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European Banks Still Running to Stand Still: Report

A new report says that banks, especially in Europe, are struggling to reach returns in double figures.

Banks will take another three to five years before their returns can cover their cost of capital, says the author of a new McKinsey & Co. report on global banking.

Toos Daruvala, a New York–based director of the consultancy firm, says, “the macroeconomic environment has deteriorated sharply, and banks are running hard just to stay in place. They need to restructure their balance sheets and cut costs in order to boost their returns.” McKinsey’s second annual review of the banking industry calculates that banks delivered, on average, a return on equity (ROE) of 7.6 percent in 2011, compared to 13.6 percent in 2007 and a historical average of about 11 percent, a level which is close to their cost of capital.

Banks, especially in Europe, are struggling to reach returns in double figures. Even BNP Paribas, one of the most successful banks in Europe in the first half of 2012 with an ROE of 9 percent, doesn’t believe 10 percent will be in range next year. In an interview with Institutional Investor in September, the French bank’s CEO Jean-Laurent Bonnafe, said a return of 10 percent in 2013 would be “very difficult” to achieve. The U.K’s Barclays Bank, meanwhile, which achieved only 6.6 percent in 2011, said in August that it now wants to cut its target ROE, which had been as high as 13 to 15 percent, down to around 11 or 11.5 percent. Average ROE was 0 percent in Europe in 2011 compared to 7 percent in the U.S., although if peripheral countries such as Greece and Portugal were excluded, the figure would rise to 5 percent in Europe.

Daruvala says that the industry’s average cost-to-income ratio of 68 percent would have to be cut to 46 percent in Europe and to 51 percent in the U.S. in order to achieve a return of 12 percent. Although this would be difficult, he points out that both the automotive and the telecoms industries cut costs by over 30 percent in the 1990s, over a period of 5 years, in the face of increasing competition. Investors are urging banks to reduce costs. “Cutting costs has to be one of the most important levers by which banks can improve performance. There’s a lot more to do in reducing headcount in particular,” says Satish Pulle, Lead Portfolio Manager for the European Financials team at ECM Asset Management in London, a wholly owned subsidiary of Wells Fargo. The report argues there is huge potential to reduce costs by embracing new technology and by stripping away layers of management. Much of this is already underway, as the report acknowledges. In the U.S., McKinsey says, for instance, the number of bank branches will fall by a third between now and 2020.

Daruvala also points out that, “European banks, in particular, need to look closely at their assets. Whereas in the U.S. the total assets of banks represent about 80 percent of GDP, in Europe it’s about 300 percent.”

Banks have made important progress in one area, however, thanks to regulatory pressure: They have become more solidly capitalized. From 2007 to 2011, the core Tier 1 ratio grew by $2 trillion or 57 percent, and the average Tier 1 capital ratio increased from 8.2 percent to 11.7 percent. What’s more, leverage (assets-to-equity ratio) fell in the same period from 21 to 17.

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