Despite solid margin growth, more than half of the world’s banks continue to experience profitability problems and a return on equity that is below their cost of equity, according to the 12th edition of the McKinsey Global Annual Banking Review. This is also the case for many banks in Romania, which could face significant challenges in a future period of uncertainty when European returns on equity could fall below 6%, according to the report.
In this context, Romanian banks will be forced to apply resilience measures and fundamentally rethink their business model. Most of them still follow the universal bank model, but currently generate an adequate ROE (return on equity) of over 12% only for the top five banks in the Romanian banking system.
In the short term, banks need to prepare for a period that requires them to adopt measures focused on resilience (financial, digital & technological and organizational). In this way, local players will be able to position themselves in a sufficiently strong position in the future, mitigating the economic impact.
In the long term, they need to invest in strategic priorities that can really improve the business model and revitalize profitability. While the opportunities are vast, from competing effectively in online banking to funding sustainable projects or offering additional services that create active customer engagement, the effort can be significant. Locally, more than 85% of players need to make these investments while also focusing on the viability of their business model that struggles to generate ROE above the cost of equity. In this respect, it remains to be seen how many Romanian banks will manage to reinvent themselves and adopt a business model that will ensure a competitive advantage in the future.
Romanian banks struggled to return the cost of equity even during the years of growth
Banks worldwide rebounded strongly from the pandemic with an average ROE (return on equity) of 12%. In Romania, banks recorded revenues of EUR 130 Bn in 2021, up 12.5% from 2020 and profitability reached a record high with a 13.5% ROE in 2021, exceeding the CEE average by 4.4%. Propelled by a sharp increase in interest rates, ROE in Q3 2022 (16.6%) proved to be even higher than the same period in 2021 (13.6%), according to the National Bank of Romania.
More than half of the world’s banks continue to have a return on equity that is below the cost of equity (9-11%), and the recent margin increases delivered returns above the cost of equity for just 35% of banks globally. This is also the case for many Romanian banks which have been struggling to return the cost of equity even during the recent years of growth.
Amid a period of economic uncertainty, Romanian banks will face fundamental challenges
The boost to profitability from higher margins may prove transitory, and the divergence between banks will widen further. While most banks face a long-term growth slowdown, European ones may face a bleaker outlook: in the event of a long recession, the McKinsey report estimates that bank’s ROE could fall below 6%. Considering a global cost of equity between 9-11% (and even higher ranges for Romanian banks), this poses fundamental challenges to local players.
The impact could be significant for the Romanian banking sector, where ~65% of revenues are generated by interest, compared to the European average of ~55%, and the top ten players in the sector (out of 34) account for ~86% of market assets. In addition, most still follow the universal bank model but currently generate an adequate ROE of over 12% only for the top five banks in the Romanian banking system.
“The big question is what will happen to these local market leaders if faced with a slowdown in volume growth and higher costs. To pass any recession in a strong enough position, Romanian banks should play both defense (applying resilient-focused measures) on the short-term, but also offense (accelerating digital aspirations to enhance value proposition)”, states Ovidiu Tișler, Associate Partner at McKinsey & Company in Bucharest.
Out of the four key types of resilience identified by the McKinsey report – financial, operational, digital & technological, and organizational – the first and last two seem highly relevant for the Romanian banking sector:
- Financial: Romanian players need to ensure a net income structure with lower sensitivity to interest rates. They should also aim for a cost-to-income ratio below 40%, an ambitious target compared to the ~54% cost-to-income achieved by Romanian banks in 2021.
- Digital & technological: Banks should continue laying strong digital foundations and focus on addressing the customer growing demand for digital services. In 2021, Romania had the 2nd highest share of customers (27%) that had recently started using digital banking services (vs. 20% in CEE), with most of the digital traction being driven by mobile activity, according to the ‘Digital Sentiment Survey’ by McKinsey. In the short-term, Romanian banks should facilitate the transition towards more digital customer journeys by focusing, for instance, on advanced products (non-life insurance, loans) where branches remain the main channel to drive sales.
- Organizational: Banks that perform best will be those who embed agility in their day-to-day operations and decision-making processes as well as those that have rapid reaction times and invest in attracting, reskilling, and retaining the best talent.
In the long-run, banks will need to refocus their strategy to strengthen the foundations of their growth. Differentiated value propositions will be key to create enhanced business models that revitalize profitability. Future opportunities include sustainable finance, which is on the cusp of a “next era” as banks finance not just green energy but a much wider range of projects across all industry sectors. This creates remarkable opportunities, including for the Romanian banking sector, where only one of the 34 banks is active in sustainable debt issuance like green bond.
However, the effort will be significant as over 85% of players locally need to make these investments and focus on the viability of their business model, which struggles to generate an ROE above the cost of equity. The current context, therefore, offers Romanian banks the opportunity to choose between continuing with the universal bank model or adopting a strategy focused on specific segments or products (e.g. exclusively serving the digital segment through online lending or SMEs through working capital). It remains to be seen how many Romanian banks will manage to reinvent themselves and adopt a business model that will ensure a competitive advantage in the future.
“Regarding the very dinamic market conditions, the need for digitisation generating hard-to-sustain investment, and the battle to attract high-calibre employees intensifying further, it remains to be seen to what extent banks outside the top ten will be able to lay the foundations for long-term growth. What is certain is that maintaining the universal bank model that most follow is inadequate for ensuring profitability and building a solid foundation for growth. It is time for banks to rethink their strategy,” adds Ovidiu Tișler.