Falling profits signal radical changes for retail banks

Falling profits signal radical changes for retail banks

Over the past two decades, leading retail banks enjoyed enjoyed significant returns on equity, at levels that they are unlikely to see again.

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Falling profits signal radical changes for retail banks

Over the past two decades, leading retail banks enjoyed returns on equity averaging 24 per cent, a level that they are unlikely to see again.

Even before regulators impose changes that probably will reduce returns, the economic slump will have knocked away many of the struts that supported earnings growth.

Profits are apt to shrink across all key lines of business over the next three or four years. Based on a range of scenarios we have examined, banks' return on equity will decline by at least seven percentage points from its pre-recession peak. Troubled mortgage books will continue to depress earnings and spreads will shrink. Savings-account profits will decline as banks compete for depositors to strengthen their balance sheets. Making money on unsecured loans and credit cards will continue to be a challenge.

New regulation will further reduce profits. Proposals contained in the Turner Report would set clear limits on leverage and wholesale funding to guard against systemic risk and increase reserve requirements to shore up liquidity. On the customer side, scrutiny in favour of the consumer will increase across the board. Our analysis indicates that the tougher regulatory regime could reduce sector returns by at least five additional percentage points.

Compounding these pressures, banks' cost of equity has soared, from around 10 per cent a year ago to about 15 per cent today. While this should ease gradually, banks can expect to pay an excess risk premium of two or three percentage points for several years.

The spread between equity returns and the cost of equity could drop, therefore, from around 13 percentage points to near zero or below. This would tip economic profits into negative territory, making retail banking businesses worth less than the capital put into them. These numbers should give serious cause for thought to shareholders of businesses such as Tesco that are considering large-scale entry into banking.

These effects are already starting to show through in performance. In recent results announcements, British retail banks' key ratios have suffered, with net interest margins reduced by up to 60 basis points. Falling incomes of around 10 per cent have outpaced efficiency gains, with cost-to-income ratios increasing as a result by between five and eight percentage points.

To claw back lost earning power, banks will need to consider radical changes. They may need to end the practice of offering free current accounts, to reintroduce fees for all customers and to strip out the costly complexity that built up in the boom years. As they tighten lending practices and price for profitability, they need to sharpen their focus on their most profitable customers.

Banks will also need to consider substantially shrinking their branch networks. By our analysis, many banks could close up to one third of their branches, regulators permitting, and reorient the remainder to focus more on increasing sales. Most importantly, they will have to relearn the old art of allocating scarce capital to the highest-value areas of return.

Matt Symonds is a partner in the global financial services practice at Bain & Company and leads the UK Retail Banking practice.


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