Year in Review: Big Profits, but Big Regulatory Fines, Too

The banking industry has never seen it so good. Or has it? Bank earnings have returned to record levels, and average return on equity (ROE) is about what is has been historically. At the same time, regulatory fines are huge and banks are contending with increased regulation like never before. Digitization is providing new opportunities for some banks to cut costs and please customers, and yet the surge in technology startup companies poses special challenges for banks. Because of this, management consulting firm McKinsey & Co. concludes in its 2014 annual review that “those banks that have articulated and executed a regulation-savvy, customer-centric strategy are collecting all the surplus value in the industry.”

Improved Profitability
One of the most impressive trends has been the industry’s return to profitability following the financial crisis six years ago. In 2013, U.S. banks above $10 billion in assets made $114 billion in profits, second only to the record year that was 2007, according to McKinsey.Year-end earnings for the largest banks will be released in the next few weeks, but 2014 is shaping up to top $100 billion in earnings again, says Fritz Nauck, senior partner at McKinsey. Improved credit quality and cost cutting were major drivers of the increased profits. Where is this cost cutting coming from? Many banks are cutting branches. Since 2011, U.S. banks have downsized the industry’s branch network by nearly 5 percent. In 2013 alone, that amounted to 1,300 branches, according to McKinsey.“Should that continue, that will drive future earnings and ROE,’’ Nauck says.

Banks now are close to an historical average ROE of 10 percent, calculated since 1980.

U.S. and Canadian banks are doing better than their European counterparts. The ROE for U.S. and Canadian banks went from 8.4 percent in 2012 to 9.3 percent in 2013 and 9.9 percent in the first half of 2014. For comparison’s sake, Western European banks had an ROE in 2013 of only 2 percent. Credit quality is better in the U.S. than in Europe, plus banks trimmed operating expenses and added capital earlier in the financial crisis than European banks, Nauck says.

Increased Regulation
Fines and settlements, however, have put a damper on the banking world’s profitability, both in Europe and North America, with many of those settlements relating to the financial crisis. The top 15 European banks and top 25 U.S. banks paid $60 billion in fines and settlements combined in the first half of 2014, according to McKinsey. From 2010 to 2014, those banks have paid about $165 billion in fines and settlements, and some of that involves regulators stepping up enforcement in areas not relating to the crisis, including money laundering rules, McKinsey says. Without those fines, the banking industry would have been significantly more profitable. In addition, increased regulation is taking more staff time and more hours out of the executive management team. McKinsey estimates that senior executives spend about 20 to 25 percent of their time on regulatory matters.

Driven to Digitization
The trend toward digitization—connecting with customers through apps and websites as well as automation of transactions and personalization of products and services—is transforming banking. McKinsey estimates that there are now more than 12,000 financial technology startups in existence. Fintech companies such as PayPal were first interested in transactions but many of them are now moving into new areas, including lending.

Interestingly, McKinsey sees fintech companies as more of an opportunity than a threat, because banks can set up joint ventures and sometimes acquire them to deepen and broaden their offerings for customers, just like Spanish bank BBVA did when it acquired the innovative online banking startup Simple in 2014.

Banks that have well defined strategies and execute them effectively are outperforming others, McKinsey says. But as the past year has made clear, banks must respond well to enhanced regulation and have a digital strategy in place to be successful.