Can the Financial Sector Promote Growth and Stability? Presentation - PowerPoint PPT Presentation

Can the Financial Sector Promote Growth and Stability? Presentation to the Brookings Institution June 8, 2015 CONFIDENTIAL AND PROPRIETARY Any use of this material without specific permission of McKinsey & Company is strictly prohibited

Paranoia or visionary prophecy? “I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale” – Thomas Jefferson “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning” – Henry Ford | SOURCE: Web search McKinsey & Company 2

The banking system has become “safer” Total capital (Tier 1) USD billions 1,421 1,263 1,162 995 868 555 18 1990 2000 2005 2007 2010 2012 2014 | SOURCE: SNL Financial McKinsey & Company 3

But returns remain “unsound” ESTIMATES ROE change 2013–14E United States banking ROE 1 , 2000–14E % % Value creation 20 No value creation Margin 17.3 18 +2.0 increase 16 14 Risk cost ~0 improvement 12 Cost of equity 10 Decreasing cost 8.3 -1.4 efficiency -0.3 8 8.0 6 Increasing capital, tax, fines and other -0.9 4 costs 2 Total -0.3 0 -1.0 -2 14E 2000 06 08 13 1 Based on a sample of listed banks with >$10 billion in assets. | SOURCE: Thomson Reuters; McKinsey Panorama—Global Banking Pools McKinsey & Company 4

US banking ROEs range between 2.2% and 15.7% regardless of size ESTIMATES Return on Equity 2014E, Percent Individual banks 16 14 12 10 United States average: 8.0% 8 6 4 2 0 0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 Asset size 2014, USD trillion | SOURCE: Thomson Reuters; McKinsey Panorama—Global Banking Pools McKinsey & Company 5

The capital and liquidity proposals are expected to reduce RoE by 300-390 bp, depending on implementation of the NSFR RoE impact of Basel III capital and liquidity proposals Percentage points ▪ Key question as to where Historical U.S. 11-12 the incidence of regulatory average RoE 1 changes will fall, i.e.,: Other tier one 0.2 – On customers, through higher loan pricing Capital deductions 0.9 – On banks, through cost reduction (e.g., 1.5 RWA 3 increases compensation, consolidation among 0.1 Increase in capital ratio small banks) – On shareholders Leverage ratio 0 0.4 LCR ▪ Analysis does not consider likely business model RoE after capital 9.1 changes and LCR proposals 0.8 NSFR (when implemented) ▪ Even in an environment where banks are better ROE after Basel III 8.2 capitalized and more liquid, ▪ ▪ Bank taxes/levies the reduction in RoE likely to Other potential “Too big to fail” ▪ ▪ changes not “Living wills” Accounting be greater than the reduction ▪ ▪ included in Volcker rule Consumer protection in cost of equity ▪ ▪ modeling 2 Central clearing of OTC derivatives … 1 Using consensus 2012 analyst forecasts does not materially change the results 2 See separate material on Dodd-Frank for other regulatory changes 3 Risk weighted assets Sources: BIS; Bloomberg McKinsey & Company 6 6 6 6 6

And bank balance sheets are undergoing dramatic transformation Aggregated balance sheets of US commercial banks, 4Q 2013 $ Trillions 4Q 2013 balances 4Q 2007 4Q 2007 balances Assets Liabilities balances O/N & S/T repos: 0.4 0.8 0.1 Cash: 2.3 Commercial Paper: 0.5 (-50%) (+2200%) Checkable deposits 1.8 1.6 0.8 Government securities: (+40%) (-40%) 2.3 1.1 0.7 Corporate bonds: 0.8 (-30%) (+160%) 2 .1 Bank loans: 2.5 7.6 (+20%) Time & savings (+30%) deposits: 9.9 5.0 Mortgages: 4.4 (- 10 %) 0.2 (+100%) 1.1 Bonds: 0.4 Consumer credit: 1.5 (+40%) 1.8 Other: 2.0 (+11%) 1.5 Other: 2.0 0.5 Common Equity: 0.9 (+30%) (+85%) 15.8 15.8 | SOURCE: Federal Reserve Flow of Funds, 4Q 2013, L109 schedule McKinsey & Company 7

