Why It’s Time for Banks to Make Bold Late-Cycle Moves

An economic downturn is approaching on the horizon. Amid low interest rates and a manufacturing slowdown, industries and investors alike are scrambling to prepare as the window of opportunity closes.

Banking is no different. After a decade of expansion, the industry is showing many signs of a late-cycle economy. On top of this, a staggering 60% of banks are destroying value. Today’s infographic from McKinsey & Company explores the steps banks can immediately take to succeed in the next economic cycle.

How is Value Created?

In the banking sector, three main factors contribute to value creation:

• The location of the bank
• The scale of its operations
• The effectiveness of its business model

Given that geographic reach is mostly out of a bank’s control, and scale takes time to build, banks must focus on their business model.

There are three universal business model levers that all banks can immediately act on to change their destiny.

1. Risk Management
Banks can protect returns in an economic downturn by managing risk. For example, new machine-learning models can predict the riskiest customers with 35 percentage points more accuracy than traditional models.

2. Productivity
To radically reduce costs, banks can transfer non-differentiating activities to third-party “utilities”, through outsourcing, carve-outs, or partnerships. This has the potential to increase return on equity by as much as 100 basis points.

3. Revenue Growth
When customers are satisfied, they generate more value for banks—and vice versa. For instance, customers who report low satisfaction with their mortgage experience are almost seven times more likely to refinance with a different bank.

By materially improving decisive points in the customer experience, banks can increase revenue and reduce churn rates within 12-18 months.

The Four Banking Archetypes

Beyond these universal performance levers, a bank should prioritize late-cycle economic decisions based on the archetype it falls under.

• Market leaders are top-performing financial institutions in attractive markets
• Resilients are top-performing operators despite challenging market conditions
• Followers are mid-tier organizations generating returns due to favourable market conditions
• Challenged banks are poor performers in unattractive markets

Different archetypal levers are available depending on each bank’s unique circumstances.

1. Ecosystem
   Banks can find new revenue streams across and beyond banking, leveraging customer relationships and white-label partnerships.
2. Innovation
   Banks can create value by developing new methods, ideas, products and services. To implement this effectively, banks must set goals for the return on innovation as well as the timeframe.
3. Zero-based budgeting
   By justifying expenses for each new period, banks can drastically reduce costs. This involves starting from a “zero base” rather than prior years’ numbers.

Here’s how banks across the various archetypes can take action:

For example, while market leaders’ large capital base is best used for ecosystem and innovation plays, challenged banks need to radically rethink their business model or merge with similar banks.

Reinvent, Scale, or Perish

As the late-cycle economy slows even further, no banks can afford complacency. In fact, history has shown that 35% of market leaders drop to the bottom half of peers in the next cycle.

Now is the time for banks to take bold action through universal and archetypal levers—or risk being left behind.

For a more detailed breakdown of the actions that banks can take in this market environment, check out the full report by McKinsey & Company.

The World’s Most Powerful Reserve Currencies

When we think of network effects, we’re usually thinking of them in the context of technology and Metcalfe’s Law.

Metcalfe’s Law states that the more users that a network has, the more valuable it is to those users. It’s a powerful idea that is exploited by companies like LinkedIn, Airbnb, or Uber — all companies that provide a more beneficial service as their networks gain more nodes.

But network effects don’t apply just to technology and related fields.

In the financial sector, for example, stock exchanges grow in utility when they have more buyers, sellers, and volume. Likewise, in international finance, a currency can become increasingly entrenched when it’s accepted, used, and trusted all over the world.

What’s a Reserve Currency?

Today’s visualization comes to us from HowMuch.net, and it breaks down foreign reserves held by countries — but what is a reserve currency, anyways?

In essence, reserve currencies (i.e. U.S. dollar, pound sterling, euro, etc.) are held on to by central banks for the following major reasons:

• To maintain a stable exchange rate for the domestic currency
• To ensure liquidity in the case of an economic or political crisis
• To provide confidence to international buyers and foreign investors
• To fulfill international obligations, such as paying down debt
• To diversify central bank portfolios, reducing overall risk

Not surprisingly, central banks benefit the most from stockpiling widely-held reserve currencies such as the U.S. dollar or the euro.

Because these currencies are accepted almost everywhere, they provide third-parties with extra confidence and perceived liquidity. This is a network effect that snowballs from the growing use of a particular reserve currency over others.

Reserve Currencies Over Time

Here is how the usage of reserve currencies has evolved over the last 15 years:

Over this timeframe, there have been small ups and downs in most reserve currencies.

Today, the U.S. dollar is the world’s most powerful reserve currency, making up over 61% of foreign reserves. The dollar gets an extensive network effect from its use abroad, and this translates into several advantages for the multi-trillion dollar U.S. economy.

The euro, yen, and pound sterling are the other mainstay reserve currencies, adding up to roughly 30% of foreign reserves.

Finally, the most peculiar data series above is “Other”, which grew from 2.0% to 8.4% of worldwide foreign reserves over the last 15 years. This bucket includes the Canadian dollar, the Australian dollar, the Swiss franc, and the Chinese renminbi.

Accepted Everywhere?

There have been rumblings in the media for decades now about the rise of the Chinese renminbi as a potential new challenger on the reserve currency front.

While there are still big structural problems that will prevent this from happening as fast as some may expect, the currency is still on the rise internationally.

What will the composition of global foreign reserves look like in another 15 years?