Banks need full-scale digitalisation

DESPITE SIGNS of renewed health with regard to capitalisation, liquidity and costs, the global banking industry’s performance continues to be lacklustre, with return on equity (ROE) stuck in a narrow range between 8 per cent and the 10 per cent figure that most consider the industry’s cost of capital.

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Banks Digitalisation

 

Moreover, the industry is facing an accelerating digital threat, both from new digital competitors and from customers’ rapid and widespread adoption of digital banking. Left unchecked, this threat could lower the industry’s ROE to 5.2 per cent by 2025, according to the 2017 McKinsey Global Banking Annual Review recently.

The accelerating pace of digitisation represents not only a threat, but also an opportunity for banks, argued the McKinsey report.

To counteract the digital threat, banks first need to fully deploy the digital tools available to them to industrialise their operations to boost revenue, improve capital usage, and especially cut costs.

McKinsey estimates that fully digitising, along with significantly improving skills in digital marketing and analytics, could add $350 billion to the banking industry’s bottom line over the next three to five years. Second, the digital ecosystems, characteristic of the integrated economy now emerging, represent a growth opportunity for banks, if they could find ways to compete effectively with platform companies like Amazon, Alibaba and Tencent.

Banks that develop and execute a successful ecosystem strategy could achieve an ROE between 9 per cent and 14 per cent by 2025, according to the report, entitled “The Phoenix Rises: Remaking the Bank for an Ecosystem World”.

The McKinsey Global Banking Annual Review 2017 is based on insights from McKinsey’s proprietary Panorama Global Banking Pools, a database that covers banking markets in more than 90 countries, and Panorama FinTech, a database that includes more than 3,000 Fintech innovations globally, as well as interviews with a number of banking industry leaders.

Today, banks are facing “the four horsemen of the e-pocalypse” disintermediation from their customers, unbundling of their services, commoditisation of their products, and invisibility as customers fail to connect with bank brands, said the McKinsey report.

The impact is manifested in the loss of the customer relationship and margin compression, primarily in retail banking, leading to sluggish growth and diminished profitability. Globally, revenue margin declined by approximately 4 per cent from 2014 through 2016, which lowered ROE by 1.5 percentage points.

“A full-scale digital transformation is essential, not only for the economic benefits, but also because it will earn banks the right to participate in the next phase of digital banking,” said the report.

Seven initiatives offer banks the most potential to capture digital productivity improvements:

Building better marketing skills, as excellence in digital marketing is now a core foundational capability

Reshaping the distribution architecture to create a true multi-channel experience for customers

Using digital tools and analytics to enhance sales productivity (e.g. by equipping relationship managers with a digital workbench)

Industrialising operations through automation and artificial intelligence (e.g. robotic process automation and cognitive technologies)

Reimagining underwriting, using data and analytics, to build a truly data-driven underwriting process and capabilities

Embracing cloud computing, open APIs, and other essential technologies, such as shared digital utilities

Creating an agile organisation that is both stable (resilient, reliable and efficient) and dynamic (fast, nimble and adaptive).

The greatest threat to banks from digital competitors no longer comes from fintechs, which have often struggled to scale and have entered into partnerships with banks, but rather from what the McKinsey report terms “a formidable new force” — platform companies.

These firms are creating digital ecosystems in which they provide customers with intuitive and pleasing ways to shop for a wide range of products and services through a single access gateway.

And now they are beginning to target the retail distribution end of banking, where there is huge value at stake. According to McKinsey’s report, distribution (i.e. origination and sales) accounts for 47 per cent of banking revenues and 65 per cent of profits, with an ROE of 20 per cent.

For banks that choose not to pursue an ecosystem strategy, McKinsey sees two options: (1) white-label balance sheet operator, or (2) focused or specialised bank.

White-label balance sheet operators would greatly expand their balance sheets, as they lend to companies with stronger customer relationships. This model is narrowly focused on wholesale activities.

A focused or specialised bank would concentrate on either a business line (e.g. private banking or investment banking), a specific segment of the value chain, a product category, a geography, a customer segment, or a service model (e.g. a stand-alone digital bank).