Over 50 percent of the world's banks may not be economically viable when a downturn arrives, according to a survey by consultancy firm McKinsey.

A majority of banks' returns on equity are not keeping pace with costs, McKinsey said in its annual review of the industry released Monday. Banks need to take urgent steps for developing technology, farming out operations and bulking up in size through mergers before a potential economic slowdown arrives.

«We believe we’re in the late economic cycle and banks need to make bold moves now because they are not in great shape,» said Kausik Rajgopal, a senior partner at McKinsey, who was quoted in a «Bloomberg» report.

Emerging Market Banks Saw Sliding Returns

In particular, emerging market banks have seen return on tangible equity (ROTEs) decline steeply, from 20 percent in 2013 to 14.1 percent in 2018. This is largely due to digital disruption that continues unabated. Banks in developed markets have strengthened productivity and managed risk costs, lifting ROTE from 6.8 percent to 8.9 percent.

On balance, the global industry approaches the end of the cycle in less than ideal health with nearly 60 percent of banks delivering returns below the cost of equity. «A prolonged economic slowdown with low or even negative interest rates could wreak further havoc,» the report wrote.

Not Allocating Enough to Innovation

Banks set aside just 35 percent of their information-technology budgets to innovation, whereas fintechs spend more than 70 percent, McKinsey notes. The consultancy, whose clients are some of the biggest corporations in the world, said banks risk «becoming footnotes to history» as new entrants change and shape consumer behavior. 

Lenders can lower costs and find funds for technology by outsourcing «non-differentiating activities» including some trading and compliance functions. Banks also need to get much more comfortable with external partnerships and being able to leverage talent externally, Rajgopal added.

Increasingly Conducive for Newer Firms

With looser requirements for new players to enter financial services in various jurisdictions, the environment looks increasingly conducive for newer firms to take a slice of incumbent banks' profits. Amazon in the U.S. and Ping An in China are examples of technology firms that are capturing financial-services customers from banks.

To add salt to the wound, these new players tend to go after the business segments that are most lucrative to the banks. Credit cards and foreign exchange fees are just some examples.

Merge or Disappear ?

Another way to get better, is to get bigger, McKinsey suggested. In the U.S., the merger of BB&T and SunTrust Bank earlier this year speaks volumes about consolidations to come. It is the the biggest U.S. bank merger since the financial crisis.

Rajgopal said he expects M&A to continue in the late cycle. «Going forward, scale will likely matter even more as banks head into an arms race on technology,» the report says.