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

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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

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Paranoia or visionary prophecy?

SOURCE: Web search

“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 “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

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The banking system has become “safer”

Total capital (Tier 1) USD billions 2012 1,263 1,162 2010 1,421 2014 2007 995 2005 868 2000 555 1990 18

SOURCE: SNL Financial

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United States banking ROE1, 2000–14E %

SOURCE: Thomson Reuters; McKinsey Panorama—Global Banking Pools 1 Based on a sample of listed banks with >$10 billion in assets.

But returns remain “unsound”

Value creation No value creation

+2.0

0.3

Increasing capital, tax, fines and other costs

0.9

Decreasing cost efficiency

1.4

Risk cost improvement ~0 Margin increase Total ROE change 2013–14E %

Cost of equity

14E 8.0

1.0

17.3

2

2 4 6 8 10 12 14 16 18 20 8.3 2000 06 08 13

0.3

ESTIMATES

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US banking ROEs range between 2.2% and 15.7% regardless of size

2 4 6 8 10 12 14 16 1.4 1.2 1.0 2.4 2.0 1.8 0.4 0.6 0.8 1.6 2.2 0.2 Return on Equity 2014E, Percent Asset size 2014, USD trillion

Individual banks

SOURCE: Thomson Reuters; McKinsey Panorama—Global Banking Pools

ESTIMATES

United States average: 8.0%

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RoE impact of Basel III capital and liquidity proposals Percentage points

Sources: BIS; Bloomberg

▪ “Too big to fail” ▪ “Living wills” ▪ Volcker rule ▪ Central clearing of OTC derivatives ▪ Bank taxes/levies ▪ Accounting ▪ Consumer protection ▪ … Other potential changes not included in modeling2

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

▪ Key question as to where the incidence of regulatory changes will fall, i.e.,: – On customers, through higher loan pricing – On banks, through cost reduction (e.g., compensation, consolidation among small banks) – On shareholders ▪ Analysis does not consider likely business model changes ▪ Even in an environment where banks are better capitalized and more liquid, the reduction in RoE likely to be greater than the reduction in cost of equity 0.8 0.4 0.1 1.5 0.9 0.2 Leverage ratio Increase in capital ratio RWA3 increases Capital deductions Other tier one Historical U.S. average RoE1 11-12 NSFR (when implemented) 8.2 ROE after Basel III RoE after capital and LCR proposals 9.1 LCR

The capital and liquidity proposals are expected to reduce RoE by 300-390 bp, depending on implementation of the NSFR

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| Other: 2.0 Consumer credit: 1.5 Mortgages: 4.4 Bank loans: 2.5 Corporate bonds: 0.8 Government securities: 2.3 Cash: 2.3 Bonds: 0.4 Time & savings deposits: 9.9 Checkable deposits 1.8 Commercial Paper: 0.5 O/N & S/T repos: 0.4 Other: 2.0 Common Equity: 0.9

SOURCE: Federal Reserve Flow of Funds, 4Q 2013, L109 schedule

Aggregated balance sheets of US commercial banks, 4Q 2013 $ Trillions 4Q 2007 balances 4Q 2007 balances Assets Liabilities 15.8 15.8 4Q 2013 balances

And bank balance sheets are undergoing dramatic transformation

0.1 (+2200%) 1.6 (+40%) 1.1 (-30%) 0.2 (+100%) 0.7 (+160%) 0.5 (+85%) 1.1 (+40%) 7.6 (+30%)

2.1

(+20%)

5.0

(-10%) 1.5 (+30%)

1.8

(+11%) 0.8 (-40%) 0.8 (-50%)

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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 Lower mass Mass market Mass affluent Affluent HNW

Revenues Profits SOURCE: McKinsey Panorama - US micro segmentation tool Note: Segment cuts are the following; Lower mass: <$50k, Mass market: $50-200k, Mass affluent: $200k-1M, Affluent: $1-5M, HNW: >$5M

▪

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 33% 55% 7% 1% 3% 3% 2.8 Payments Consumer finance 100% = Mortgage Deposits 0.5 Investments 48% 34% 13% 3% 13% 4.2 0.9 39% 15% 11% 7% 13% 19% 34% 37% 10% 17% 19% 22% 25% 13% 11% 17% 30% 7.5 19% 26% 2.2 6.9 13% 10% 15% 33% 29% 20.7 18% 21% 12% 26% 23% 17% 7% 27% 9% 27% 98.4 31% 29.2 8% 45% 7% 22%

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“Durbin” will have a net negative impact on Debit’s wallet share, impacting the lower mass segment the most

Likely reactions and impact on debit

Source: McKinsey US Payments Map; team analysis

Key provisions in the Durbin amendment Debit interchange rate

▪

Fed to set debit interchange for issuers with more than $10bn in assets at a level reasonable and proportional to issuer transaction-related processing costs Prepaid economics

▪

Prepaid cards are exempt from debit interchange regulation, unless issuers charge cardholders overdraft fees or a fee for the first in-network ATM withdrawal per month Network exclusivity

▪

Debit card issuers must issue cards that allow authorization via more than one network

perator (i.e., prohibits Visa- and Interlink-only

debit cards)

▪

Network agreements cannot restrict merchant’s routing of debit authorizations (e.g., prohibits priority routing mandates on cards with many PIN networks) Merchant steering

