Asia Pacific banking continues to be in the spotlight due to its attractive outlook relative to other regions but lower growth, higher risk cost provisions, and need for scale are factors that could cause return on equity to plummet in the coming years, according to a report by McKinsey.

In 2018, Asia Pacific banking generated approximately $1.6 trillion in revenue and $700 billion in profits before tax, representing 37 percent of the global banking profits, according to McKinsey’s «Panorama Global Banking Pools». Despite continued growth, the report highlights headwinds ahead, typical of mature markets that will challenge the sector: slowing growth, thinning margins, higher capital requirements and the need to build scale. 

Between 2010 and 2014, regional banks posted double-digit annual revenue growth. From 2014 to 2018, this growth slowed to 5 percent with profit pools slowing to 3 percent. Macroeconomic factors aside, the report also underlines market-specific developments evidenced by higher risk-cost provisions from non-performing loans in the region.

The average emerging market risk-cost provision spiked to 0.49 in 2019 (compared to 0.43 in 2015) with particularly high rates in Indonesia, Thailand, Vietnam and, especially, India non-performing loans accounted for 11.7 percent of loans in 2018. Even in the broader region, risk-cost provision reached 0.3 percent, the highest since 2002’s 0.31 percent.

Tech Disruptors

Consequently, return on equity (ROE) has been significantly hit and could trend lower. Average ROEs in APAC banking decreased from 12.4 percent in 2010 to 10.1 percent in 2018. McKinsey estimates that this figure could drop to as low as 6.4 percent by 2023.

The report stresses that the ROE outlook is very dependent on regulators' posture towards non-bank innovators. «We estimate if regulators maintain a cautious posture toward non-bank innovators during a period of weak growth, banking ROEs in Asia-Pacific could decline to 9.8 percent by 2023,» the report added. «However, if low-cost digital-first banks can build scale rapidly and take significant market share from incumbents, ROE could drop to 6.4 percent in 2023.»

Success Stories

But the downtrend is not absolute. Should an industry-wide effort take place to optimize operations, risk and capital costs, a decline in returns could be reversed a push ROEs to 12.1 percent by 2023. 

«Banks that fail to improve productivity, optimize capital consumption, and revitalize revenue growth may see their ROE drop below the cost of capital, leading, in turn, to efforts to restructure portfolios or seek a merger partner.»

 The report cites regional success stories such as Yu’e Bao, Ant Financial Service’s digital savings offering, which has grown from $30 billion in assets under management in 2013 to approximately $160 billion in 2018. South Korea’s messaging service KakaoTalk launched KakaoBank of Korea in 2017 and its user base grew to 8 million and assets under management to $10.4 billion within 18 months.

«Scale Matters More Than Ever»

«Historically, there has been a limit to how big an operation could become and still reap scale efficiencies. This has changed, however.» the report said. «Innovations in machine learning, artificial intelligence, and robotics have lifted this limit, launching a new wave in productivity. Scale is back on the agenda, even for the largest, most efficient organizations.»

McKinsey notes that banks that do not take drastic measures to improve efficiency, build scale and develop superior offerings risk disappearing altogether. But this is not to say that there is no place for smaller banks. 

«While the biggest banks will increase their market share, there will always be a role for smaller institutions that offer, for example, high-touch banking and investment for high-net-worth individuals and small and medium-size businesses or a highly efficient everyday banking proposition for underserved market segments,» the report said.