The Big-Bank Comeback

Banks, challenged lately by macro and digital trends, are stronger now.

The bad times ahead could be good times for banks. At least, for some banks—if the times don’t get too bad.

That’s the prognosis, as the world gropes its way through slowing growth and the first bout of prolonged inflation in 40 years—plus a 1970s-style energy squeeze and 1960s-style nuclear threats. Rate-hike-induced recessions are also expected.

Rising interest rates—the tool central banks are dusting off to quell inflation—benefit lenders up to a point. Crashing growth stocks sapped some of the momentum and swagger from the fintechs and “neobanks” that were supposed to be eating the old guard’s lunch, giving the banking establishment an interval to catch up. The moment is more propitious than it looks, so long as economic disturbances stay within baseline bounds.

Lessons of the Past

It’s tempting but misleading to compare 2022 with the global financial crisis (GFC) that erupted in 2008—a calamity of financiers’ own making. This time, bankers are reacting to extrinsic factors. And they are much better prepared, thanks largely to the regulatory onslaught that followed the GFC. Tier 1 capital ratios have doubled across the globe from a low in 2011, S&P Global reports. Ratios in Asia rose from 9% to 12% over the past decade. Europe is the regional safety champion, with capital buffers averaging around 17% of assets. The Continent may need it, as Russia’s energy squeeze makes Europe the region most vulnerable to global macro upheaval. This capital buildup “will allow the global banking sector to show some resilience,” S&P analysts conclude.

The extra protection drags on profitability, though. Half the world’s banks are not even covering the cost of their equity, McKinsey & Co. found in its latest Global Banking Annual Review. Keeping up with government oversight draws resources from more-productive pursuits. “Maybe 70% of banks’ IT spending goes to adapting to constantly changing regulation,” says Erwann Bruyelle, chief commercial officer at Paris-based fintech Skaleet. “Just 30% is about the future.”

Alternative financial service providers, which go much lighter on capital and regulation, have meanwhile gobbled market share in payments and, increasingly, deposits. McKinsey’s short list of “super fintechs” ranges from Nubank in Brazil to Square in the US to Afterpay, an Australian service offering interest-free installment payments over six weeks.

Now the tide may be turning in the establishment’s favor. Lending money, which many people view as the main reason banks exist, became almost an unpleasant necessity under record-low interest rates—barely worth the cost. Return on equity (ROE) from “bread-and-butter” banking operations averaged a mere 4% industrywide as of late 2021, McKinsey found. ROE from “origination and distribution” averaged 20%.

That’s changing as central banks race to tighten money supplies. Interest charged on loans is expected to rise faster than interest paid to depositors, who shy away from the hassle of changing banks to chase an extra half percent. That means increased spreads.

The Big Four US banks—JPMorgan Chase, Bank of America, Citigroup and Wells Fargo—reported year-on-year net interest income increases up to 26% in second-quarter results. DBS, the biggest bank in Southeast Asia, saw a 17% jump. Europe, the global laggard in raising rates, is waiting for its own windfall. Other regions are waiting for something similar. “Even in Europe, deposits are becoming attractive again,” says Jens Baumgarten, Frankfurt-based global head of financial services at consultant Simon-Kucher & Partners.

That assumes that banks find borrowers who can afford higher interest rates even as most economies slow, if not shrink. The most dire visible financial threat on the planet may be imploding Chinese property developers. Nonperforming loans (NPLs) in this sector will more than double this year, S&P estimates.

Beijing’s state-controlled banking system has ways to sweep this under the carpet. But a preponderance of variable-rate mortgages threatens a tsunami of defaults in several large market economies. The three most at risk are Australia, the UK and Spain, Fitch Ratings reports.

