Global Banking Annual Review 2023: The Great Banking Transition

Banking has had to chart a challenging course over the past few years, during which institutions faced increased oversight, digital innovation, and new competitors, and all at a time when interest rates were at historic lows. The past few months have also brought their share of upsets, including liquidity woes and some bank failures. But, broadly speaking, a favorable wind seems to have returned to the industry’s sails. The past 18 months have been the best period for global banking overall since at least 2007, as rising interest rates have boosted profits in a more benign credit environment.

Below the surface, too, much has changed: balance sheet and transactions have increasingly moved out of traditional banks to nontraditional institutions and to parts of the market that are capital-light and often differently regulated—for example, to digital payments specialists and private markets, including alternative asset management firms. While the growth of assets under management outside of banks’ balance sheets is not new, our analysis suggests that the traditional core of the banking sector—the balance sheet—now finds itself at a tipping point. Given the size of this movement, we have broadened the scope of this year’s Global Banking Annual Review to define banks as including all financial institutions except insurance companies.

In this year’s review, we focus on this “Great Banking Transition,” analyzing causes and effects and considering whether the improved performance in 2022–23 and the recent rise in interest rates in many economies could change its dynamics. To conclude, we suggest five priorities for financial institutions as they look to reinvent and future-proof themselves. The five are: exploiting leading technologies (including AI), flexing and potentially even unbundling the balance sheet, scaling or exiting transaction business, leveling up distribution, and adapting to the evolving risk landscape.

All financial institutions will need to examine each of their businesses to assess where their competitive advantages lie across and within the three core banking activities of balance sheet, transactions, and distribution. And they will need to do so in a world in which technology and AI will play a more prominent role, and against the backdrop of a shifting macroeconomic environment and heightened geopolitical risks.

The past 18 months brought banks their highest highs and lowest lows

The recent upturn arises from the sharp increase in interest rates in many advanced economies, including a 500-basis-point rise in the United States. The higher interest rates enabled a long-awaited improvement in net interest margins, which boosted the sector’s profits by about $280 billion in 2022 and lifted return on equity (ROE) to 12 percent in 2022 and an expected 13 percent in 2023, compared with an average of just 9 percent since 2010 (Exhibit 1).

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Over the past year, the banking sector has continued its journey of continuous cost improvement: the cost-income ratio dropped by seven percentage points from 59 percent in 2012 to about 52 percent in 2022 (partially driven by margin changes), and the trend is also visible in the cost-per-asset ratio (which declined from 1.6 to 1.5).

The ROE growth was accompanied by volatility over the past 18 months. This contributed to the collapse or rescue of high-profile banks in the United States and the government-brokered takeover of one of Switzerland’s oldest and biggest banks. Star performers of past years, including fintechs and cryptocurrency players, have struggled against this backdrop.

Performance varied widely within categories. While some financial institutions across markets have generated a premium ROE, strong growth in earnings, and above-average price-to-earnings and price-to-book multiples, others have lagged (Exhibit 2). While more than 40 percent of payments providers have an ROE above 14 percent, almost 35 percent have an ROE below 8 percent. Among wealth and asset managers, who typically have margins of about 30 percent, more than one-third have an ROE above 14 percent, while more than 40 percent have an ROE below 8 percent. Bank performance varies significantly, too. These variations indicate the extent to which operational excellence and decisions relating to cost, efficiency, customer retention, and other issues affecting performance are more important than ever for banking. Strongest performers tend to use the balance sheet effectively, are customer centric, and often lead on technology usage.

The geographic divergence we have noted in previous years also continues to widen. Banks grouped along the crescent formed by the Indian Ocean, stretching from Singapore to India, Dubai, and parts of eastern Africa, are home to half of the best-performing banks in the world (Exhibit 3). In other geographies, many banks buoyed by recent performance are able to invest again. But in Europe and the United States, as well as in China and Russia, banks overall have struggled to generate their cost of capital.

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One aspect of banking hasn’t changed, however: the price-to-book ratio, which was at 0.9 in 2022. This measure has remained flat since the 2008 financial crisis and stands at a historic gap to the rest of the economy—a reflection that capital markets expect the duration-weighted return on equity to remain below the cost of equity. While the price-to-book ratio reflects some of the long-term systematic challenges the sector is facing, it also suggests the possible upside: every 0.1-times improvement in the price-to-book ratio would cause the sector’s value added to increase by more than $1 trillion.

Looking to the future, the outlook for financial institutions is likely to be especially shaped by four global trends. First, the macroeconomic environment has shifted substantially, with higher interest rates and inflation figures in many parts of the world, as well as a possible deceleration of Chinese economic growth. An unusually broad range of outcomes is suddenly possible, suggesting we may be on the cusp of a new macroeconomic era. Second, technological progress continues to accelerate, and customers are increasingly comfortable with and demanding about technology-driven experiences. In particular, the emergence of generative AI could be a game changer, lifting productivity by 3 to 5 percent and enabling a reduction in operating expenditures of between $200 billion and $300 billion, according to our estimates. Third, governments are broadening and deepening regulatory scrutiny of nontraditional financial institutions and intermediaries as the macroeconomic system comes under stress and new technologies, players, and risks emerge. For example, recently published proposals for a final Basel III “endgame” would result in higher capital requirements for large and medium-size banks, with differences across banks. And fourth, systemic risk is shifting in nature as rising geopolitical tensions increase volatility and spur restrictions on trade and investment in the real economy.