▪

Eliminates any restrictions on merchants to discount based on any method of payment; upholds network rules prohibiting discrimination by issuer

▪

Merchants may set a $10 minimum for credit card purchases (governments and universities may also set a maximum)

▪

Issuers steer consumers away from debit to higher interchange instruments (credit, charge cards)

▪

Elimination of debit rewards pushes transactors to credit where rewards still proliferate

▪

Increased DDA costs to consumers due to decreased interchange revenue will increase unbanked population, and thus, decrease number of potential debit users

▪

Targeted merchant steering to debit (i.e., offering discount coupons particularly to customers that have used credit in the past)

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Product Student-centric product National banks Regional banks Community/ credit unions * Free with stipulations product Enhanced checking with added features Interest-bearing product Tiered-interest premium product Free checking

Source: FI literature; McKinsey payments practice * Bank of America offers free checking if the account is opened online Key trend

National banks are replacing free checking with ‘free with stipulations’ products, while smaller banks have kept these free (thus far)

Percentage of free checking accounts fell from ~75% in 2009 to ~35% in 2012

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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 7.7 8.2 7.6 20.0 20.1 17.7 2011 2009 2013 25.3% 28.3% 27.7%

Under-banked Unbanked

SOURCE: FDIC National Survey of UnBanked and UnderBanked Households, 2009, 2011, 2013

Total xx

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Moreover, credit for lower mass segment has declined by 20% since the new regulations

SOURCE: Survey of Consumer Finance 2013

22.1 27.7 2007 21.5 2004 19.5 2001 15.1 2013 2010 Debt per household for lower mass segment (income <30k$) $’000 per household

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Access to credit has fallen for both the near- prime and sub-prime segments since 2009

SOURCE: CFLS data from GCI

49 2 6 10 45 39 4 6 5 42

20%

+100% 0%

50%
7%

45 1 5 20 44 42 1 4 14 52

7%

0%

20%
30%

+18%

2009 2013

44 5 8 8 31 30 5 6 4 25 Payday loans Installment loans HEL/ HELOC Credit cards

32%

0%

25%
50%
19%

Others

▪ Increase in credit

card usage, as an alternative for the reduction in HE credit

▪ Reduction in access

to most forms of credit; alternative forms (installment, payday) held steady

▪ Significant reduction

in access to all forms

f credit

Prime (>650 FICO score) Near-prime (600-649 FICO score) Sub-prime (<600 FICO score) Population using the product, percent Takeaways Segment

RESULTS BASED ON MCKINSEY SURVEY OF 1,500 CONSUMERS

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P2P lending has grown over 90% p.a. since 2008 with the number of loans growing more than 10x and loan sizes doubling

U.S. Peer to peer (P2P) lending volume, 2008-19 600 900 400 1,100 200 1,300 1,200 1,500 1,000 1,700 800 100 700 300 500 1,400 1,600 2008 19P 18P 17P 16P 15P 14P 13 12 11 10 09 $, Million

1 Return on Tangible Equity

Number

f loans

13,900 Average loan size, $ 6,400 7,300 8,400 18,200 8,400 32,900 10,000 72,900 11,900 178,000 13,600 94 30

SOURCE: The Finovate Group: Online Banking Report forecast, Jan 2014

CAGR, % 2008-13 2014-19 xx xx

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Post crisis, average share prices of shadow banks have increased by nearly 20% p.a. since 2008, compared to 6% for banks

Weighted average share price of US financial institutions $, per share1 18.0% CAGR, 2008-13 5.7% 10 20 30 40 50 60 70 80 90 100 110 Banks Shadow banks 2013 12 11 10 09 2008 2007

SOURCE: FDIC 1 Based on Q4 data for each year; weights for each bank/shadow bank based on proportion of total assets relative to the industry (in 2013)

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Banking matters: GDP growth is correlated with private- sector financing

X axis: Change in household and corporate debt and book equity as a share of GDP (t-1) Y axis: Nominal GDP growth (t) (%)

1 Emerging markets excluding China shows correlation of 0.66 and a slope of 0.20. NOTE: Not to scale. SOURCE: McKinsey Global Institute Financial Assets Database; McKinsey Global Institute analysis

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2 4 6 30 25 20 15 10 5

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5 10 15 20 30 25 20 15 10 5

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2 4 6 8

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30 -25 -20 -15 -10
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5 10 15 20 25 30 World United States Western Europe Emerging markets1 0.64 0.09 0.83 0.13 0.81 0.23 0.70 0.07 Correlation Slope of regression line

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Key contributions of the financial sector to the economy and society

Trade, payments and transactions

▪ A robust banking system has enabled society to move beyond the

barter system for transactions and payments

▪ Moreover, international payment systems (backed by banks) enable

cross-border trade, remittances and financial market transactions in large volumes at low unit transaction costs Risk management

▪ The banking system enables businesses and households to pool

their risks from exposures to financial market and commodity price risks, mostly through derivatives transactions Credit and financing

▪ Banks significantly boost economic activity by supporting individual

household investments (e.g., buying a home) and offering credit to businesses to invest beyond their liquid resources Savings and liquidity

▪ Banks facilitate savings through deposits, and protect businesses

and households against unexpected needs for cash Employment provider

▪ The financial sector is one of the main providers of employment in

the economy (e.g., 5-6% U.S. workforce is employed in the financial sector) Role of Banking