The US, which triggered the 2008 crisis, looks relatively safe this time. Almost all mortgages are written at fixed rates, and NPLs in the US recently fell to a 16-year low of 0.75%. This is no time to get complacent, though, a senior regulator warned America’s bankers. “The banking industry continues to face significant downside risks [that] may reduce profitability, weaken credit quality and capital, and limit loan growth in coming quarters,” Federal Deposit Insurance Corporation acting chairman Martin Gruenberg said in a September statement

Bank managers apparently agree. Net profit across the industry fell in the latest earnings, as loss provisions outweighed the interest-income jump. That pattern is more pronounced in emerging markets, where the tightening cycle is more advanced. Brazil’s biggest bank, Itaú Unibanco, more than tripled provisions in the first half of 2022, wiping out an 18% gain in interest income.

Rising rates have led to plunging stock and bond prices, sawing at two other legs of the bank profitability stool: capital markets and wealth management–after many years when managers shifted toward these businesses for higher margins. “The environment has changed 180 degrees,” says Nilesh Vaidya, global industry head for retail banking and wealth management at Capgemini. “The challenges now are with fee-based income.”

The first potential crisis of this reverse-flow age has been brewing around Credit Suisse, which since 2008 has shed retail business in favor of these fee-based disciplines. The venerable brand’s stock plunged, and bonds flirted with distress, as it signaled a retreat from investment banking. Credit Suisse may be unique in its recent management turmoil and blunders, though it’s likely to muddle through in some form. But better-run banks struggle with the same underlying issues.

Fintechs on the Run?

Current conditions give banks a chance to flip the script on fintechs, which had seemed to be running rings around the banks for some years. “The counterattack is absolutely underway,” Vaidya says.

One prong of the counteroffensive is to catch up to the insurgents’ innovations. Fintechs have found a rich seam, for instance, in facilitating cross-border payments, which were slow and expensive through traditional banks, Vaidya explains. The establishment’s Swift system is preparing to strike back, though. “Changes in Swift over the next 12-to-15 months will level the playing field in cross-border,” he predicts.

Legacy banks, after long discussion and a few false starts, are moving energetically into blockchain systems, which could make multiparty, multijurisdictional transactions faster and cheaper. The most visible pioneer is J.P. Morgan’s Onyx Digital Assets, launched at the depths of the Covid-19 pandemic in 2020. European giant BNP Paribas joined its US rival’s network in May of this year, giving Onyx the promise of global reach. “Onyx Digital Assets will allow for precise intraday liquidity management,” explained Paribas in its announcement. “They could be foundational to adding velocity to collateral, security settlement and ultimately decreasing systemic risks through the reduction of intraday credit.”

The highest-stakes battles between fintech and the old guard may come in emerging markets, where much of the population has never connected with a brick-and-mortar institution. Nearly two-thirds of Mexicans and Filipinos remain unbanked, along with about half of all Indonesians or Bangladeshis and 30% of Brazilians, according to October 2020 industry research by Acuant.

The proliferation of cellphones and mobile internet devices has made these excluded masses accessible, opening massive long-term opportunity for financial providers. The developing world is on track to deliver more than half of all banking income by 2025, up from about 20% in 2000, McKinsey calculates.

New model fintechs and e-commerce providers hopped on this wave first. The future will see more collaboration with the establishment, which can take the upstarts beyond payments into lending and other, stickier banking services, Simon-Kucher’s Baumgarten predicts.

One sign of the times is Standard Chartered Bank’s partnership with Indonesian e-commerce platform Bukalapak, which reaches 6.8 million online merchants and more than 110 million customers across the archipelago nation. In September, the pair launched the BukaTabungan (“open savings”) digital banking channel, aimed at “the micro, small and medium enterprises who make up 97% of Indonesia’s workforce,” a company statement read.

In India, HDFC Bank has joined forces with the juggernaut nonbank payments and commerce platform Paytm to service that nation’s army of small shopkeepers. In Brazil, Itaú has teamed with Locaweb Servicios de Internet to enhance its corporate business. “Big banks have the brand, the trust and many more products to offer fintechs,” Baumgarten comments. “They’re moving forward toward a ‘frenemy’ relationship.”