The Great Transition for the balance sheet, transactions, and payments has gained momentum

In this context, the future dynamics of the Great Transition are critical for the banking sector overall. Evidence of the transition’s profound effect on the sector to date abounds. For example, between 2015 and 2022, more than 70 percent of the net increase of financial funds ended up off banking balance sheets, held by insurance and pension funds, sovereign wealth funds and public pension funds, private capital, and other alternative investments, as well as retail and institutional investors (Exhibit 4).

The shift off the balance sheet is a global phenomenon (Exhibit 5). In the United States, 75 percent of the net increase in financial funds ended up off banking balance sheets, while the figure in Europe is about 55 percent.

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The growth of private debt is another manifestation of the transition away from traditional financial institutions. Private debt saw its highest inflows in 2022, with growth of 29 percent, driven by direct lending.

Beyond the balance sheet, transactions and payments also are shifting. For example, consumer digital payment processing conducted by payments specialists grew by more than 50 percent between 2015 and 2022 (Exhibit 6).

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The oscillating interest rate environment will affect the Great Transition, but exactly how remains to be seen. We may be going through a phase in which a long-term macroeconomic turning point—including a higher-for-longer interest rate scenario and an end to the asset price super cycle—changes the attractiveness of some models that were specifically geared to the old environment, while other structural trends, especially in technology, continue. Fundamentally, the question for banks is to what extent they can offer the products in high demand at a time when risk capacity is broadening and many clients and customers are searching for the highest deposit yields.

Focusing on five priorities can help banks capture the moment

Regardless of the macroeconomic developments, financial institutions will have to adapt to the changing environment of the Great Transition, especially the trends of technology, regulation, risk, and scale. Mergers and acquisitions may gain importance.

As financial institutions consider how they want to change, we outline five priorities which, though not an exhaustive list, can serve as thought starters (Exhibit 7).

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1. Exploit technology and AI to improve productivity, talent management, and the delivery of products and services. This includes applying AI and advanced analytics to deploy process automation, platforms, and ecosystems. Other principles associated with success include operating more like a tech company to scale the delivery of products and services; cultivating a cloud-based, platform-oriented architecture; and improving capabilities to address technology risks. Distinctive technology development and deployment will increasingly become a critical differentiator for banks.
2. Flex and even unbundle the balance sheet. Flexing implies active use of syndication, originate-to-distribute models, third-party balance sheets (for example, as part of banking-as-a-service applications), and a renewed focus on deposits. Unbundling, which can be done to varying degrees and in stages, pushes this concept further and can mean separating out customer-facing businesses from banking as a service and using technology to radically restructure costs.
3. Scale or exit transaction business. Scale in a market or product is a key to success, but it can be multifaceted. Institutions can find a niche in which to go deep, or they can look to cover an entire market. Banks can aggressively pursue economies of scale in their transactions business, including through M&A (which has been a major differentiator between traditional banks and specialists) or by leveraging partners to help with exits.
4. Level up distribution to sell to customers and advise them directly and indirectly, including through embedded finance and marketplaces and by offering digital and AI-based advisory. An integrated omnichannel approach could make the most of automation and human interaction, for example. Deciding on a strategy for third-party distribution—which could be via partnerships to create embedded finance opportunities or platform-based models—can create opportunities to serve customer needs including with products outside the institution’s existing business models.
5. Adapt to changing risks. Financial institutions everywhere will need to stay on top of the ever-evolving risk environment. In the macroeconomic context, this includes inflation, an unclear growth outlook, and potential credit challenges in specific sectors such as commercial real estate exposure. Other risks are associated with changing regulatory requirements, cyber and fraud risk, and the integration of advanced analytics and AI into the banking system. To manage these risks, banks could consider elevating the risk function to make it a true differentiator. For example, in client discussions, product design, and communications they could highlight the bank’s resilience based on its track record of managing systemic risk and liquidity. They could also further strengthen the first line and embed risk in day-to-day activities, including investing in new risk activities driven by the growth of generative AI. Underlying changes in the real economy will likely continue in unexpected ways, requiring banks to remain ever more vigilant.

All these priorities have significant implications for financial institutions’ capital plans, including the more active raising and return of capital. As financial institutions reexamine their businesses and identify their relative competitive advantages in each of the balance sheet, transactions, and distribution components, they will need to ensure that they are positioned to generate adequate returns. And they will need to do so in a very different macroeconomic and geopolitical environment and at a time when AI and other technologies are potentially changing the environment and with a broader set of competitors. Scale and specialization will be determinant, as will value-creating diversification. Minimum economies of scale are also likely to shift, especially where technology and data are the drivers of scale. The years ahead will likely be more dynamic than the immediate past, with the gap between winners and losers increasing even more. Now is the time to begin charting the path forward.