Outlook for western banks – still bad

I’ve written before about the dismal outlook for the western banks, suffering from overcapacity, increasing regulation and slow GDP growth (or continued contraction in the case of much of Europe). A new McKinsey report reinforces my pessimism.

In particular McKinsey emphasise the need for a sharp drop in the cost to income ratio for the capital markets businesses, loosely the investment banking business. Despite large layoffs in recent years, the cost income ratio still needs to fall from 68% in 2011 to 46% in Europe and to 51% in the USA, to achieve a reasonable return on equity (ROE) of 12%. Currently banks are achieving well below their cost of equity, which is one reason why their shares are trading far below book value. (The other reason, especially in Europe, is that markets doubt that the assets are worth their book value, an argument made in the Bank of England’s November 2012 Financial Stability Report). All of this entails further large cuts in labour costs.

Things could improve in some areas. Higher interest rates would tend to raise bank profitability, at least for banks that rely heavily on bank deposits, as the rates they pay to depositors tend to rise less than what they charge borrowers i.e. the spread rises. And there are opportunities for technology to reduce the cost of both retail and investment banking. But much of those improvements (e.g. reducing the branch network as people use online banking) have already happened. And cuts in trading costs arising from replacing traders with algorithms tend to be passed on to customers through lower commissions.

So in the west, and particularly Europe, the outlook for employment in banking remains poor, in the absence of a vigorous macroeconomic recovery that would trigger equity raising, M&A and a rise in borrowing. Regrettably, for students seeking jobs, that doesn’t seem imminent.

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