Fintechs have meanwhile lost some of their luster, to put it mildly, as rising rates have jerked financial markets into risk-off mode. Investors began to look much harder at when and how these growth starts might pivot to profit. Nubank shares have lost more than half their value since an initial public offering last December, due in part to a legal wrangle. Block, the renamed Square, is down 65% year to date. That crimps these disrupters’ ability to fund further expansion and dents their aura of invincibility. “Fintechs are really great at creating innovation—not so good at sustaining it,” Baumgarten comments.

Regulators are also starting to scrutinize the new breed of not-exactly banks more carefully. The UK’s Financial Reporting Council lately found an “unacceptably high” risk of “material misstatement” on the books of Revolut, another McKinsey super fintech that clocked a private market valuation of $33 billion in 2021. The Revolut app’s forte is seamless, low-commission currency conversions for international travelers. It has also tacked on deposits and credit cards through partnerships with legacy banks and providers.

That’s not to mention China, where authorities have demonstrably clipped the wings of the world’s hottest fintech, Alipay, and reined in private sector rivals as well.

For traditional banks, the great wave of post-2008 regulation is past its crest, says Arthur Long, a partner focused on regulatory issues for fintechs and other financial institutions, at US law firm Latham & Watkins. Institutions have digested new capital and stress-test requirements, as evidenced by their bulging capital ratios. The next frontier in oversight, accounting for climate risk in the loan portfolio, remains over the horizon. “We may have seen a degree of overregulation in the early stages after 2008,” Long says. “Since 2016, it has gotten a bit more in balance.”

Sizing Up Competition

Technology is helping some small banks punch above their weight, particularly in the US, with its legion of 4,400 licensed lenders. Some are using off-the-shelf “banking-as-a-service” technology to expand nationally through a particular industry niche—say, veterinarians or funeral homes—or government agency relationships. An outstanding example is Live Oak Bank, online only and based in Wilmington, North Carolina, which has become the dominant player in funneling Small Business Administration loans. “The pandemic taught community banks how to reach customers without branches, but still embrace their strength in relationship banking,” says Charles Potts, chief innovation officer for the Independent Community Bankers of America.

The larger industry trend is toward bigness, however. McKinsey foresees a shift from “convergent resilience” over the past decade—as banks hoarded capital, then navigated the pandemic—to “divergent growth” going forward. That divergence will favor the large. “We expect scale to matter even more as banks compete on technology,” the McKinsey brain trust finds. “IT investments tend to involve a fixed cost that makes them cheaper over a higher asset or revenue base.”

Star community banks aside, US institutions are back in consolidation mode after a pandemic lull, with some 100 mergers and acquisitions announced in the first half of 2022, by Capgemini’s count.

Europe is inching toward consolidation, too. The biggest deals announced so far are within a single country, as governments remain protective of their national champions. Italy’s top bank, Intesa Sanpaolo, bought UBI Banca for $4.8 billion in mid-2020. In Spain, CaixaBank and Bankia merged to create a new number one.

The current global economic storm—driven by back-from-the-dead inflation, energy-market havoc and malaise in China—may evolve into a crisis that shakes global financial foundations again. But it will be a crisis banks are much better armored against, and one that the abler institutions will not allow to go to waste. If inflation is back, so are margins for long-suffering “bread-and-butter” bank lending. Falling stock markets have hit much harder at new-breed fintechs than old-guard financial houses. The disrupters have lost funding runway and market momentum, and are rapidly losing their free pass from regulators.

All that is creating some boom-time opportunities for establishment banks, even as the world economy heads more toward bust. Grabbing them will require good guesses on the emerging sweet spots where technology meets income streams, and some good luck with the macro and regulatory backdrop. “There are a lot of untapped opportunities out there, particularly in Asia,” Simon-Kucher’s Baumgarten says. “But you could lose a lot of money with the wrong approach.”