategy. In practice, this means that banks must make clear strategic decisions along five dimensions:

  1. improving revenue margins through better and more sophisticated pricing,
  2. reducing costs in line with the new normal of lower revenues,
  3. improving risk management,
  4. increasing capital efficiency, and
  5. rethinking portfolio strategy.

Specifically, these five dimensions mean the following in detail:

  1. 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. Several elements of sophisticated pricing are required. More specific, banks should evaluate the structure of their account prices to better align themselves with customer preferences. Next element is implementing price differentiation based on local competitive scenarios and growth targets for each micro market or branch. Banks should also customize products at individual customer level and set prices relative to their next best alternatives and key buying factors. The last element is improving price execution and price discipline. This includes optimizing discount rules and introducing performance indicators and monitoring systems.
  2. Significant adjustments in the cost base, apart from cost-reduction programs run by most banks in Europe in recent years, require a fundamental rethinking of business strategies and a partial rebuilding of the value chain. 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 shift to direct channels, true internal productivity leaps through lean programs, much more industrialized production and disposal of all noncore activities. It might be completed by large-scale M&A deals that enable significant cost synergies.
  3. Skyrocketing LLPs are one of the main reasons for the strong decline of ROE and a main driver for negative TRS. Generating positive TRS and increasing a bank’s valuation requires continuing a prudent risk strategy with regard to financial investments and credit lending rules. 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 is building a leading credit-monitoring function that can reduce risk cost by 10 to 20 percent. Leading banks are able to detect risky customers up to nine months earlier through better models and classification rules. This advantages 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.
  4. Robust improvement in capital efficiency is essential to regain acceptable ROE levels and especially now that regulators increase the demand for equity. This can be achieved with both technical mitigation and a focus on more capital- and funding-light operating models. The former measure can improve ROE by between 30 and 160 basis points. It requires improving the efficiency of capital and funding though 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)
  5. 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. Banks also need to assess the impact of increasing regulation and changing consumer behavior on their different businesses and need to get rid of noncore assets that tie up equity and management resources which are needed elsewhere in the organization. As some non-core activities and potentially critical credit portfolios can be a burden on bank’s valuation, banks 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 business.

More than four years after the financial crisis erupted, the world is still absorbing its aftershocks. Profitability in general has worsened and valuation multiples have fallen further, indicating that investors fear that this poor performance will continue. In fact, a full recovery to the profitability of the pre-crisis days seems very unlikely within the foreseeable future. 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, McKinsey believes that banks will have to be more systematic in how they allocate capital and measure and monitor the performance of their portfolios of businesses. Getting back on the path to value creation will require bold strategic steps.

The Light in the Dark Box:  On How to Improve Profitability in the European Banking Sector.

Prof Dr André Thibeault, Vlerick Business School

McKinsey  & Company published in December 2012 “Value creation in European banking 2012”.  The report could be a natural follow-up of the study published in April 2012 by the Vlerick Centre for Financial Services and KMPG, “A scorecard for bank performance: The Belgian banking industry”.  Both studies analysed the value chain in banking and both are looking at the necessity to maintain healthy ROE for the shareholders.

The concept of the value chain in banks  is presented in Figure 1.  The value chain is broken down into three components on the income side (net interest income, net commissions and financial transactions) and into two blocks on the expenses side (operating expenses and loan losses). 

figure 1

Figure 1: The Value Chain of a Bank

The overall financial performance when managing the value chain is often measure by the return on equity, ROE,  which is the most used benchmark to measure profitability from a shareholder point of view.  In a first level of analysis, the ROE can be broken down into two components: namely, the return on assets (ROA) and the leverage (L). In a second level of analysis, the return on assets (ROA) can be split into  the asset yield (AY) and the profit margin (PM). This breakdown is called the Dupont analysis (see Figure 2).


figure 2

Figure 2: The Dupont Analysis


Figure 2 gives the mathematical relationships between the components of the Dupont system.  For example: multiplying the ROA by the leverage, the asset component disappears, leaving us with the ROE. While this is interesting from a mathematical point of view, one can derive much more information by looking at the Dupont system from a managerial point of view. 

The first level of analysis tells us that the return to the shareholders is composed of the ROA, which reflects the profit derived from the bank’s overall operations, times a factor called leverage, which reflects the structure of the bank’s balance sheet. While the ROA can be defined as the operational profitability of the bank, the leverage, Asset / Equity, reflects the willingness to take solvency risk.  Thus, a bank can improve the return to its shareholders by leveraging itself, which means taking more risk.

The second level of analysis links the asset yield (AY) and the profit margin (PM) to the operational profitability, the ROA. Looking at Figure 2, one can see that multiplying AY by PM cancels out total revenue to yield the ROA. 

The asset yield (AY), total revenue / total asset, is measuring the proportion of gross revenue to total assets.  Thus, AY reflects the capacity of the bank to generate income. Among other things, this capacity to generate income is related to the type of balance sheet and off-balance sheet activities carried out by the bank, as well as its pricing policy.

The profit margin (PM), net profit / total revenue, relates to the way net profit compares to total revenue.  The difference between these two figures is a series of various costs. Thus, PM may be associated with the way the bank manages its costs, given a certain level of gross revenue.

This is along these lines that the McKinsey Report defines five dimensions where banks will have to make clear strategic decisions: “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.”

Based on a sample of 40 of Europe’s largest banks, the McKinsey Report shows that on average, after 2007, European banks have destroyed significant shareholder value by generating a lower average return on equity (ROE) than their average cost of equity (COE).

While comparing different business models of banks, namely retail banking, corporate and investment banking and private banking, the McKinsey report concludes as the Vlerick-KPMG scorecard that “while retail banking has stabilized, 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…” This conclusion is in line with the risk profile of each segment of the market going from the lowest risk profile for private banking to the highest risk profile for the corporate and investment banking segment.

However, the most interesting point of the McKinsey report is their simulation to find out how European banks can achieve in the near future an ROE slightly higher than their COE of 10.5%.  

“Improving 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 (loan loss provisions), 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.”  Thus, depending on their business model and their capacity and willingness to compete, banks can decide on a plan of actions giving specific weights to their revenue yield which depends on their lines of business and their pricing, to costs reduction and where to cut, to the quality of their loan portfolios, and to their decision to use more or less leverage depending on the type of activities they are targeting.

The McKinsey report shows how important it is to have a sound conceptual framework of what banking is about in order to identify the relevant actions for the road to value creation.  The report identifies five actions in the value chain in order to improve profitability: (1) improve the net interest income and net commissions the two first value drivers on the income side.  Interesting enough no reference is made regarding financial transactions, the third value driver and the one mainly responsible for the financial crisis.  (2) align operational expenses to the new environment.  (3)  control the risk profile of the credit portfolios.  (4)  increase capital efficiency in order to generate an acceptable leverage.  (5)  rethink strategy with regard to noncore activities.

To conclude, the last paragraph of the McKinsey report summarizes where the industry stands right now.  “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.”


Value creation in European banking 2012

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