It has been almost 10 full years since the recovery from the 2008 financial crisis began. At this point in time, many economic indicators point to the possibility that we may be experiencing the end of the economic cycle, with market indices at all-time highs, weakening manufacturing data and peak employment. One issue that should concern investors is the health of the financial sector. A recent report from McKinsey found that the banking sector is also in the middle of the ‘late cycle’ phase, with stagnating growth in lending and contracting margins. Here is what could be in store for the industry.
Slowing loan growth
In recent years, bank lending growth has slowed down to the point where it now lags behind nominal global GDP growth. The global compound annual growth rate in 2017-2018 was 5.9%, whereas bank lending grew by just 4.4%. Moreover, in addition to slowing growth, margins are also getting thinner:
“Across all markets, margin contraction has accelerated, while the rate of gains from productivity improvements has diminished”.
In other words, banking has become less profitable, and the extent to which new technology can drive productivity seems to be plateauing. If this is indeed the end of the economic cycle, legacy banks may have few opportunities left to reinvent themselves. The report goes as far as saying that banks that fail to invest in technology risk becoming ‘footnotes to history’.
The role of technology
The pressures experienced by banks in this late-cycle environment have been compounded by the role of disruptors in the financial sector. In retail banking, a part of the sector where customer loyalty has traditionally been strong, churn is increasing as digital technologies have made it easier and easier to switch banks. It used to be that switching banks was an ordeal that required multiple journeys. Now this can be done without leaving the house.
“Churn rates for current accounts in the US have risen from 4.2% in 2013 to 5.5% in 2017, and in France they have risen from 2.0% in 2013 to 4.5% in 2017”.
Poor health overall
The report also finds that a majority of banks worldwide may not be economically viable, with 56% of banks having a cost of equity that exceeds return on equity. Specifically, it found a wide disparity between North American and European banks, with the former doing comparatively well and the latter falling behind. One factor that may be driving this change is low interest rates (which of course in Europe have been even lower than in the US).
Higher interest rates mean a higher net interest margin for banks (the spread between the money paid to savers and money received from debtors), and a low-rate environment has been challenging. The report goes on to say that a “prolonged economic slowdown with low or even negative interest rates could wreak further havoc”, and calls for the industry to reform itself to avoid such an outcome.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: In Defense of Uncertainty
- Seth Klarman: Exploiting Erratic Market Behavior
- Howard Marks: Negative Interest Rates Are Weird
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