Banks in emerging markets dominate global players

MANILA, Philippines - In the next four years, the major banks of the emerging markets will outperform the global banking giants, who will need to raise as much as $600 billion in capital.

Based on a study made by McKinsey Global Institute (MGI), global banks will need more capital that may possibly lead to a capital crunch, further forced asset sales, and the need for additional government assistance.

In undertaking its study, MGI adapted these scenarios to include the particular forces that most influence banking returns: Inflation and the shape of the yield curve, as well as uncertainties about state intervention, including new capital requirements, consumer protection measures, new rules on risk management, pay caps, and the extension of regulation to the “shadow” banking system.

MGI, or simply McKinsey, conducted an analysis of 25 global banks, together representing about 40 to 45 percent of global industry assets and all major Western and emerging markets, including Brazil, China, Eastern Europe, India, and Russia. McKinsey aggregated these institutions into five archetypes: Three kinds of universal banks (European, Japanese, and North American), emerging-market giants, and global investment banks.

Then the study extrapolated current performance into the future, producing a “run rate” forecast – that is, an estimate of how various portfolios of banking businesses and geographic distributions might fare in either scenario if the banks don’t respond to the forces shaping the industry in the next few years. This estimate establishes the baseline.

“Our findings suggest that they will be subject to five substantive forces that will considerably change their fortunes,” the report said.

One key finding is that the capital shortage triggered by the crisis, and recently addressed through several rounds of massive capital raising, will endure and get worse. Demand for capital, or the amount needed to finance projected asset growth and meet regulatory requirements, will exceed supply, or the earnings, less the amount likely to be paid out as dividends.

A second factor weighing on returns will be the high and rising cost of long-term funding, the McKinsey stated.

Several factors are at work here, beginning with a shift in demand. As part of balance sheet restructuring, many banks are cutting back on short-term, unsecured funding (such as commercial paper) and seeking instead to issue longer-dated debt. Demand will also rise as the longer-dated funding currently on banks’ books expires and is renewed.

On the supply side, government asset-purchase programs-quantitative easing-are already being retired. Finally, the market will see greater competition for funds, not least from governments that must finance their deficits. All this implies that prices for long-term funding will inexorably rise, shaving as much as several percentage points off ROE, depending on the scenario.

“Given these drags on performance, returns will be weak by the standards of the past decade. Worse, they will be highly uncertain-our third finding,” the report stated.

Industry revenues are estimated to range from a high of five percent to as low as one. “Either way, the emerging-markets giants come out on top.”

The story for the other groups of banks is mixed. In the midpoint case, the European and US universals and the investment banks would generate middling return on equity (ROE) well below their pre-crisis levels. The Japanese universal bank returns would suffer.

In the extreme scenario, all but the emerging-market giants will find it extraordinarily difficult to return even their cost of equity. In other words, these banks will face a challenging period reminiscent of the early 1980s.

Which confirms the study’s fourth finding, that the crisis affected emerging markets, especially Asia, less severely than Western ones. Parts of Asia were the last areas to enter into recession and the first to emerge from it-indeed, China’s economy never stopped growing. Asian banks had less trouble with toxic assets and excess leverage than their counterparts elsewhere did.

The crisis served to demonstrate that the balance of power shifts abruptly and powerfully rather than gradually; many Asian banks have vaulted to the top of league tables in one go.

“Our research confirms that for the next several years, Asia’s economic might will continue to grow, as will the influence and power of its banks. Indeed, in these markets, banking is likely to grow much faster even than the broader economy, because so much of the population is unbanked. In both scenarios, all the emerging markets will grow substantially faster than the more mature markets of Europe and North America,” the Mckinsey study said.

The last finding states that archetypes constitute a form of destiny: emerging-market giants, riding the back of faster gross domestic product (GDP) growth, will outperform developed-market universals.

The findings suggest that banks should take many strategic steps, including reconfiguring and empowering regulatory strategy, placing big bets on the fastest-growing areas, and rethinking liquidity to treat it like other scarce resources the corporate center manages.

‘Such steps, as well as innovations yet unseen, will be important variables in determining the shape of global banking over the long term,” the study concluded.