Customer View Credit drives bank profits from lower-income households, while deposits and investments drive profits from more affluent households Bank revenues and profits by customer segmentation $ per H.H, 2013 Revenues Profits 2.8 0.5 100% = 20.7 4.2 0.9 7.5 2.2 6.9 98.4 29.2 3% 3% Deposits 1% 3% 10% 13% 7% 17% 17% Investments 19% 23% 13% 27% 7% 29% Payments 13% 11% 17% 22% 25% 34% 26% 19% Consumer 55% 13% finance 7% 31% 33% 37% 15% 19% 12% 22% 9% 11% 45% 15% 21% 48% 27% 39% 10% 34% Mortgage 33% 30% 26% 18% 13% 8% 7% Lower mass Mass market Mass affluent Affluent HNW ▪ Credit (i.e., payments, consumer finance, and mortgages) are the drivers of profit for lower mass/mass households ▪ Deposits and investments are the drivers of profit for more affluent households Note: Segment cuts are the following; Lower mass: <$50k, Mass market: $50-200k, Mass affluent: $200k-1M, Affluent: $1-5M, HNW: >$5M | SOURCE: McKinsey Panorama - US micro segmentation tool McKinsey & Company 8

“Durbin” will have a net negative impact on Debit’s wallet share, impacting the lower mass segment the most Key provisions in the Durbin amendment Likely reactions and impact on debit ▪ Debit in- Fed to set debit interchange for issuers with ▪ Increased DDA costs to consumers terchange more than $10bn in assets at a level due to decreased interchange revenue rate reasonable and proportional will increase unbanked population, and to issuer transaction-related processing costs thus, decrease number of potential debit ▪ Prepaid Prepaid cards are exempt from debit users economics interchange regulation, unless issuers charge cardholders overdraft fees or a fee for the first ▪ Elimination of debit rewards pushes in-network ATM withdrawal per month transactors to credit where rewards still ▪ Network Debit card issuers must issue cards that allow proliferate exclusivity authorization via more than one network operator (i.e., prohibits Visa- and Interlink-only debit cards) ▪ ▪ Network agreements cannot restrict Issuers steer consumers away from merchant’s routing of debit authorizations debit to higher interchange instruments (credit, charge cards) (e.g., prohibits priority routing mandates on cards with many PIN networks) ▪ Merchant Eliminates any restrictions on merchants to steering discount based on any method of payment ; ▪ Targeted merchant steering to debit upholds network rules prohibiting discrimination (i.e., offering discount coupons by issuer particularly to customers that have used ▪ Merchants may set a $10 minimum for credit credit in the past) card purchases (governments and universities may also set a maximum) Source: McKinsey US Payments Map; team analysis McKinsey & Company 9 9 9 9 9

National banks are replacing free checking with ‘free with stipulations’ Key trend products, while smaller banks have kept these free (thus far) Community/ National banks Regional banks credit unions * Product Student-centric product Free checking Free with stipulations product Enhanced checking with added features Interest-bearing product Tiered-interest premium product Percentage of free checking accounts fell from ~75% in 2009 to ~35% in 2012 * Bank of America offers free checking if the account is opened online McKinsey & Company 10 10 10 10 10 Source: FI literature; McKinsey payments practice

As a result, the unbanked and under-banked U.S. households have increased between 2009 and 2013 Banking Status of U.S. households, 2009-2013 Percentage xx Total Unbanked Under-banked 20.1 20.0 17.7 8.2 7.7 7.6 2009 2011 2013 25.3% 28.3% 27.7% | SOURCE: FDIC National Survey of UnBanked and UnderBanked Households, 2009, 2011, 2013 McKinsey & Company 11

Moreover, credit for lower mass segment has declined by 20% since the new regulations Debt per household for lower mass segment (income <30k$) $’000 per household 27.7 22.1 21.5 19.5 15.1 2001 2004 2007 2010 2013 | SOURCE: Survey of Consumer Finance 2013 McKinsey & Company 12

Access to credit has fallen for both the near- RESULTS BASED ON MCKINSEY 2009 SURVEY OF 1,500 CONSUMERS prime and sub-prime segments since 2009 2013 Segment Population using the product, percent Takeaways ▪ Increase in credit +18% -7% card usage, as an Prime 52 -30% alternative for the 44 45 42 (>650 FICO -20% 0% reduction in HE credit score) 20 14 5 4 1 1 ▪ Reduction in access -20% -7% to most forms of Near-prime 49 credit; alternative 45 42 (600-649 -50% 39 0% +100% forms (installment, FICO score) 10 payday) held steady 6 6 5 4 2 ▪ Significant reduction -32% in access to all forms -19% Sub-prime of credit 44 (<600 FICO -50% -25% 0% 31 30 25 score) 8 8 6 5 5 4 Credit HEL/ Installment Payday Others cards HELOC loans loans | SOURCE: CFLS data from GCI McKinsey & Company 13